DECLARATION

I, Khushboo Agrawal, hereby declare that the project work has been carried out through my own efforts and under the guidance of Mr. Taral Pathak and Mr. Mayank Joshipura, faculty of AES PGIBM, Ahmedabad. This project has been submitted as a part of study curriculum of MBA program. The report has not been submitted to any other university.

Signature

ACKNOWLEDGEMENT
It is my great pleasure to present this report. I thank all those people who helped me to make this project, by providing necessary information. I would like to express my gratitude towards Mr. Nayan Thakkar of Kunvarji group who spent his most valuable time and provided with all the necessary details regarding the company. I would also like to thank Ms. Sheetal Panchal and Mr. Kunal Shah, who shared their knowledge and expertise. I would also like to thank Mr. Taral Pathak and Mr. Mayank Joshipura of AESPGIBM for their guidance throughout the preparation of the project and for their valued suggestion. At last I would like to thank all those people who helped me bring this project to fruitism.

Date: Place: Signature

EXECUTIVE SUMMARY
This project mainly focuses on Share market as a whole, its history and development. Herein, I discuss the basic concepts of the share market, what is equity market, commodities market and derivatives market, how they function. It discusses Kunvarji as a stock broking company, and its services. Lastly, it includes an analysis on The Historic Market Crash of May 2006.

KUNVARJI COMMODITIES & FINSTOCK PVT LTD.

The group is doing the business activities in the field of Shares and Stock for more than 10 years and in the field of Commodities for more than 2 year. The activities include those of trading as well as broking. The company's sister concern, Kunvarji Commodities Brokers Pvt. Ltd. is a member of NCDEX, MCX, NMCE and ACEL. Kunvarji Commodities Brokers Pvt. Ltd. (India) a company which is pioneer service provider in the field of an organized commodities and derivatives sector with wide range of clients at large. The trading in commodity futures and derivatives has an immense potential in India and worldwide. In the international market, the commodity future trading holds a big part of total turnover in the allied markets. Kunvarji Commodities Brokers Pvt. Ltd. having wide business with 24 branches spread across the state of Gujarat, Maharashtra and Rajasthan. It is an active member of Multi Commodity Exchange of India Ltd. (MCX) and National Commodities & Derivatives Exchange Ltd. (NCDEX), and Ahmedabad Commodities Exchange Limited (ACEL) which are totally professional and since they work with the best technology, they can adopt the best international practices for trading in the commodities and derivative The Kunvarji Fin stock Pvt. Ltd. is acting as a Member of National Stock Exchange of India, NSE FO, BSE and ASE. The KFPL is hopeful to take benefits of existing clients and can develop the business of broking in shares and stock with the help of its rich experience. In nut shell, Kunvarji are very well established enterprises with wide coverage to host the investors.

SPREAD OF BUSINESS:
Date of Incorporation: 28th, August 2003 No. of Branches: 24Branches across the state of Gujarat, Maharashtra & Rajasthan Active Trading Users: 164 Avg. Daily Volume: Rs. 950 crores (Approx 200 Million US $)

ASSOCIATE CONCERNS:
Kunvarji Finance Pvt. Ltd. Kunvarji Fin stock Pvt. Ltd. Kunvarji Financial Brokers Pvt. Ltd.

Kunvarji Brokers Pvt. Ltd. Kunvarji international commodities Pvt. Ltd. (DMCC) Dubai. Kunvarji Commodities Brokers Pvt. Ltd.

REGISTERED OFFICE:
310/311 SHYAMAK COMPLEX OPP. SAHJANAND COLLEGE, NEAR L COLONY, AMBAWADI, AHMEDABAD 380 0015 PH NO: 079-30089130-42

Track Record:
KCBPL stands for service quality and Innovation. Its share in the overall commodity activity as improved over the years. KCBPL enjoys pioneer position in broking business in India in commodity futures and derivatives.

Infrastructure
Office Area Number of Branches Qualified employees - 16000 Sq. Ft -24 -134

Client Network
Corporate Clients Individual Clients - 35 - 3500

Coverage Of Business
Ahmedabad 3 Branches 14 Users Mehsana 3 Users Patan 4 Users Deesa 5 Users Bhabhar 6 Users Bhuj 4 Users Rajkot 4 Users Baroda 2 Users Bhavnagar 3 Users Surendranagar 3 Users Single Users: Mansa, Jetpur, Gondal, Surat, Nadiad

Technology & Connectivity

Number of V-Sat Total V-Sat Users Internet Connections Total Users

26 108 2000 350

Services Offered
Information for Trading and Arbitrage opportunities in various commodities Daily Market Outlook Online Accounting Position on Website 14 Hours a day, Trading Opportunities Dematerialization of Commodities Stock

 MEMBERSHIP:

National Commodity & Derivatives Exchange Ltd. Multi Commodity Exchange of India Ltd. Ahmedabad Commodities Exchange Ltd. Dubai (DGCX) NMCE

Kunvarjis Bankers & DPS

Bankers: HDFC Bank Ltd. ICICI Bank Ltd. UTI Bank Ltd. Central Bank of India The Bhuj Mercantile Bank Ltd. Bhabhar Vibhag Nagrik Sahakari Bank Ld. Sardar Ganj Nagrik Bank - Patan

DPS
HDFC Bank Ltd. UTI Bank Ltd

At present the firm has above 8000 registered clients, 24 V-sats, 350 user ids. Average daily volume of over 950 crores (200 $ mn approx) for the group branches and dealing offices spread across whole Gujarat. The group has all the ingredients for providing best services viz. professionally qualified work force, pin point guidance and most professional advice, transparency, advanced technical support to cope up with the entire changing scenario. The two guiding regulation to success till now have been : Regulation 1 Regulation 2 Maximization of wealth of clients with true integrity. Always remember Regulation 1.

Turnover At NCDEX

Consistent increase in turnover along with trade increase in commodities is shown in the graph. November December January February March April May 9.13 9.92 12.13 12.36 17.68 20.43 26.15

percentage share at NCDEX

26.15

9.13

9.82 12.13

20.43 17.68

12.36

nov dec jan feb mar apr may

10

TURNOVER AT MCX:
Consistent increase in the turnover along with the increase in commodities of the firm is shown in the chart below November December January February March April may 4.13 5.12 9.03 21.45 29.63 32.63 38.05

4.13 38.05

5.12

9.03 21.45

november december january february march april may

32.63

29.63

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INTRODUCTION TO COMMODITY MARKET

WHAT IS A COMMODITY? The dictionary defines commodities as Something useful that can be turned to commercial or other advantage or an article, of trade or commerce, especially an agricultural or mining product that can be processed and resold Therefore commodities really refer to things which in day to day life, we simply take for granted. Like the wheat in our bread, the cotton in our clothes, the gold in our ornaments, the petrol in our cars and so on. However, shat many dont know is that these very ordinary items are also one of the finest investment avenues available.

WHAT ARE COMMODITIES FUTURES?

The commodity futures are the part and parcel of the commodity market, but it does form a distinctive market within the wider commodity market. The risks that will be dealt with are risks that originate in the commodity markets. The tool that will be used to manage that risk is commodity futures contracts. The futures markets trade huge numbers of contracts daily. Many futures contracts are thus extremely liquid. If the number and size of contracts are taken into account, future market trades greater quantity (volume) than the cash or spot markets. The futures markets do not really fulfill the role of acting as a conduct for the cash commodity. They are financial markets that play a financial role.

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WHAT ARE COMMODITY FUTURES USED FOR?

It is estimated that around 60 to 70 percent of all trades transacted on futures exchanges are done for the purpose of hedging. Although hedging is the most important use of futures contracts, their use is obviously not limited to that. They are there to take risk for profit. That is why speculators are drawn to the futures markets like bees to a honey jar. Speculators play a very important role in the whole market mechanism. They bring liquidity to the markets. Commodity futures contracts are also used to diversify portfolios. Producers and their representatives (cooperatives, govt organizations) of commodities use commodity futures to protect the selling price of their commodity. Consumers and their representatives of the commodity use commodity futures to fix their purchasing price within an acceptable level. Other than the actual producers and consumers, there are participants with investment interest in commodities. These participants seek to capitalize on the profit opportunity and assume higher risks. Generally, these investors are called SPECULATORS There is a kind of participant who looks at imperfection in pricing of the commodity between different markets. These imperfections are often short lived and caused by restrictions in the markets, flow of capital, or physical asset. These participant, called arbitrageurs assume relative low level of risk compared with speculators

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ACCESSIBILITY OF THE COMMODITY FUTURES MARKET

What may not be so generally known is that the futures markets are extremely accessible and can be utilized by virtually every business. They are often more accessible than other derivatives, simply because they offer risk management possibilities for much smaller quantities. This opens the door to effective risk management even for the smaller business.

THE ORIGIN OF COMMODITY FUTURES TRADING

Futures trading must have originated from the execution of a pre-harvest agreement between the farmer and the person who needs the grain. The practice of buying futures contracts for a lower price and selling them at higher price and buying for lower prices become a part of the futures market. Agriculture started with food crops. Futures trading must have originated from the execution of a prior to harvest agreement between the farmer and the person who needs the grain. What first started as oral agreements later grew to be contracts. Then came advancing amounts for contracts surety. When contracts became a normal practice, they were assigned the value of the commodities themselves. Also, these contracts started getting to be sold and bought like commodities. That is, if the person who got into a agreement with the farmer didnt need the commodity anymore he could exchange the contracts with someone who needed the grain. Likewise, the farmer who reached the agreement and did not want to sell his grain that moment could assign the contact to some other farmer ready to sell. In the meantime, owing to some other farmer ready to sell his grain at that moment could assign the contract to some other farmer ready to sell. In the meantime to change in market and weather, there could be an increase or decrease in the price. If due to any reason there is a shortage in the availability of the commodity then the selling price increases.

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However if the supply increases the buying contract price decreases. It is this situation that has attracted people to the future markets, bringing in people who do not have their own commodity to sell or even those who do not really need to buy. Thus the practice of buying for lesser prices has become a part of the futures market. Seeing this opportunity to make bigger profits when compared to common investment methods, many people, even non-farmers, non buyers and even those who didnt have a real requirement are lured to the future market.

HOW TRADING BEGAN INTERNATIONALLY?

Though it is said that commodity trading formally started in Japan in the 17th century, there is evidence to suggest that a form of futures trading in commodities existed in china 6000 years earlier. In the US, the futures markets were developed initially to help agricultural producers and consumers manage the price risks they faced while harvesting, marketing and processing food crops each year. The modern futures industry still serves those markets. The worlds oldest established futures exchange, the Chicago Board of Trade, was founded in 1848 by 82 Chicago merchants. The first of what were then called to arrive contracts were flour, timothy seed and hay, which came into use in 1849. Forward contracts on corn came into use in 1851 and gained popularity among merchants and food processors. Meanwhile, what is now the largest futures exchange in the US the Chicago Mercantile Exchange, was founded as the Chicago Butter and Egg Board in 1898. At that time, trading was offered in-you guessed it-butter and eggs.

15

COMMODITIES MARKET WORLD WIDE PICTURE

Commodities unlike stock/share, which mostly have an impact on the country in which it is being listed or traded, can leave a long lasting impression in almost all the countries in which it is traded. A group of traders can never be in command of influencing a large price fluctuations in commodities, as the prices are not determined by that particular sect/ or group but by other factors i.e. international demand, supply, total production, consumption expected, international regulation and international state of affairs etc. The cost of living index/wholesale price is determined by the price variations in the commodities which are consumed by the general public and the industries. The inflation or deflation are mostly linked with the commodity price instability, they have epitomized themselves as a very sturdy force in the international state of affairs. Now almost all type of commodities are being traded that too in a more organized manner, for instance CBOT has switched over to electronic trading platform in the year 2000 and very recently it has switched over its clearing operations to the same mode, at NYMEX the trading takes place both in Open Out Cry and Electronic Mode, at TOCOM (Tokyo Commodity Exchange) the trading is computerized and like wise all the international exchanges the following the suit.

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LEADING EXCHANGES AROUND THE WORLD:

EXCHANGES CBOT (Chicago Board of Trade) CME (Chicago Mercantile Exchange) NYBOT (New York Board of Trade) LME (London Metal Exchange)

PLACE Chicago USA Chicago USA New York USA London UK

TRADED COMMODITIES Soya (Bean, Oil and Meal), Corn, Wheat, Rice, Gold and Silver. Milk, Live cattle, Butter, Urea, Ammonium Nitrate, and Phosphate. Cocoa, Coffee, Cotton, Sugar, and Citrus (Frozen Orange Juice) Crop. Aluminum and its alloys, Copper, Lead, Nickel, Tin and Zinc. Gold, Silver, Platinum, Palladium, Aluminum, Gasoline, Kerosene, Crude and Rubber. Cocoa, Coffee (Robusta), Sugar (White), Wheat, Corn and Rapeseed. Rubber and Coffee. Gold, Silver, Palladium and Platinum. Crude oil (Brent and Sweet), Heating oil, Natural Gas, Electricity, Propane, Coal, Gold, Silver, Palladium, Platinum, Copper and Aluminum.

TOCOM (Tokyo Commodities Tokyo Japan Exchange) LIFFE (London International Financial Futures and Options Exchange) SICOM (Singapore Commodity Exchange) KITCO NYMEX (New York Mercantile Exchange) London UK Singapore New York USA Quebec Canada New York USA

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THE EVOLUTION OF COMMODITY TRADING IN INDIA

THE BEGINNING OF COMMODITY FUTURES TRADING IN INDIA

Commodity futures markets in India have a long history. The first organized futures market appeared in 1921, when the Cotton Exchange, which dealt in various types of cotton, was created in Bombay. A second exchange, the Seeds Traders Association Ltd, also in Bombay was created in 1926. This exchange traded oilseeds and their products like castor seeds, groundnuts and groundnut oil. Many other exchanges followed, trading in commodities such as raw jute, jute products, black pepper, turmeric, potatoes, sugar, food grains and silver. Several exchanges traded in the same commodities and some of these had formal trading links. A complete regulatory framework for futures was drafted, including rules for trading in futures, a system for the licensing of brokers and a clearing house structure. Not only futures, but also options on a number of commodities were traded on the exchanges; for example, options on cotton were traded up to one year out, until all options were banned in 1939.

18

In the 1940s, forward and futures contracts as well as options were outlawed as part of the governments drive to contain inflation or trading in these contracts was made impossible through price controls. This situation prevailed until 1952, when the government passed the Forward Contract (Regulation) Act, which controls all transferable forward contracts and futures up to this day. The Act again allowed futures trade in a number of commodities (but excluded some essential foods like sugar and food grains). It provided that forward and futures markets should normally be selfregulating through governing bodies of recognized associations in which the government has the right to place representatives. During the 1960s, the central government banned or suspended futures trading in several commodities including cotton, raw jute, edible oil seeds and their products. In the 1970s, futures trading in non-edible oil seeds like castor seed and linseed were forbidden. The reason for this crackdown in futures markets was that government felt that these markets helped drive up prices for commodities, by giving free reign to speculators. Restrictive measures were directed at combating speculation, which affected the activities of 31 recognized associations, which were supposed to regulate trade and commodities futures. The government policies softened somewhat in the late 1970s when futures trade in jaggery was allowed. Two government appointed comities the Datwala Committee in 1966 and the Khusro Committee in 1979 recommended the revival of futures trading in a wide range of commodities, but little action resulted. Contracts in most commodities are actively traded for periods up to six months out and as should be the case for mature future markets, most contracts are used for hedging purposes and not for physical trade. This means that a large majority of positions are closed out before maturity and physical delivery is relatively rare. The Indian economy is going through a process of liberalization and is opening up to the world market. Partly, as a result, Indian exporters are increasingly confronted with highly competitive world markets in which they are forced not only to work on slimmer margins but also to sell further forwards in order not to lose markets.

19

The rupee gas becomes fully convertible for commercial purposes. Against this background, the role of commodity futures market is being recognized by the government, through the Forward Market Commission (FMC) to assist them in this internationalization process. India has recently seen three National Level Electronic Exchanges facilitating commodity trading. National Commodity Exchange ( www.ncdex.com) Multi Commodity Exchange (www.mcxindia.com) National Multi Commodity of India (www.nmce.com) Besides this, there are at least 20 other Regional Commodity Exchanges also in India. Rajdhani Oils and Oilseeds Exchange Ltd., Delhi (www.roel.com) Ahmedabad Commodity Exchange Ltd. (www.acecastorfuture.com) Bhatinda Om and Oil Exchange Ltd. Bikaner Commodity Exchange Ltd. (www.bcel.org) Esugarindia Ltd. (www.esugarindia.com) First commodity Exchange of India Ltd, Kochi (www.fceikochi.com) Haryana Commodities Ltd. (www.hissarcommodities.com) India pepper and Spices Trade Association., Kochi (www.ipsta.com) National Board of Trade; Indore (www.nbotind.org) Surendranagar Cotton Oil and Oilseeds Association Ltd. The Bombay Commodity Exchange Ltd. (www.booe.com) The Central India Commercial Exchange Ltd; Gwalior The Chamber of Commerce ; Hapur The Coffee Futures Exchange India ltd; Bangalore (www.cofei.com) The East India Cotton Association; Mumbai (www.eicaexchange.com) The Meerut Agro Commodities Exchange Co. Ltd. The Rajkot Seeds Oil and Bullion Merchants Association Ltd. (www.rajkotexchange.com) The Spice and Oilseeds Exchange Ltd; Sangli Vijay Beopar Chamber Ltd; Muzaffarnagar.

20

THE FUTURES EXCHANGES

(MCX)- MULTI COMMODITY EXCHANGE OF INDIA Highlights Key Shareholders Financial Technologies (India) Ltd. State Bank of India State Bank of Indore State Bank of Hyderabad Bank of Baroda Bank of Saurashtra Union Bank of India Bank of India Canara Bank Corporation Bank HDFC Bank SBI Life Insurance Co.

Strategic Alliance with Prominent Industry Associations Bombay Bullion Association Bombay metal Exchange Solvent Extractors Association and Pulses Importer Association UPSAI IPSTA

International Alliances MOUs with the Tokyo Commodity Exchange (TOCOM) and the Baltic Exchange, London. The New York Mercantile Exchange (NYMEX) Joint Venture to set up The Dubai Gold and Commodity Exchange

21

 Daily mark to market, real time price and trade information dissemination MCX presently has over 1000 trading members spread in more than 275 centers in India.

22

(NCDEX) THE NATIONAL COMMODITY AND DERIVATIVES EXCHANGE LTD.

NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has commenced its operations on December 15, 2003 NCDEX is located in Mumbai and offers facilities to its members in more than 550 centers throughout India the reach will gradually be expanded to more centers. NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters of NCDEX are prominent player NCDEX is a nation-level, technology driven de-mutualized on-line commodity exchange with an independent Board of Directors and professionals not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

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NCDEX currently facilitates trading of 48 commodities Cashew, Castor Seed, Chana, Chili, Coffee - Arabica, Coffee - Robusta, Common Parboiled Rice, Common Raw Rice, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Groundnut (in shell), Groundnut Expeller Oil, Grade A Parboiled Rice, Grade A Raw Rice, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Indian 28 mm Cotton, Indian 31 mm Cotton, Lemon Tur, Maharashtra Lal Tur, Masoor Grain Bold, Medium Staple Cotton, Mentha Oil, Mulberry Green Cocoons, Mulberry Raw Silk, Rapeseed - Mustard Seed, Pepper, Raw Jute, RBD Palmolein, Refined Soy Oil, Rubber, Sesame Seeds, Soy Bean, Sponge Iron, Sugar, Turmeric, Urad (Black Matpe), V-797 Kapas, Wheat, Yellow Peas, Yellow Red Maize, Yellow Soybean Meal, Electrolytic Copper Cathode, Aluminium Ingot Nickel Cathode, Zinc Ingot, Mild Steel Ingots, Sponge Iron, Gold, Silver, Brent Crude Oil, Furnace Oil. At subsequent phases trading in more commodities would be facilitated.

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Highlights

Key Shareholders. NSE (National Stock Exchange) Canara Bank Punjab National Bank ICICI Bank Ltd. CRISIL (Credit Rating Information Service of India Ltd.) IFFCO (Indian Farmers Fertilizers Co-operative Ltd.) LIC (Life Insurance Corporation of India) NABARD (National Bank for Agricultural and Rural Development)

Strategic Alliance with prominent industry associations In talks with GAIL & BPCL to promote gas futures

International Alliances MOUs with The Dalian Commodity Exchange, The International Petroleum Exchange (IPE) & The Tokyo Grain Exchange

Daily mark to market, real time price and trade information dissemination NCDEX presently has over 720 trading members spread in more than 450 centers in India.

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LIKELY PLAYERS IN THE COMMODITY MARKET

At the Indian commodity exchanges, where futures trading is currently ongoing, half of the trade is estimated to be speculative, half of which is conducted by traders or what the international trading community calls as the scalpers (day traders buy and sell during same day, trying not to keep any positions overnight). These scalpers earn through their daily trading transactions and contribute significantly to the liquidity of the exchange. The remaining half of the trade is by way of hedging, with traders being the most active. The various categories of users of these commodity exchanges in India are discussed below: Farmers in India rarely use futures markets directly. Indian farmers benefit indirectly from using co-operatives or other intermediaries or simply from better deals with traders using futures markets. Traders, both large and small are the main users of futures contracts in India. For oil seeds, pepper and gur, there is an active participation of town dealers. Castor seeds and pepper, exporters are active in the exchanges. Virtually, all speculators in these exchanges are relatively small either they are day-traders as explained above or are individuals placing their deals through brokers. Large institutional investors such as banks and NBFCs are absent. Their participation in commodity exchanges is not allowed under the Reserve Bank of India regulations, which stipulates prudential norms for banks and non banking financial institutions. Processors and manufacturers use the exchanges to a limited extent for two reasons: First, some manufacturers, especially in the oil sector, are so large that they are unable to lay off a significant part of their risks on domestic exchanges, which suffer from chronic illiquidity. Secondly, the range of the commodity futures contracts offered is too small resulting in incomplete risk management. For example, many firms do not

26

find castor seeds contract useful as few manufacturers use castor oil and it is an imperfect risk management instrument for other oils. Foreign trading firms participated in some of the commodity exchanges until their participation was banned. But, the current scenario of development in commodity futures trading will bring the issue of allowing them to participate in this field too. This will result in commodity linked mutual funds to spring up across the country.

ADVANTAGES OF THE FUTURES MARKET FOR VARIOUS PLAYERS

Farmers Get an extensive market opened for them Can decide the market even before harvest Can sell the commodity to the customer without any agents Get an opportunity to trade, knowing the national and international trends and standards Get an opportunity to gain by leveraging the futures market There is an opportunity to keep the commodity in the warehouse and use the warehouse receipts to deal with financial needs as it is an extensive document Can avoid deliberate in price in the name of quality Farmers can trade even if they are computer illiterate by the help of renown broking house

Traders / Stockiest Can trade by parking only the margin amount Can hedge their underlying by selling the same in the futures market and save from any losses from the price fluctuation For those who have kept their commodity in the Central Warehouse, loans are available on the basis of stock. The benefit is that you can keep the commodity somewhere without blocking the working capital

27

 Corporates / Exporters Can get a better price discovery Can buy goods without agents Can hedge themselves by offsetting their exposure in the future market and minimize their risk Can take positions by paying only the margin value instead of whole value of the contract Can assure the quality of the goods because of standardized future contacts.

Arbitrageurs / Speculators Can get benefit by an arbitrage between Spot to Future Inter Commodity Exchanges (MCX & NCDEX) Spread Trading

FUTURES MARKET V/S FORWARD MARKET

FORWARD CONTRACTS Forward contracts are agreements to purchase or sell a specified amount of a commodity on a fixed future date at a pre determined price. Physical delivery is expected. If, at maturity (the future date has been agreed to in the contract), the actual price (the spot price) is higher than the price in the forward contract, the buyer makes a profit and the seller suffers a corresponding loss.

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FUTURES CONTRACT Future contracts are exchange traded agreements to purchase or sell a given quantity of a commodity at a predetermined price at a predetermined time. But, unlike forward contracts, physical delivery in fulfillment of this agreement is not necessarily implied, the contract can be used to make or to take physical delivery, but usually, it is offset on or before maturity (the closing date of the contract) by an equivalent reverse transaction. On organized commodity exchanges, where most futures contracts are traded, this involves the buying at different times of two identical contracts for the purchase and sale of the commodity in question, each canceling the other out. This is called the closing out of the position and is possible because all transactions are guaranteed through a central organism, the clearing house, which automatically assumes the position of the counterpart to both sides of the transaction. Thus, a producer who wishes to hedge has an obligation not Vis-a Vis a consumer or a speculator, but vis-a vis a clearing house. Likewise, consumers obtain a position Vis-a Vis the clearing house. FOUR IMPORTANT FEATURES THAT DISTINGUISH FUTURES CONTRACT FROM A FORWARD CONTRACT: Contract terms (amounts, grades and delivery terms) are standardized Transactions are almost always handled by organized exchanges through clearing house systems. Most futures contracts are marked to market everyday, using the settlement price of the day. Hence, if the futures price moves adversely for a holder of a futures contract, that holder is obliged to pay into the clearing house a sum equal to the value of the adverse movement (a margin call). This prohibits users of the market from carrying large unrealized losses over a long period, and thus reduces the risk of default. In the case of profitable price movements, clearing members (including intermediaries such as brokerages), but not necessarily their clients, receive the profits of the days futures trading Futures contracts require depositing small amounts of initial margin money in the exchange as collateral. Due to this, futures contacts significantly reduce the credit of default risk contained in the forward transactions.

29

MECHANICS OF FUTURES TRADING

Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as Going Long, Going Short and Spreads. GOING LONG When an investor goes long i.e. enters a contract by agreeing to buy the underlying at a set price it means that he or she is trying profit from an anticipated future price increase. GOING SHORT A speculator, who goes short, i.e. enters into a futures contract by ageing to sell the underlying at a set price is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator. SPREAD TRADING Going long and going short are positions that involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called spreads. Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short futures contracts. Spread-trading is a more sophisticated trading tool than just purchasing or selling futures or option contracts. There are mainly three different types of spreads: Calendar Spreads

30

Inter-Exchange Spreads Inter Commodity Spreads

It is important that you understand that when you are trading a spread, you are speculating on the price difference or spread between the two contracts. Spreaders are focused on the price relationship between the two contracts. A spread position is not to be looked at as two separate trades, but rather as one trade. The success or failure of the trade is determined by the change in the price difference between the two contracts or commodities. It is much obvious for one side of the trade to make money, and the other side to lose money. It is much obvious for one side of the trade to make money, and the other side to lose money. It is the perception of the spread trader that the winning side makes more than the losing side. One might ask, Why dont you just put on the wining side forget about spreading with the losing side? The answer is simple the spread trader does not know which side of the trade will be the prime mover and impact the spread value. CALENDER SPREADS The calendar spread is perhaps the easiest to understand and the most commonly used type of spread in the industry. A spread trader in a calendar attempts to profit from the price difference between two futures contracts of the same commodity, traded on the same exchange, but with different expiry dates. The trader putting on this spread believes that the price differences are too close or too close or too far apart to suggest further expansion or contraction in the prevailing spread: EXAMPLE: Mr. X bought a March contract of sugar at Rs.2100 and sold April sugar at Rs.2125 with a spread of Rs.25 for March over the April contract. At the expiry, March sugar was at Rs. 2115, and April sugar was at Rs. 2130 spread has narrow down to Rs. 15 Hence, sold March sugar Rs. 2115 and bought April sugar Rs. 2130, resulting into a net profit of Rs. 10

31

Why would a spreader put on the trade? Because he would have reason to believe that the price of March sugar would gain on or get closer to the April price. As you can see in this example the above mentioned trade was profitable, but one side of the spread lost money. INTER EXCHANGE SPREAD (ARBITRAGE) It is a spread or arbitrage in prices for the same commodity in two different exchanges. The spread may be into existence due to the factors of : Price difference: during volatile market situations due to price elasticity the prices may go either side of the equation. Arbitrageurs, enters to take positions in opposite direction i.e. buy in one exchange and a simultaneous sell in the other exchange. As and when the market stabilizes, the prices return to the normal parity levels where in the arbitrageur reversed their respective exposures in the two exchanges to leave them with risk less profit from the series of transactions. Distance: globalization have erased the international boundaries of trade though, but primarily at the market levels price differences remain due to duties, freight, insurance and other levies as per the rules of trade. Very often it is observed by the traders that even after the loading of these factors, the prices in the futures market are over or under valued from the price parity levels. Immediately the arbitrageurs steps in to take advantage of the situation and keeps a doing this till the time market returns to the existing norms of parity. Time: operational hours differences between two exchanges located on two geographical parts of the world lend opportunity for the investors to move their trades profitably in both the exchanges. Typically this is the case with the Crude oil, Gold and Silver futures contracts. Whilst the Indian exchanges close their session by 23:55 hours IST, US markets are open till 01:30 hours IST followed by Japanese markets which start trading by 07:00 hours IST. Movements in the price during this intermediate time is chased by the Indian market in the opening session align itself with the 32

international market scenario and thus portraying a spread opportunity between two exchanges till they finally coverage to a parity level in existence. INTER COMMODITY SPREADS Inter commodity spreads are the most difficult to understand and the most risky to trade, therefore not used as much as the inter market spread. A spreader of inter commodity spreads is spreading two different but related commodities, in the same or different delivery months. Examples of inter commodity spreads are Cattle / Hogs Gold / silver Heating oil / Crude oil T-Bills / T- Bonds Canadian Dollar / Swiss Franc

This is just a small example of the inter commodity spreads available to trade

33

Risk Free Returns Hedging arbitrage

Hedging Hedging in futures contracts provides an effective tool to manage price risks and it is always associated with an opposite transaction that involves physical cash transaction.

What Makes Hedge Works? Spot and Futures price for the same commodity tend to go up and down together. Losses in one side are cancelled out by gains on the other. EXAMPLE: Let Us Take Example of Client-A, which is seller of the gold Client-B, buyer of Gold. Client-A Plans to sell 1 Kg. Gold in December 2005. It expects futures prices to be lower and feels that Rs. 7000 per 10 gm will be a good price to get in December. So, Client-A decides to lock in 1kg. At a price of Rs. 7000 on the future market for December contract.

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Scenario-1: The prediction of Client-A come true. The spot price for December 1st is Rs. 6980 per 10 gm. SPOT MARKET PRICE Rs. 6980 FUTURES MARKET Locked in atRs.7000/for 1 kg Current price @ Rs. 6980/Squares off 1 kg. @ Rs. 6980/Gain of Rs. 20/- per kg. from spot against the budget. Bought @ Rs. 6980 and sold @ Rs. 7000/-

SALE RESULT

Sold 1 kg. in the spot @ Rs. 6980/Loss of Rs. 20/- against budget

Scenario-2: The predictions of Client-A has gone wrong. Spot prices for December 1st are Rs. 7020 per 10 gm. SPOT MARKET PRICE SALES RESULT Rs. 7020/Sold entire 1 kg. in the spot market @ Rs. 7020/Books Rs. 20/- profit against the budget FUTURE MARKET Locked in at Rs. 7000/for 1 kg. Squared off 1 kg. @ Rs. 7020/Bought at Rs. 7020/and sold at Rs. 7000/therefore books a loss of Rs. 20/-

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By a stockiest using futures market SPOT MARKET 01/01/2006 A stockiest purchases, say, 10 tones of Castor seed in the physical market @ Rs. 1600/p.q. FUTURES MARKET To hedge price-risk, he would simultaneously sell 10 contracts of one tone each in the futures market at the prevailing price. Assuming the ruling price in June 2006 contract is Rs. 1750/- p.q. The stockiest liquidates his contract in the futures market by entering into purchase contract @ Rs.1625/p.q.

01/05/2006

The stockiest sells his stock in the month of May when the spot price is Rs. 1500/- p.q.

RESULT

Loss = Rs. 25 + Loss on A/c gain = Rs. 125/- of carrying Stocks.

The stockiest is able to lock in a spread/ Badla of Rs. 150/- p.q. i.e. about 9% for about 6 months. Looking at the gain / loss in the two segments, we find that the stockiest is able to hedge his price by operating simultaneously in the two markets and taking opposite positions. He gains in the futures market if he loses in the spot market; but would lose in futures market if he gains in the spot market. Similarly, processors, exporters, and importers can also hedge their price risks.

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FOR IMPORTER When spot prices decreases faster than the future price. SPOT GOLD OCT 2005 JAN 2006 RESULT The spot gold is @ Rs. 5850 per 10 gms Sell spot gold @ 5750 per 10 gms Loss Rs. 50 per 10 gms GOLD FUTURE Sell gold Future @ 5900 per 10 gms Buy back gold future @ Rs. 5850 per 10 gms Gain Rs. 50 per 10 gms

If the importer had not hedged his position, he would have, had to sell the gold at Rs. 5750 per 10 gms, accounting for a loss for Rs. 100 per 10 gms By cover his position at the futures market he minimized his losses.

FUTURES TRADING A LUCRATIVE BUSINESS Futures trading in castor seed have been going on for a long time in India. In this context, it would be best to understand futures trading taking castor seed contracts as an example. XYZ mill sells castor oil in the export market for December shipment at Rs.100 per kilo. Their cost sheet is as follows: Sale price Cost of castor seed (Present spot price) Labour Overheads Profit Rs.100 Rs. 60 Rs. 20 Rs. 10 Rs. 10

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They are unable to find a castor seed supplier who would offer them the required quantity for the December delivery. They therefore hedge their castor seed moves up to Rs. 80 per kilo by December. Spot price of castor seed moves up to Rs. 80 per kilo by December. XYZ mill buys physical castor seed in the spot market at Rs.80 per kilo and settles in the futures market at a price of Rs. Per kilo. Thus their cost sheet would now be as follows: Sale price Cost of castor seed (Present spot price) Labour Overheads Loss Add: profit on futures Net profit Rs. 100 Rs. 80 Rs. Rs. Rs. Rs. Rs. 20 10 10 20 10

Due to hedging in the futures market, the profit of the mills remains intact.

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ARBITRAGE The simultaneous purchase and selling of an asset in order to profit from a differential in the price. This usually takes place on different exchanges or marketplaces. Also known as a "risk less profit". Say a domestic stock trades also on a foreign exchange in another country, where it hasn't adjusted for the constantly changing exchange rate. A trader purchases the stock where it is undervalued and short sells the stock where it is overvalued, thus profiting from the difference. Arbitrage is recommended for experienced investors only.

Market Arbitrage Purchasing and selling the same security at the same time in different markets to take advantage of a price difference between the two separate markets. An arbitrageur would short sell the higher priced stock and buy the lower priced one. The profit is the spread between the two assets. EXAMPLE: If we buy Jeera from NCDEX at rate Rs. 6488and than Sell it in MCX at rate Rs. 6589.85, that is arbitrage. The Rs. 101.85 we gain that represents an arbitrage profit.

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NEED OF COMMODITIES IN A PORTFOLIO:

COMMODITIES AS A HEDGING TOOL Hedge against inflation Hedge against a currency fluctuation Hedge against event risk

COMMODITIES AS AN INVESTMENT AVENUE Growing popularity as an investment tool Global underlying broadly difficult to manipulate Pure play demand/supply/inventory/trading pattern driven High degree of cyclicality/seasonality Extremely high leverage instrument due to low margins (4-5%) Established as an asset class world wide option to invest direct in commodities than investing in commodities stocks

INDIAN EXPERIENCE / COMMODITY STOCKS Commodities account for about 38% (ask) of Nifty Market Cap. (as on 31/03/2006)

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COMMODITY GROUPS

COMMODITY GROUPS AVAILABLE FOR TRADING

BULLION BASE METAL

ENERGY

OIL SEEDS

CEREALS COMMOD ITY FUTURES MARKET

PULSES

PLANTATI ONS, FIBRES & PETRO CHEMICAL

SPICES

OTHERS

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COMMODITY FUTURE TRADING REGULATIONS

REGULATORY FRAMEWORK The ministry of consumers affairs, food and public distribution governs all commodity exchanges in India through the forwards markets commission (FMC). The FMC is a regulatory body set up under the forward contracts (regulation) act, 1952 (FCRA). The FCRA lays down the general provisions in relation to the administration of the commodity exchanges and other regulatory provisions pertaining to commodity trading in India. All exchanges dealing in trading of commodities are required to obtain registration from FMC. PERMISSIBLE BUSINESS ACTIVITIES Only futures trading in commodity is permitted on the exchange. Options in goods are presently prohibited under the FCRA. Further, only the commodities notified under the FCRA can be traded on the commodity exchange. Presently, futures trading is permitted in all the commodities. These commodities can be broadly classified under the following categories: Agro products Precious metals and base metals Energy At present there are 22 commodity exchanges in India providing futures trading in commodities. However currently only 4 exchanges have been accorded a national commodity exchange status as under: National Commodity and Derivatives Exchange Limited (NCDEX) Multi commodity Exchange of India Limited (MCX) National Multi Commodity Exchange (NMCE) National Board of Trade (NBOT)

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The aforesaid exchanges are entitled to commence trades in all permitted commodities prescribed under the FCRA. NCDEX & MCX are located in Mumbai and provide active platforms for metals and agro commodities futures. NMCE is located in Ahmedabad and presently the trading volumes of commodities at NMCE are limited to NCDEX & MCX. These exchanges are expected to be role model to other exchanges and are likely to compete for trade not only among them but also with the existing exchange.

MEMBERSHIP OF THE COMMODITY EXCHANGE Any person desiring to trade over the commodity exchange, is required to register with the exchange as a member. Unlike the stock broking regulations, in case of commodity trading membership, no SEBI registrations are required and the relevant commodity exchange is the sole authority to sanction registration. However, recently there has been news articles proposing that as application would also required to be made to the FMC for seeking trading membership registration with the exchange; the procedures for registration with the FMC is however not clarified.

In order to regulate the activities of its members, each of the stock exchanges have formulated its own bye-laws, rules and regulations. Presently, the following memberships are offered by the commodity exchanges: Trading cum clearing membership entitling a member to execute transactions on the exchange and also a right to clear the trades on its own. Professional clearing membership providing only clearing rights to the members

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ENTITLEMENT TO MEMBERSHIP:

Stock broker A stock broker registered with NSE/BSE can also obtain membership of the commodity exchange. However, the SCRA does not permit a stock broker to undertake business in commodity derivatives in the same entity in which stock broking is carried out. For this purpose the SCRA prescribes setting up a separate company for undertaking commodities trades. NBFC As regards trading in commodities by NBFC, RBI would not permit a NBFC to undertake any activities which would result in the NBFC being governed by multiple regulators (i.e. the commodities exchanges and the FMC). BANKS Banks are currently not permitted to engage in buying or selling or bartering of goods except engaging in bullion trades.

FDI IMPLICATIONS ON ESTABLISHING THE NEW ENTITY From a FDI perspective, currently commodity broking unlike stock broking is not specifically covered under the list of nineteen permitted NBFC activities wherein investment is permitted under the automatic route subject to adherence to the stipulated minimum capitalization norms. Based on informal talks the regulatory authorities have informed that commodity broking would nor form part of stock broking for FDI purposes and not subjected to minimum capitalization norms.

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PROSPERING INDIAN COMMODITIES MARKET (PRESENT SCENARIO)

The exchange, National Commodity and Derivative Exchange which is just two and a half years old, is Asia's third-largest commodities exchange after Tokyo and Shanghai and the 14th-largest in the world. It is unlisted and trades $1.2 billion worth of products daily. Goldman Sachs Group, the large U.S. securities firm, plans to buy a stake in the National Commodity & Derivatives Exchange, reflecting growing interest in the surge in commodity trading in India. Among its institutional shareholders are four state-owned companies, the National Stock Exchange, ICICI Bank and Crisil, a rating agency. ICICI Bank, which owns 15 percent of the exchange, is selling less than half its stake to Goldman Sachs. Strong economic growth and rising income levels in India have bolstered investments in commodities, making the country attractive for investors in the trading exchanges. Earlier this year, Fidelity International paid $49 million for 9 percent in the Multi Commodity Exchange of India, which is primarily a metals-trading operation. About 80 percent of the trades in the National Commodity & Derivatives Exchange are currently in agricultural commodities like sugar, wheat and vegetables. But the share of energy commodities, like Brent blend crude oil, natural gas, coal and electricity is rising significantly. With India one of the world's largest consumers of energy, the rising energy commodities trade has undoubtedly been an attraction. There is also significant potential in bullion. India is the world's largest consumer of gold and is expected to soon turn into a price-setter in the commodity. Currently, foreign investors and overseas institutions are not allowed to trade on the commodities exchanges but there are indications that regulators might relax the rules for some commodities.

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COMMODITY MARKET V/S. EQUITY MARKET Commodity trading Three national platforms for screen based trading Upfront margin between 5-10% Low downside risk Less volatile, providing an efficient portfolio diversification option. Short selling is allowed across the board

Equity trading Two national platforms for screen based trading Upfront margin between 25-30% High downside risk More volatile Short selling is restricted to a few scripts where futures are there.

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BOMBAY STOCK EXCHANGE (BSE)

For the premier Stock Exchange that pioneered the stock broking activity in India, 125 years of experience seem to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called "Bombay Stock Exchange Limited" by paying a princely amount of Re1. Since then, the stock market in the country has passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no measure or scale that could precisely measure the various ups and downs in the Indian stock market. Bombay Stock Exchange Limited (BSE) in 1986 came out with a Stock Index that subsequently became the barometer of the Indian Stock Market. SENSEX, first compiled in 1986 was calculated on a "Market CapitalizationWeighted" methodology of 30 component stocks representing a sample of large, well-established and financially sound companies. The base year of SENSEX is 1978-79. The index is widely reported in both domestic and international markets through print as well as electronic media. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. From September 2003, the SENSEX is calculated on a free-float market capitalization methodology. The "freefloat Market Capitalization-Weighted" methodology is a widely followed index construction methodology on which majority of global equity benchmarks are based. The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. More recently, the bourses in India witnessed a similar frenzy in the 'TMT' sectors. The SENSEX captured all these happenings in the most judicial manner. One can identify the booms and bust of the Indian equity market through SENSEX. The launch of SENSEX in 1986 was later followed up in January 1989 by introduction of BSE National Index (Base: 1983-84 = 100). It comprised of 100 stocks listed at five major stock exchanges in India at Mumbai, Calcutta, Delhi, Ahmedabad and Madras. The BSE National Index was renamed as BSE-100 Index from October 14, 1996 and since then it is calculated taking into consideration only the prices of stocks listed at BSE. The Exchange launched dollar-linked version of BSE-100 index i.e. Dollex100 on May 22, 2006. 47

With a view to provide a better representation of the increased number of companies listed, increased market capitalization and the new industry groups, the Exchange constructed and launched on 27th May, 1994, two new index series viz., the 'BSE-200' and the 'DOLLEX-200' indices. Since then, BSE has come a long way in attuning itself to the varied needs of investors and market participants. In order to fulfill the need of the market participants for still broader, segment-specific and sector-specific indices, the Exchange has continuously been increasing the range of its indices. The launch of BSE-200 Index in 1994 was followed by the launch of BSE-500 Index and 5 sectoral indices in country's first free-float based index - the BSE TECk Index. The Exchange shifted all its indices to a free-float methodology (except BSE PSU index) in a phased manner. The Exchange also disseminates the Price-Earnings Ratio, the Price to Book Value Ratio and the Dividend Yield Percentage on day-to-day basis of all its major indices.

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NATIONAL STOCK EXCHANGE:

The trading on stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient. this imposed limits on trading limits on trading volumes and efficiency. In order to provide efficiency, liquidity and transparency, NSE introduced a nation wide on line fully automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. 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. NSE became the leading stock exchange in the country, impacting the fortunes of other exchanges and forcing them to adopt SBTS also. Today India can boast that almost 100% trading take place through electronic order matching. Technology was used to carry the trading platform from the trading hall of stock exchanges to the premises of brokers. NSE carried the trading platform further to PCs at the residence of investors. This made a huge difference in terms of equal access to investors through the internet and to handheld devices through WAP for convenience of mobile investors. This made a huge difference in terms of equal access to investors in a geographically vast country like India. Trading volumes in the equity segment have grown rapidly with average daily turnover increasing from Rs.17 crores during 1994-95 to Rs.4, 328 crores during 2003-04. During the year 2003-04, NSE reported a turnover of Rs.1, 099,535 crores in the equities segment accounting for 68.60% of the total Indian securities market.

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CLEARING AND SETTLEMENT The clearing and settlement mechanism in Indian securities market has witnessed significant changes and several innovations during the last decade. Till recently, the stock exchanges in India were following a system of account period settlement for cash market transactions. T+2 rolling settlement have now been introduced for all securities. Due to setting up of Clearing Corporations, the market has full confidence that settlements will take place on time and will be completed irrespective of possible default by isolated trading members. Two depositories viz., National Securities Depositories Ltd. (NSDL) Central Depository Services Ltd. (CDSL) Provide electronic transfer of securities and more than 99% of turnover is settled in dematerialized form. The pay-in and pay-out of securities is affected on the same day for all settlements.

Partners

CLEARING MEMBERS

CLEARING BANKS

DEPOSITORIES

PROFESSIONAL CLEARING MEMBERS

CUSTODIANS

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TRANSACTION CYCLE

PLACING ORDER

DECISIO N TO TRADE

TRADE EXECUTI ON

FUNDS/ SECURITI ES

CLEARIN G OF TRADES

SETTLEM ENT OF TRADES

A person holding assets (securities/funds), either to meet his liquidity needs of to reshuffle his holding in response to changes in his perception about risk and return of the assets, decides to buy or sell the securities. He selects a broker and instructs him to place buy/sell order on an exchange. The order is converted to a trade as soon as it finds a matching sell/buy order.

51

At the end of the trade cycle, the trades are netted to determine the obligations of the trading members to deliver securities/funds as per settlement schedule. Buyer/seller deliveries funds/securities and receives securities/funds and acquires ownership of the securities. A securities transaction cycle is presented in the above figure

SETTLEMENT CYCLE: At the end of each trading day, concluded or locked-in trades are received from NSE by NSCCL. NSCCL determines the cumulative obligations of each member and electronically transfers the data to Clearing Members (CMs). All trades concluded during a particular trading period are settled together.

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NORMAL MARKET In a rolling settlement, trade day is T day, T+1 day and T+2 day for NSCCL. At NSE, trades in rolling settlement are settled on a T+2 basis i.e. on the 2nd working day. Typically trades taking place on Monday are settled on Wednesday, Tuesdays trades settled on Thursday and so on. A tabular representation of the settlement cycle for rolling settlement is given below: ACTIVITY TRADING CLEARING Rolling settlement trading Custodial confirmation Delivery generation SETTLEMENT Securities and funds pay in Securities and funds pay out Valuation of shortages based on closing prices POST SETTLEMENT Auction Bad delivery reporting Auction settlement Rectified bad delivery pay in and pay out Re-bad delivery reporting and pick up Close out of re-bad delivery and funds payin and pay-out DAY T T+1 working days T+1 working days T+2 working days T+2 working days At T+1 closing prices T+3 working days T+4 working days T+ 5 working days T+6 working days T+8 working days T+9 working days

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INTRODUCTION TO DERIVATIVES:
Inroduction of derivatives in the Indian capital market is beginning of an exciting era. Index futures were introduced as the first exchange traded derivatives product in the Indian capital markets in june 2000. the trading and risk management systems set up by SEBI are today international benchmarks. With introduction of index options, individuals stock futures and options and interest rate futures, the Indian derivatives market has become a vibrant and dynamic part of the capital markets. Derivatives worldwide are recognized as risk management products. These products have a long history in India in the unorganized sector, especially in currency and commodity markets. The availability of these products on organized exchange have provided the market participants with a safe efficient and transparent market. Derivatives have been a key factor in creation of new and innovative financial products. These products by unbundling and bundling various risks and return parameters are meeting the specific and growing needs of investors and issuers. MEANING: Derivative is a product which derives its value from some underlying. This underlying can be securities, currency, commodities or even another derivative. The derivative does not have indepent of the underlying. Forwards, futures, options and swaps are amongst the more popular of derivatives products today used across the financial markets. Following is a brief introduction to various derivative contracts.

FORWARD CONTRACTS: A forward contract is a bi-partite contract, to be performed in the future at the terms decided at the time of entering into the contracts. These terms are in respect of value of transaction, place of settlement, date and time of settlement, what is being bought/sold etc.

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Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities). Delivery time and place, in some markets some markets some of the terms are decided by convention though the parties have the flexibility to adjust the terms to suit their requirements. For example in markets a spot transaction is settled after two working days. However parties free to decide free to decide any other delivery date also. Forward contracts suffer from relatively poor liquidity as compared to actively traded futures. As the contract is bi-partite, the closing of the position requires a party to approach the same party with whom the original contract was entered into. Sometimes as the choices are limited this may limited this may result in not getting the best price. This alternate is to enter into an equal and opposite contract with another party. While this closes the price risk, the counter party risk goes up. FUTURES CONTRACTS: Futures contracts are organized which are traded on the exchanges. The terms like quantity, quality (in case of commodities) delivery time and place, value of one contract etc. are standardized and traded on the exchanges are very liquid in nature. In futures market, clearing corporation house reduces the credit risk by either it self becoming the counter party to every trade (through novation) or by giving a guarantee to do settlement in case any counter party fails to honor the contract. Also each contract is seetled with the clearing corporation. This enables the clearing corporation to do net settlement, cancelling all equal and opposite contracts for each party thereby further reducing the credit risk as well the size of settlement.

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Forward / Future contracts Features Trading Settlement Contract specifications Forward contract Not traded on exchange Directly between the two parties May differ from trade to trade. High flexibility in deciding the terms Future contract Traded on exchange Through the clearing system of the exchange Contracts are specified

Counterparty risk of credit risk

Each party takes credit The counterparty risk risk on the other is transferred to clearing system. Clearing system takes credit risk on the clearing system. Poor liquidity as contracts are tailor made High liquidity as contracts are standardized. And traded on the exchange. Better, as traded on a transparent exchange

Liquidity

Price discovery

Poor, as markets are fragmented

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SWAPS: A swap represents an exchange of obligations. The two most common types of swaps are interest rate swaps and currency swaps. Lately credit swaps are also becoming popular.

EQUITY DERIVATIVES IN INDIA _ AN OVERVIEW

DERIVATIVES TRADING Derivatives trading broadly can be classified into two categories, those that are traded on the exchange and those traded one to one or over the counter. They are hence known as Exchange traded derivatives OTC (Over The Counter) Derivatives OTC equity derivatives Traditionally equity derivatives have a long history in India in the OTC market. Options of various kinds (called Teji and Mandi and Fatak) in unorganized markets were traded as early as 1900 in Mumbai. The SCRA however banned all kind of options in 1956.

DERIVATIVE MARKETS TODAY The prohibition on options in SCRA was removed in 1995. foreign currency options in currency pairs other than Rupee were the first options permitted by RBI. The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products. Besides the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today they have 18 commodity exchanges most of which trade futures e.g. the Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI). In 2000 an amendment to the SCRA expanded the definition of securities to included derivatives thereby enabling stock exchanges to trade derivative products 57

The year 2000 heralded the introduction of exchange traded equity derivatives in India for the first time.

EQUITY DERIVATIVES EXCHANGES IN INDIA IN THE EQUITY MARKETS BOTH THE National Stock Exchange of India Ltd. (NSE) and The Stock Exchange, Mumbai (BSE) have set up their derivative segments. Both the exchanges have set up an in house segment instead of setting up a separate exchange for derivatives. BSEs derivatives segment, started with Sensex futures as its first product. NSEs Futures and Options segment was launched with Nifty futures as the first product. The market share of NSE is very large compared to that BSE.

MEMBERSHIP: Membership for the new segment in both the exchanges is not automatic and has to be separately applied for. All members have to be separately registered with SEBI before they can be accepted. Both the exchanges have specified certain Net worth, deposit and annual membership requirements for both Clearing and Trading members.

TRADING SYSTEMS NSEs trading system for its futures and options segment is called NEAT F&O. it is based on the NEAT system for the cash segment. BSEs trading system for its derivatives segment is called DTSS. It is built on a platform different from the BOLT system though most of the features are common.

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SETTLEMENT AND RISK MANAGEMENT SYSTEMS Systems for settlement and risk management are required to satisfy the conditions specified by L.C. Gupta Committee and the J.R. Verma committee subject to modifications made by SEBI from time to time. These include upfront margins, daily settlement, online surveillance and position monitoring and risk management using the Value-at Risk concept (VAR).

OPTIONS BASICS: Options are one of the widely used derivative tools just like the futures markets and it is the integral part of Risk Management. Options demand broad based understanding of the derivatives segment. OPTION TERMINOLOGY Option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An

59

option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. CALLS The right to sell a stock or a commodity future at a given price before a given date. Calls are similar to having long positions on stock. The owner of the call option is speculating that the rice of the underlying will go up and is therefore bullish. PUTS The right to sell a stock or a commodity at a given price before a given date is defined as a Put option. Puts are similar to having short positions on the stock. The owner of the Put option is speculating that the price of the stock will go down and is therefore bearish. PLAIN VANILLA OPTIONS The simple calls and Puts discussed above are referred to as plain vanilla options. They are termed so since are standardized options available for trading on the exchange.

OPTION PRICE The price which the option buyer pays to the option seller. It is also referred to as the Option premium. EXPIRATION DATE The date specified in the option contract is known as the expiration date, the exercise date, the strike date or the maturity date. STRIKE PRICE The price specified in the Options contracts is known as the strike price or the exercise price. AMERICAN OPTIONS

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American options are options that can be exercised at any time up to the expiration date. Most exchange traded options are American. EUROPEAN OPTIONS European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American options are frequently deduced from those of its European counterpart. IN THE MONEY OPTION An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price-strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. AT THE MONEY OPTION An at-the-money (ATM) option is an option that would lead to zero cash-flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price=strike price).

OUT OF THE MONEY OPTION An out-of-money (OTM) option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a Put, the put is OTM if the index is above the strike price.

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PARTICIPANTS OF OPTION MARKET There are four types of participants in Options markets depending on the position they take: Buyers of calls Sellers of calls Buyers of puts Seller of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. Here is an important distinction between buyers and sellers Call holders and put holders (buyers) are not obliged to buy or sell. They have the choice to exercise their rights if they choose. Call writers and put writers (sellers) however are obliged to buy or sell. This means that a seller may be required to make good on their promise to buy or sell. The European option can be exercised only on the maturity date, while American option can be exercised before or on the maturity date. In most exchanges trading starts with European options, as they are easy to execute and keep track of. This is the case in the BSE and the NSE. Cash settled options are those where the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put). Delivery settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of undertaking (puts)

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CALL OPTIONS The following example would clarify the basics on call options Example: An investor buys one European call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31st July. The strike price is Rs. 60 and the contract matures on 30th September. The payoffs for the investor, on the basis of fluctuating spot prices at any time are shown by the payoff table. It may be clear from 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 option 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. Payoff from Call Buying / Long (Rs.) S 57 58 59 60 61 62 63 64 65 66 XT 60 60 60 60 60 60 60 60 60 60 C 2 2 2 2 2 2 2 2 2 2 PAYOFF 0 0 0 0 1 2 3 4 5 6 NET PROFIT -2 -2 -2 -2 -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)

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S = stock price XT = exercise price at time T C = European call option premium payoff Max (S XT, 0)

Payoof Call Bying / Long Payoff fromFrom Call Buying / Long 6

Profit / Loss

4 2 0 1 57 2 3 59 Spot Price 4 5 61 6 63 7 8 65 9 10 PL

-2 -4

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 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

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premium can be charged and returns from selling the call option can be used to make up for 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 investor gets out of the contract just before its expiry.

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PUT OPTIONS: The European Put option is the reverse of the call option deal. Here, there is a contract to sell a particular number of underlying assets on a particular date at a specific price. An example would help understand the situation a little better Example: An investor buys one European Put option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31st July. The strike price is Rs. 60 and the contract matures on 30th September. The payoff table shows the fluctuations of net profit with a change in the spot price. Payoff from Put buying/Long (Rs.) S 55 56 57 58 59 60 61 62 63 64 XT 60 60 60 60 60 60 60 60 60 60 P 2 2 2 2 2 2 2 2 2 2 PAYOFF 5 4 3 2 1 0 0 0 0 0 NET PROFIT 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 minus (S XT, 0)

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These are the two basic options that from the whole gamut of transactions in the options trading. These in combination with the other derivatives create a whole world of instruments to choose from depending on the kind of requirement and the kind of market expectations. Exotic Options are often mistaken to be another kind of option. They are nothing but non-standard derivatives and are not a third type of option.

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MARKET PLAYERS HEDGERS The objective of these kinds of traders is to reduce the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiraling oil prices have to be tamed using the security in derivative instruments. SPECULATORS They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down. ARBITRAGEURS Risk less profit making is the prime goal of Arbitrageurs. Buying in one market and selling in another, buying two products in the same, market are common. They could be making money even without putting their own money in and such opportunities come up in the market but last for very short time frames. This is because as soon as the situation arises arbitrageurs take advantage and demand-supply forces drive the markets back to normal. OPTIONS UNDERLYING Stocks Foreign currencies Stock indices Commodities And other Futures options

Are options on the futures contracts or underlying assets are futures contracts. The futures contract generally matures shortly after the options expiration

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OPTIONS PRICING Prices of options are commonly depending upon six factors. Unlike futures which derives there prices primarily from prices of the underlying. Options prices are far more complex. The table below helps understand the affect of each of these factors and gives a broad picture of option pricing keeping all other factors constant. The table presents the case of European as well as American Options.

EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION PRICES EUROPEAN OPTIONS Buying PARAMETERS CALL PUT Spot prices(S) Strike price (XT) Time to expiration (T) Volatility Risk Free Interest Rates (r) Dividends (D) AMERICAN OPTIONS Buying CALL PUT

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Spot prices In case of a call option the payoff for the buyer is max (S XT, 0) therefore , more the spot price more is the payoff and it is favorable for the buyer. It is the other way round for the seller, more the spot price higher is the chance of his going into a loss. In case of a put option, the payoff for the buyer is max (XT S, 0) therefore, more the spot price more are the chances of going into a loss. It is the reverse for Put Writing. Strike price In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the call option. Time to Expiration : More the time to expiration more favorable is the option. This can only exist in case of American option as in case of European options the options contract matures only on the date of maturity. Volatility: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/she can buy the same shares from the spot market at a lower price. Similar is the case of the put option buyer. Risk free rate of interest: In reality the r and the stock market are inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices discounting factor increases making the price fall. In case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the

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buyer to the position of loss in the payoff chart. The discounting factor increases and the future value become lesser. In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second effect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favorable on the call option. Dividends: When dividends are announced then the stock prices on ex-dividend are reduced. This is favorable for the put option and unfavorable for the call option.

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Bull spreads Simple option positions carry unlimited profits, limited losses for buyers and limited profits, unlimited losses for sellers (writers). Spreads create a limited profit, limited loss profile for users. By limiting losses, you are limiting your risks and by limiting profits you are reducing your costs. Those spreads which will generate gains in a bullish market are bull spreads. How is a bull spread created? one can create a bull spread by using two calls or two puts. If you are using calls, you should buy a call with a lower strike price and sell another call with a higher strike price. Example: CALL Satyam May buy Satyam May sell Net STRIKE PRICE 260 300 PREMIUM 24 5 19 PAY/RECEIVE Pay Receive pay

When should one enter into a bull spread like above? If you are bullish on Satyam which is quoted around Rs. 260. you believe it will rise during the month of may. However, you do not foresee Satyam rising beyond in that period. If you simply buy a call with a strike price of Rs. 260, the premium of Rs. 24 that you are paying is for unlimited gains which include the possibility of Satyam moving beyond Rs. 300 also. However, if you believe that Satyam will not move beyond Rs. 300, why should you pay a premium for this upward move? You might therefore decide to sell a call with a strike price of Rs. 300. by selling this call, you earn a premium of Rs. 5. You are sacrificing any gains

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beyond Rs. 300. the gain on the strike call which you bought will be offset by the loss on the 300 strike call which you are now selling. Thus, above Rs. 300 you will not gain anything. What will the payoff? The maximum loss is Rs. 19 i.e. the net premium you paid while entering into the bull spread. Your maximum receivable from the position on a gross basis is Rs. 40 i.e. the difference between the two strike prices. Thus, your maximum net profit is Rs. 21 (Rs. 40 minus Rs. 19). Various closing prices (on the expiry day) will result in various payoffs shown in the following table : Closing price Profit on 260 strike call (gross) 0 0 0 10 19 30 40 50 Profit on 300 strike call (gross) 0 0 0 0 0 0 0 -10 Premium paid on day one 19 19 19 19 19 19 19 19 Net profit

250 255 260 270 279 290 300 310

-19 -19 -19 -9 0 11 21 21

The above table shows that maximum loss will be of Rs. 19 if Satyam closes at Rs. 260 or below (i.e. the lower strike price) and the maximum profit of Rs. 21 will arise if Satyam closes at Rs. 300 or above (i.e. the higher strike price).

HOW MANY BULL SPREADS CAN BE CREATED ON ONE SCRIP? There are a minimum of 5 strike prices available. On volatile scrip, the number of strike prices is around 7 on an average. There are 7 calls and 7 puts on each scrip. You can create several spreads. On calls alone, you combine strike 1 with strike 2, strike 1 with strike 3 and so on.

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The number of spreads on calls will be 21 and a similar number on puts. Thus, there are 42 spreads on one scrip in one month series alone.

How does a Bull Spread work in a Put option? Interestingly, the bull spread logic remains the same. You buy a put option with a lower strike price and sell another one with a higher strike price. In this case however, the Put option with the lower strike price will carry a higher premium than that with the higher strike price. Example: If you buy a Reliance put option strike 280 for Rs. 24 and sell another Reliance put option strike Rs. 320 for Rs. 47, this would be a bull spread using puts. On day one you will receive Rs. 23 (Rs. 47 minus Rs. 24). Your maximum profit is this amount Rs. 23 which will be realized if Reliance closes above Rs. 320 (your higher strike price). Your maximum loss will be Rs. 17 and will arise if Reliance closes below Rs. 40 on closing out of the position. The payout of Rs. 40 minus the option premium earned of Rs. 23 will result in a loss of Rs. 17. Various closing prices will result in various payoffs shown in the following table:

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Closing price

Profit on 280 strike Put (gross) 30 10 0 0 0 0 0 0

Profit on 320 strike Put (gross) -70 -50 -40 -23 0 0 0 0

Premium received on day one 23 23 23 23 23 23 23 23

Net profit

250 270 280 297 320 330 340 350

-17 -17 -17 0 23 23 23 23

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BEAR SPREAD: In a bear spread, the profits and losses are both limited. Strategy view: investor thinks that the market will not rise, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to fall than rise How to use a bear spread? In a bear spread, you buy a call with a high strike price and sell a call with a lower strike price. For example, you could buy a Satyam 300 call at say Rs 5 and sell a Satyam 260 call at Rs. 26. You will receive a premium of Rs. 26 and pay a premium of Rs. 5, thus earning a Net Premium of Rs. 21. If Satyam falls to Rs. 260 or lower, you will keep the entire premium of Rs. 21. On the other hand if Satyam rises to Rs. 300 (or above) you will have to pay Rs. 40. After set off of the income of Rs. 21, your maximum loss will be Rs. 19. Satyam closing price 250 255 260 270 281 290 300 310 Profit on 260 strike call (gross) 0 0 0 -10 -21 -30 -40 -50 Profit on 300 strike call (gross) 0 0 0 0 0 0 0 10 Premium received on day one 21 21 21 21 21 21 21 21 Net profit

21 21 21 11 0 -9 -19 -19

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FUTURES
The first derivative product introduced in the Indian securities market was Index Futures. In the world, first index futures was traded in U.S. on Kansas city board of trade (KCBT) on value arithmetic index (VLAI) in1982

What are index futures? Index futures are the future contracts for which underlying is the cash market index, For example : BSE may launch a future contract on BSE sensitive index and NSE may launch a future contract on S&P CNX NIFTY

Product specifications BSE_30 Sensex futures Contract size Rs. 50 times the index Tick size 0.1 points or Rs. 5 Expiry day-last Thursday of the month Settlement basis cash settled Contract cycle 3 months Active contracts 3 nearest months

Product specification S&P CNX Nifty futures Contract size Rs. 200 times the index Tick size 0.05 points or Rs. 10 Expiry day last Thursday of the month Settlement basis cash settled Contract cycle 3 months Active contracts 3 nearest months

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Frequently used items in index futures market Contract size 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 Tick size it is the minimum price difference between two quotes of similar nature. Contract month the month in which the contract will expire. Expiry day the last day on which the contract is available for trading. Open interest total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open interest, only one side of the contracts is counted. Volume no. of contracts traded during a specific period of time. During a day, during a week or during a month. Long position outstanding/unsettled purchase position at any point of time Short position outstanding/unsettled sales position at any point of time. Open position outstanding/unsettled long or short position at any point of time. Physical delivery-open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low. Cash settlement-open position at the expiry of the contract is settled in cash. These contracts are designated as cash settled contracts. Index futures fall in this category Alternative delivery procedure (ADP)-open position at the expiry of the contract is settled by two parties one buyer and one at the terms other than defined by the exchange. World wide a significant

seller,

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portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.

ANALYSIS ON BIGGEST EVER CRASH IN THE INDIAN STOCK MARKET

Tumbling emerging markets? Whatever be the reason for the huge drop in the Sensex, the confidence of the average retail investor in the bourses has taken a strong beating.

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ON May 18, the Sensex, which had been on a record upswing, even crossing 12600 points on May 10, registered a fall of 826 points to close at 11,391. Such was the fall that on June 9, despite a gain of 514.65 points, the Sensex closed at 9810.46 points. Investors who had shifted from equity shares to commodities in order to neutralise the risk factor have also lost heavily as global commodity prices too have plunged sharply. The plummeting share market was followed by a wave of panic selling, most of it on loss. The brokers, who had hoped to book profits in the short-term, began exiting the markets in a hurry. But, while more seasoned brokers and long-term players might just manage to recoup their losses, it is the average retail investor, one of the over two lakh across India, who has been hit the hardest. Forced by the rising cost of living and falling interest rates in fixed deposit schemes of banks and post offices, the common man suddenly seemed interested in stocks and mutual funds. Applications for opening of demat accounts reached new heights. But now after the May 18 debacle and the decline thereafter, the common man is no longer much interested in the markets. Incidentally, such was the panic in the wake of the recent crash that police was deployed at many places, including the Kankaria Lake in Ahmedabad, to prevent investors and lossstricken broken from taking the suicide route. In Mumbai, a desolate businessman, who had lost over Rs 50 crores in the market crash, tried to end his life by consuming poison. Worried, the Union Finance Ministry stepped in and asked the government-backed mutual funds to pump in money to sustain the markets and ensure that there was no liquidity crisis. But, the mutual funds too have come unstuck when it mattered the most. Most of the mutual fund managers, including those which had a track record of 20-30 per cent annualized return on net asset value (NAV), have started showing signs of anxiety. Faced with an unusually large number of requests for redemption in the initial days of the market crash, the funds also pushed the sell button to meet cash requirements. While opinions differ on what really triggered the collapse, there seems to be unanimity that the three major reasons were:

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Correction by the markets, Pulling out by the foreign institutional investors (FIIs) and The general meltdown in the international markets, though strictly not in this order. Just consider the facts: the Sensex had taken 48 trading sessions to jump from 9,000 to 10,000 points, 29 trading sessions to take it from 10,000 to 11,000 points. The next 1,000-point mark took even lesser time to achieve. It took all of just 15 trading sessions for the Sensex to touch 12,000 points from 11,000.

SENSEX TEN BIG FALLS:

DATE May 18, 2006 April 28, 1992 May 17, 2004 May 15, 2006 April 4, 2000 May 12, 1992 May 14, 2004 May 6, 1992 April 12, 2006 March 31, 1997

FALL 826 points 570 points 565 points 463 points 361 points 334 points 330 points 327 points 306 points 303 points

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On 24th May, the Finance Minister issued a statement in Rajya Sabha on ''Recent Developments in the Stock Market'' where he sought to downplay the market crash and reiterated that the rise in the interest rate in the US due to inflationary expectations and a global fall in metal and other commodity prices were the prime reasons for the market meltdown. These factors have no doubt contributed to the crash. It is also true that stock markets globally have witnessed downturns over the past one week. However, the market crash in India stands out both in its magnitude as well as its specific underlying causes Data from the SEBI show that FIIs' net investment stood at - 2200.30 crores rupees for the entire month of May till 23rd May 2006. FII net investment on 22nd May, i.e. the day of the crash was - 1361 crores rupees. It is clear from the data that heavy selling by the FIIs caused the market meltdown. This is further corroborated by the fact that the exchange rate has declined continuously in the month of May in keeping with the withdrawal of funds by the FIIs. The rupee which stood at Rs 44.90 against a dollar on 2nd May 2006 slided to Rs 45.73 by 24thMay 2006, indicating the capital flight

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Movements in Sensex and cumulative FII investment ($mn)

The FIIs are worried about the following macro factors in the Indian Economy: India's Current Account Deficit (Balance of Payments on trade account) is at US $ 13.2 Billion, which is around 3.5 % of its GDP. This fact is public since March'06. The other BRIC economies have Current Account (BoP) surpluses. That this level of BoP also they feel that India attracts too little FDI. FDI into China in calendar 2005 was US $ 53.0 Billion. Brazil and Russia had an FDI of US $ 15.0 Billion each in 2005. India only attracted US $ 6.5 Billion during the same period. Again this information is public since Jan'06. The US $ will strengthen further as compared to the currencies in BRIC economies. Inflation will hit the Indian economy hard as the prices of gasoline and diesel will be raised further. They also feel that there is an imbalance in the Indian Banking Sector.

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American markets fell, followed by crash in the emerging markets. The fall was further compounded by global meltdown of prices of base metal prices Aluminum, Copper and Zinc. Gold also corrected sharply from a high of US $ 726 pto at LME on 12th May06 to US $ 619.00 as on today at LME. FIIs pulled out about US $ 1.6 billion in May06 from the Indian Equity Markets as compared to US $ 10.0 billion from the emerging markets. FIIs have pumped in US $ 4.0 billion into Indian Equities from Jan to April06

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The analysts have given the following reasons for the correction in global equity markets including India, which was more severely hit: Global fall in emerging markets lead by fall in DJIA and NASDAQ. Global crash in prices of base metals Aluminum, Copper and Zinc. There are views that Copper prices can fall further by 20 %. Gold will be stable. Hike of interest rates in USA. Slowing down of the American Economy, this could lead to recession in 2007. The change of monetary policies in Japan. The Bank of Japan may hike interest rates from the current zero level regime in Japan. A stronger American Dollar vis a vis currencies of emerging economies including BRIC. On account of all these factors equities on global emerging markets got hammered. The corrections were in the range of 10 to 25 %. Indian Equities were among the worst hit.

Relative movement of Sensex and NASDAQ

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Money-making never looked so easy as the Indian stock markets nearly trebled in two years. From a low of about 4,500 points on the Bombay Stock Exchange (BSE) index in May 2004, the markets embarked on an upward spiral and the BSE index was trading at a giddying 12,800 points. Economic powerhouse The world began to take notice and even started to believe in the potential of India as an emerging economic powerhouse of the 21st century. Indian companies offered good growth potential. Foreign investors alone put in more than a record $10.5bn last year and mutual funds gave returns of up to 200%. As more and more money started to come into the stock markets, optimism soon turned into euphoria. In the last few months, investors were further lulled into a feeling of a invincibility as the BSE index started to make gains by about 1,000 points virtually every other week. And whenever there was a fall in stock prices, it was almost always extremely short lived. The markets rebounded with added vigor in a matter of a few trading sessions.

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So when the markets began to crack this may the initial reaction of a majority of investors was that it was just another of the many "corrections" seen in this otherwise one-way market. Only this time the "corrections" continued to deepen. By Monday - when the markets crashed by over 1,100 points leading to a temporary suspension of trading - there was blood on the street. The scenario was even messier in several individual stocks, which lost nearly half of their value. But it was a complete massacre for those market speculators and traders who use the forward and options system in the Indian bourses to bolster their positions by speculating which way the market would move. There was such panic in the markets that the Indian Finance Minister, P Chidambaram, was forced to hold an impromptu press briefing. He talked up the market by saying that investors need not fear a meltdown in stock prices, as the long term Indian economic and growth story remained unchanged and looked solid. The Central Bank stepped in to allay fears of a liquidity crunch, and the market regulator the Securities and Exchange Board of India (SEBI) - made soothing noises, pointing out that all systems were in place and that the stock exchanges were in perfect shape to deal with any situation. The end result is that the market is showing signs of limping back to some kind of a recovery. 'More volatility' However, the events of May have left the Indian investor much poorer, with confidence at a new low. It is important to understand the reasons behind the crash and find an answer to the problems confronting Indian investors what happened in India was due to a combination of domestic developments and events on world markets. Emerging markets across the world cracked and so did India. There are concerns about oil prices, dollar stability and valuation, fears of an interest rate hike and the US economy slowing down. Stability has come in to the markets now although a little more volatility cannot be ruled out. A sense of stability has now returned, and in the long term, the Indian markets still look healthy.

Bombay traders have had an up and down time this year

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For a long term investor who is prepared to wait between three and five years, investment in equity remains a safe bet for a steady income. But is still seems as though the party is over - at least in the short term - for those who invested in the Indian markets hoping to make big sums overnight. But, experts are still optimistic that the honeymoon between the FIIs and the Indian markets is still not over. Most watchers of India's economic revival remain bullish on its long-term prospects. The recent setback in the Sensex does not negate the fact that, since the government instituted its market reforms in 1991, the stock market has steadily multiplied in value, similar to that other remarkable Asian growth story: China.

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