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DERIVATIVES
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BASICS OF DERIVATIVES
CONTENTS
FOREWORD ...................................................................................................................... 3
1.INTRODUCTION.......................................................................................................... 5
2. FUTURES .................................................................................................................... 11
3. OPTIONS..................................................................................................................... 26
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BASICS OF DERIVATIVES
Foreword
New ideas and innovations have always been the hallmark of progress made by
mankind. At every stage of development, there have been two core factors that
drives man to ideas and innovation. These are increasing returns and reducing
The financial markets are no different. The endeavor has always been to
maximize returns and minimize risk. A lot of innovation goes into developing
financial products centered on these two factors. It has spawned a whole new
Derivatives are among the forefront of the innovations in the financial markets
and aim to increase returns and reduce risk. They provide an outlet for investors
instruments have been very popular with investors all over the world.
Indian financial markets have been on the ascension and catching up with global
international markets.
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BASICS OF DERIVATIVES
As a logical step to the above progress, derivative trading was introduced in the
country in June 2000. Starting with index futures, we have made rapid strides
and have four types of derivative products- Index future, index option, stock
future and stock options. Today, there are 30 stocks on which one can have
futures and options, apart from the index futures and options.
markets have performed smoothly over the last two years and has stabilized. The
time is ripe for investors to make full use of the advantage offered by this market.
We have tried to present in a lucid and simple manner, the derivatives market, so
Editorial Team
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BASICS OF DERIVATIVES
1.Introduction
Derivatives can be of different types like futures, options, swaps, caps, floor,
collars etc. The most popular derivative instruments are futures and options.
There are newer derivatives that are becoming popular like weather derivatives
and natural calamity derivatives. These are used as a hedge against any
What the phrase means is that the derivative on its own does not have any value.
say an Infosys future or an Infosys option, these carry a value only because of
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BASICS OF DERIVATIVES
Financial derivatives are instruments that derive their value from financial assets.
These assets can be stocks, bonds, currency etc. These derivatives can be
forward rate agreements, futures, options swaps etc. As stated earlier, the most
• Speculators: People who buy or sell in the market to make profits. For
example, if you will the stock price of Reliance is expected to go upto Rs.400
in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make
profits
• Hedgers: People who buy or sell to minimize their losses. For example, an
/$ from Rs 48/$, then the importer can minimize his losses by buying a
different markets. For example, a futures price is simply the current price plus
the interest cost. If there is any change in the interest, it presents an arbitrage
separate chapter.
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BASICS OF DERIVATIVES
Basically, every investor assumes one or more of the above roles and derivatives
Derivatives have been a recent development in the Indian financial markets. But
there have been derivatives in the commodities market. There is Cotton and
Coffee futures in Bangalore etc. But the players in these markets are restricted to
big farmers and industries, who need these as an input to protect themselves
Globally too, the first derivatives started with the commodities, way back in 1894.
only in the 1970’s. The first exchange where derivatives were traded is the
In India, the first derivatives were introduced by National Stock Exchange (NSE)
in June 2000. The first derivatives were index futures. The index used was Nifty.
Option trading was started in June 2001, for index as well as stocks. In
November 2001, futures on stocks were allowed. Currently, there are 30 stocks
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BASICS OF DERIVATIVES
ACC 1500
BHEL 1200
BPCL 1100
BSES 1100
Cipla 200
Grasim 700
Hindalco 300
HPCL 1300
HDFC 300
Infosys 100
ITC 300
L&T 1000
MTNL 1600
M&M 2500
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BASICS OF DERIVATIVES
Ranbaxy 500
SBI 1000
TELCO 3300
TISCO 1800
VSNL 700
NIFTY 200
SENSEX 50
The trading is done on the exchange in the F&O (Futures and Option) segment.
Index F&O is also traded in the market. The indices traded are the Nifty and the
Sensex.
insurance?
You buy a life insurance policy and pay a premium to the insurance agent for a
fixed term as agreed in the policy. In case you survive, you are happy and the
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BASICS OF DERIVATIVES
insurance company is happy. In case you don’t survive, your relatives are happy
as the insurance company pays them the amount for which you are insured.
Insurance is nothing but transfer of risk. An insurance company sells you risk
cover and buys your risk and you sell your risk and buy a risk cover. The risk
companies bet on your surviving and hence agree to sell a risk cover for some
premium.
There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,
insurance, two people having opposite risks can enter into a contract and reduce
their risk. The most classic example is that of an importer and exporter. An
importer buys goods from country A and has to pay in dollars in 3 months. An
months. In case of an importer, the risk is of exchange rate moving up. In case of
an exporter, the risk is of exchange rate moving down. They can cover each
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2. Futures
Future, as the name indicates, is a trade whose settlement is going to take place
in the future. However, before we take a look at futures, it will be beneficial for us
A forward rate agreement is one in which a buyer and a seller enter into a
date.
An example for this is the exporters getting into forward rate agreements on
But there is always a risk of one of the parties defaulting. The buyer may not pay
up or the seller may not be able to deliver. There may not be any redressal for
What is a future?
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BASICS OF DERIVATIVES
specified price. These contracts are traded on the stock exchanges and it can
exchange involved in between, and the exchange guarantees each trade, the
buyer or seller does not get affected with the opposite party defaulting.
Futures Forwards
exchange instruments
Exit route is provided because of high No exit route for these contracts
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BASICS OF DERIVATIVES
There are two kinds of futures traded in the market- index futures and stock
futures.
There are three types of futures, based on the tenure. They are 1, 2 or 3 month
future. They are also known as near and far futures depending on the tenure.
Index futures are futures contract on the index itself. One can buy a 1, 2 or 3-
month index future. If someone wants to take a call on the index, then index
Let us try and understand what an index is. An index is a set of numbers that
A stock index is similarly a number that gives a relative measure of the stocks
that constitute the index. Each stock will have a different weight in the index
For example, Nifty was formed in 1995 and given a base value of 1000. The
value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000
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was invested in the stocks that form in the index, in the same proportion in which
they are weighted in the index, then Rs 1000 would have become Rs 1172 today.
There are two popular methods of computing the index. They are price weighted
method like Dow Jones Industrial Average (DJIA) or the market capitalization
• Future Price: The price at which the futures contract trades in the futures
market
• Expiry date: The date on which the futures contract will be settlec
• Basis : The difference between the spot price and the future price
Globally, it has been observed that index futures are more popular as compared
to stock futures. This is because the index future is a relatively low risk product
but very difficult to manipulate the whole index. Besides, the index is less volatile
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BASICS OF DERIVATIVES
stock.
Future price is nothing but the current market price plus the interest cost for the
If F is the future price, S is the spot price and C is the cost of carry or opportunity
cost, then
F=S+C
F = S + Interest cost, since cost of carry for a finance is the interest cost
Thus,
F=S (1+r)T
Where r is the rate of interest and T is the tenure of the futures contract.
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Example 2.1:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will
Solution
The one-month Reliance future would be the spot price plus the cost of carry.
Since the bank rate is 10 %, we can take that as the market rate. This rate is an
F=300(1+0.10)(1/12)
F= Rs 302.39
Example 2.2:
The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys
is Rs 3100. The returns expected from the Gsec funds for the same period is 10
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Solution
F= 3000(1+.0.10) (1/12)
F= Rs 3023.90
76.
Dividend is an income to the seller of the future. It reduces his cost of carry to
that extent. If dividend is going to be declared, the same has to be deducted from
F= S (1+r-d) T
Example 2.3:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will
per share
Solution:
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Since Reliance is paying 50 paise per share and the face value of reliance is Rs
F=300(1+0.10-0.05) (1/12)
F= Rs. 301.22
If the dividend is declared after buying a one month future, the cost of carry will
be reduced by a pro rata amount. For example, if there is a one month future
ending June 30th and dividend is declared on June 15th, then dividend benefit will
Since the seller is holding the shares and will transfer the shares to the buyer
only after a month, the dividend benefit goes to the seller. The seller will enjoy
Example 2.4:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance
Solution:
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BASICS OF DERIVATIVES
The benefit accrued due to the dividend will be reduced from the cost of the
future.
F= 300(1+0.10) (1/12)
F = 302.39
The interest benefit of the dividend is available for 15 days, ie 0.5 months.
Rs2.39-Rs0.61 = Rs 1.78
In practice, the market discounts the dividend and the prices are automatically
adjusted. The exchange steps into the picture if the dividend declared is more
than 10 % of the market price. In such cases, there is an official change in the
price. In other cases, the market does the adjustment on its own.
If a bonus is declared, the settlement price is adjusted to reflect the bonus. For
example, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the
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unaffected.
What has been discussed above is the theoretical way of arriving at the future
But the actual market price that we see on the trading screen depends on
liquidity too. So the prices that we observe in real world are also a function of
Future vs Spot
30
20 Future Price
Price
10 Spot Price
0
1 2 3 4 5 6 7
Tim e
Future prices lead the spot prices. The spot prices move towards the future
prices and the gap between the two is always closing with as the time to
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settlement decreases. On the last day of the future settlement, the spot price
The futures price can be lower than the spot price too. This depends on the
fundamentals of the stock. If the stock is not expected to perform well and the
market takes a bearish view on them, then the futures price can be lower than
In case of index futures, the treatment of the futures calculation is the same. The
future value is calculated as the spot index value plus the cost of carry.
Practically speaking, the index is corrected for these things in case there is a
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1.The contribution of the stock to the index is calculated. The index, as discussed
3. The dividend on the index is the dividend on the number of shares of the stock
in the index.
4. The interest earned on the dividend is calculated and reduced from the cost of
Example 2.5:
contributes to 15 % of the index. The market price of HLL is Rs 150. What will be
Solution:
F= 1000(1+0.10)(1/12)
F= 1008
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But in practice, the market discounts the dividends and price adjustment is made
accordingly.
All that is okay in theory, but what happens in the real world?
In the real world, derivatives are highly volatile instruments and there have been
lot of losses in the various financial markets. The classic examples have been
Long Term Capital Markets (LTCM) and Barings. We will examine what
the contract size. This is done primarily to keep the small investors away from a
acquired. So the initial players are institutions and high net worth individuals who
Because of this minimum amount, lots are decided on the market price such that
the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in
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Similarly minimum lots are decided for individual stocks too. Thus you will find
different stock futures having different market lots. The lots decided for each
stock was such that the contract value was Rs 2 lacs. This was at the point of
introduction of these instruments. However the lot size has remained the same
and has not been adjusted for the price changes. Hence the value of the contract
Trading, i.e. Buying and Selling take place in the same manner as the stock
markets. There will be an F & O terminal with the broker and the dealer will enter
Another fact of the real world is that, since the future is a standard instrument,
you can close out your position at any point of time and need not hold till
maturity.
Buying of futures is margin based. You pay an up front margin and take a
position in the stock of your choice. Your daily losses/ gains relative to the future
price will be monitored and you will have to pay a mark to market margin. On the
final day settlement is made in cash and is the difference between the futures
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BASICS OF DERIVATIVES
For example, if the future price is Rs 300 and the spot price is Rs 330, then you
will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a
In future, there is a possibility that the futures may result in delivery. In such a
scenario, the future market will be merged with the spot market on the expiration
day and it will follow the T+ 3 rolling settlement prevalent in the stock markets
In case you start making losses in your position, exchange collects money to the
extent of the losses up front. For example, if you buy futures at Rs 300 and its
price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This
is over and above the margin money that you pay to take a position in the future.
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3. Options
As seen earlier, futures are derivative instruments where one can take a position
for an asset to be delivered at a future date. But there is also an obligation as the
Options are one better than futures. In option, as the name indicates, gives one
party the option to take or make delivery. But this option is given to only one
party in the transaction while the other party has an obligation to take or make
But since the other party has an obligation and a risk associated with making
good the obligation, he receives a payment for that. This payment is called as
premium.
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The party that had the option or the right to buy/sell enjoys low risk. The cost of
this low risk is the premium amount that is paid to the other party.
Thus we have seen an option is a derivative that gives one party a right and the
other party an obligation to buy /sell at a specified price for a specified quantity.
The buyer of the right is called the option holder. The seller of the right (and
buyer of the obligation) is called the option writer. The cost of this transaction is
the premium.
For example, a railway ticket is an option in daily life. Using the ticket, a
passenger has an option to travel. In case he decides not to travel, he can cancel
the ticket and get a refund. But he has to pay a cancellation fee, which is
analogous to the premium paid in an option contract. The railways, on the other
hand, have an obligation to carry the passenger if he decides to travel and refund
his money if he decides not to travel. In case the passenger decides to travel, the
railways get the ticket fare. In case he does not, they get the cancellation fee.
The passenger on the other hand, by booking a ticket, has hedged his position in
case he has to travel as anticipated. In case the travel does not materialize, he
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can get out of the position by canceling the ticket at a cost, which is the
cancellation fee.
But I hear a lot of jargons about options? What are all these jargons?
There are some basic terminologies used in options. These are universal
a. Option holder : The buyer of the option who gets the right
b. Option writer : The seller of the option who carries the obligation
d. Exercise price: The price at which the option holder has the right to buy or
e. Call option: The option that gives the holder a right to buy
f. Put option : The option that gives the holder a right to sell
i. American option: These are options that can be exercised at any point till the
expiration date
j. European option: These are options that can be exercised only on the
expiration date
k. Covered option: An option that an option writer sells when he has the
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l. Naked option: An option that an option writer sells when he does not have the
m. In the money: An option is in the money if the option holder is making a profit
n. Out of money: An option is in the money if the option holder is making a loss
o. At the money: An option is in the money if the option holder evens out if the
The money made in an option is called as the option pay off. There can be two
Call option:
A call option gives the holder a right to buy shares. The option holder will make
money if the spot price is higher than the strike price. The pay off assumes that
the option holder will buy at the strike price and sell immediately at the spot price.
But if the spot price is lower than the strike, the option holder can simply ignore
the option. It will be cheaper to buy from the market. The option holder loss is to
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But if the spot price increases dramatically then he can make wind fall profits.
Thus the profits for an option holder in a call option is unlimited while losses are
Conversely, for the writer, the maximum profit he can make is the premium
Put option
The put option gives the right to sell. The option holder will make money if the
spot price is lower than the strike price. The pay off assumes that the option
holder will buy at spot price and sell at the strike price
But if the spot price is higher than the strike, the option holder can simply ignore
the option. It will be beneficial to sell to the market. The option holder loss is to
But if the spot prices falls dramatically then he can make wind fall profits.
Thus the profits for an option holder in a put option is unlimited while losses are
capped to the extent of the premium. This is a theoretical fallacy as the maximum
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fall a stock can have is till zero, and hence the profit of a option holder in a put
option is capped.
Conversely, the maximum profit that an option writer can make in this case is the
premium amount.
But in the above pay off, we had ignored certain costs like premium and
So, in a call option for the option holder to make money, the spot price has to be
If the spot is more than the strike price but less than the sum of strike price and
premium, the option holder can minimize losses but cannot make profits by
Similarly, for a put option, the option holder makes money if spot is less than the
If the spot is less than the strike price but more than the strike price less
premium, the option holder can minimize losses but cannot make profits by
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Example 3.1:
The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What
will be the profit for the option holder if the spot price touches a) Rs. 350 b)337
Solution
He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340.
He makes a profit of Rs 10
He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340.
He makes a loss of Rs 3.
But he has reduced his losses by exercising the option. Had he not exercised the
option, he would have made a loss of Rs 10, which is the premium that he paid
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But should one always buy an option? The buyer seems to enjoy all
This is not always the case. The writer of the option too can make money.
Basically, the option writers and option holders are people who are taking a
divergent view on the market. So if the option writer feels the markets will be
bearish, he can write call options and pocket the premium. In case the market
falls, the option holder will not exercise the option and the entire premium amount
can be a profit
But if the option writer is bullish on the market, then he can write put options. In
case the market goes up, the option holder will not exercise the option and the
The other area that an option writer makes money is the spot price lying in the
range between the strike price and the strike plus premium
For example, if you write a call option on Reliance for a strike price of Rs 300 at a
premium of Rs 30. If the spot price is Rs 320, then the option holder will exercise
the option to reduce losses and buy it at Rs 300. But you have already got the
premium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs
10 above the spot price! This profit increases even more if you calculate the
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Let us look at a typical pay off table for a call option, for the buyer as well as
writer. Let us assume a call option with a strike price of Rs 200 and a premium of
Rs 10
Table 3.1: Pay off Table for buyer and writer of an option
Price)
205 Yes -5 +5 0
210 Yes 0 0 0
In the above pay off table, if we take 200 as the median value, we see that the
writer has made money 5 out of 7 occasions. He has made money even when
the option is exercised, as long as the spot price is below the strike price plus the
premium.
Thus writers also make money on options, as the buyer is not at an advantage all
the time.
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What are the options that are currently traded in the market?
The options that are currently traded in the market are index options and stock
options on the 30 stocks. The index options are European options. They are
settled on the last day. The stock options are American options.
There are 3 options-1, 2,3 month options. There can be a series of option within
Another lingo in option is Near and Far options. A near option means the option
is closer to expiration date. A Far option means the option is farther from
expiration date. A 1 month option is a near option while a 3 month option is a far
option.
In option trading, what gets quoted in the exchange is the premium and all that
We said we could have different option series at various strike prices. How
The strike price bands are specified by the exchange. This band is dependent on
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<50 2.5
50-150 5
150-250 10
250-500 20
500-1000 30
>1000 50
Thus if a stock is trading at Rs. 100 then there can be options with strike price of
In practice, it is the market that decides the premium at which an option is traded.
There are mathematical models, which are used to calculate the premium of an
option.
The simplest tool is the expected value concept. For example, for a stock that is
a 30 % probability that it will become Rs 105. There is 30% probability that the
stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90.
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If the strike price of a call option is to be Rs 100, then the option will have value
90.
0.20*15+0.30*10=Rs 6.
Thus this the price that one can pay as a premium for a strike price of Rs 100 for
a stock trading at Rs 95. Rs 6 will also be the price for the seller for giving the
This is a very simple thumb calculation. Even then, one would require a lot of
There are more advanced probabilistic models like the Black Scholes model and
the Binomial Pricing model that calculates the options. One need not go deep
into those and it would suffice to say that option calculators are readily available.
Black Scholes Model. The Black Scholes Model is presented in greater detail in
Annexure-3.
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I keep reading about option Greeks? What are they? They actually sound
There are something called as option Greeks but they are nothing to be scared
of. The option Greeks help in tracking the volatility of option prices.
a. Delta: Delta measures the change in option price (the premium) to the change
stock
double derivative (the mathematical one) of the option price with respect to
These are just technical tools used by the market players to analyze options and
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We saw that the stock options are American options and hence can be
exercised any time. What happens when one decided to exercise the
option?
When the option holder decides to exercise the option, the option will be
the exchange.
The European options are also the similarly decided by the software of the
In future, there is a possibility that the options may result in delivery. In such a
scenario, the option market will be merged with the spot market on the expiration
day and it will follow the T+ 3 rolling settlement prevalent in the stock markets
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There are a lot of practical uses of derivatives. As we have seen, derivatives can
be used for profits and hedging. We can use derivatives as a leverage tool too.
You can use the derivatives market to raise funds using your stocks. Conversely,
The derivative product that comes closest to Badla is futures. Futures is not
badla, though a lot of people confuse it with badla. The fundamental difference is
badla consisted of contango and backwardation (undha badla and vyaj badla) in
This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You
have shares lying with you and are in urgent need of liquidity. Instead of pledging
your shares and borrowing from banks at a margin, you can sell the stock at Rs
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3000. Suppose you need this liquidity only for a month and also do not want to
part with Infosys. You can buy a 1 month future at Rs 3050. After a month you
get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the
The other beauty about this is you have already locked in your purchase cost at
Rs 3050. This fixes your liquidity cost also and you are protected against further
price losses.
The lending into the market is exactly the reverse of borrowing. You have money
to lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000
and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs
profits?
When you speculate, you normally take a view on the market, either bullish or
bearish. When you take a bullish view on the market, you can always sell futures
and buy in the spot market. If you take a bearish view on the market, you can buy
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Similarly, in the options market, if you are bullish, you should buy call options. If
Conversely, if you are bullish, you should write put options. This is so because, in
a bull market, there are lower chances of the put option being exercised and you
If you are bearish, you should write call options. This is so because, in a bear
market, there are lower chances of the call option being exercised and you can
example, future is nothing but the future value of the spot price. This future value
But if there are differences in the money market and the interest rates change
then the future price should correct itself to factor the change in interest. But if
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Example 4.1:
A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005.
The risk free interest rate is 12%. What should be the trading strategy?
Solution:
The strategy for trading should be : Sell Spot and Buy Futures
1000(1+.012)(1/12)
=1009
But an important point is that this opportunity was available due to mis-pricing
and the market not correcting itself. Normally, the time taken for the market to
adjust to corrections is very less. So the time available for arbitrage is also less.
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One can hedge one’s position by taking an opposite position in the futures
market. For example, If you are buying in the spot price, the risk you carry is that
of prices falling in the future. You can lock this by selling in the futures price.
Even if the stock continues falling, your position is hedged as you have firmed
Similarly, you want to buy a stock at a later date but face the risk of prices rising.
You can use a combination of futures too to hedge yourself. There is always a
correlation between the index and individual stocks. This correlation may be
negative or positive, but there is a correlation. This is given by the beta of the
stock.
In simple terms, what β indicates is the change in the price of a stock to the
change in index. For example, if β of a stock is 0.8, it means that if the index
goes up by 10, the price of the stock goes up by 8. It will also fall by a similar
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A negative β means that the price of the stock falls when the index rises. So, if
you have a position in a stock, you can hedge the same by buying the index at β
Example 4.2:
The β of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I
Scenario 1
If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800
of Rs 800.
Scenario 2
If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800
But the value of the stock also falls by 8 %. The value of this stock becomes Rs
nothing but analysis of past data. So there is a chance that the above position
may not be fully hedged if the β does not behave as per the predicted value.
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Options are a great tool to use for trading. If you feel the market will go up. You
should buy a call option at a level lower than what you expect the market to go
up.
If you think that the market will fall, you should buy a put option at a level higher
When we say market, we mean the index. The same strategy can be used for
We have seen that the risk for an option holder is the premium amount. But
An option writer can use a combination strategy of futures and options to protect
his position. The risk for an option writer arises only when the option is exercised.
Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium
of Rs 20. The risk arises only when the option is exercised. The option will be
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BASICS OF DERIVATIVES
exercised when the price exceeds Rs 300. I start making a loss only after the
More importantly, I have to deliver the stock to the opposite party. So to enable
me to deliver the stock to the other party and also make entire profit on premium,
This is just one leg of the risk. The earlier risk was of the call being exercised.
The risk now is that of the call not being exercised. In case the call is not
exercised, what do I do? I will have to take delivery as I have bought a future.
So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need to
pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully
But the above pay off will be possible only when the premium I am paying for the
put option is lower than the premium that I get for writing the call.
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BASICS OF DERIVATIVES
Similarly, we can arrive at a covered position for writing a put option too,
put and the call option. So if one tracks the derivative markets on a continuous
basis, one can chance upon almost risk less money making opportunities.
The other strategies are also various permutations of multiple puts, calls and
futures. They are also called by exotic names , but if one were to observe them
• Butter fly spread: It is the strategy of simultaneous buying of put and call
a longer-term option is bought both having the same striking price. Either puts
• Double option – An option that gives the buyer the right to buy and/or sell a
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BASICS OF DERIVATIVES
• Bermuda Option – Like the location of the Bermudas, this option is located
maturity and an American style option which can be exercised any time the
dates
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BASICS OF DERIVATIVES
Derivatives are high-risk instruments and hence the exchanges have put up a lot
The most critical aspect of risk management is the daily monitoring of price and
NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that
has origins at the Chicago Mercantile Exchange, one of the oldest derivative
The objective of SPAN is to monitor the positions and determine the maximum
loss that a stock can incur in a single day. This loss is covered by the exchange
SPAN evaluates risk scenarios, which are nothing but market conditions.
The specific set of market conditions evaluated, are called the risk scenarios, and
(a) how much the price of the underlying instrument is expected to change over
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BASICS OF DERIVATIVES
(b) how much the volatility of that underlying price is expected to change over
Based on the SPAN measurement, margins are imposed and risk covered. Apart
from this, the exchange will have a minimum base capital of Rs 50 lacs and
brokers need to pay additional base capital if they need margins above the
permissible limits.
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BASICS OF DERIVATIVES
6. SETTLEMENT OF DERIVATIVES
There is a daily settlement for Mark to Market .The profits/ losses are computed
as the difference between the trade price or the previous day’s settlement price,
as the case may be, and the current day’s settlement price. The party who have
suffered a loss are required to pay the mark-to-market loss amount to exchange
which is in turn passed on to the party who has made a profit. This is known as
Theoretical daily settlement price for unexpired futures contracts, which are not
traded during the last half an hour on a day, is currently the price computed as
F = S * e rt
where :
t = time to expiration
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BASICS OF DERIVATIVES
Rate of interest may be the relevant MIBOR rate or such other rate as may be
specified.
After daily settlement, all the open positions are reset to the daily settlement
price.
Trade day). The mark to market losses or profits are directly debited or credited
to the broker account from where the broker passes to the client account
Final Settlement
On the expiry of the futures contracts, exchange marks all positions to the final
The final settlement of the futures contracts is similar to the daily settlement
process except for the method of computation of final settlement price. The final
settlement profit / loss is computed as the difference between trade price or the
previous day’s settlement price, as the case may be, and the final settlement
Final settlement loss/ profit amount is debited/ credited to the relevant broker’s
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BASICS OF DERIVATIVES
clearing bank account on T+1 day (T= expiry day). This is then passed on the
client from the broker. Open positions in futures contracts cease to exist after
Premium settlement is cash settled and settlement style is premium style. The
premium payable position and premium receivable positions are netted across all
option contracts for each broker at the client level to determine the net premium
The brokers who have a premium payable position are required to pay the
The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade
day). The premium payable amount and premium receivable amount are directly
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BASICS OF DERIVATIVES
effected for valid exercised option positions at in-the-money strike prices, at the
close of the trading hours, on the day of exercise. Valid exercised option
contracts are assigned to short positions in option contracts with the same series,
between the strike price and the settlement price of the relevant option contract.
T+3 day (T= exercise date). From there it is passed on to the clients.
prices existing at the close of trading hours, on the expiration day of an option
contract. Long positions at in-the money strike prices are automatically assigned
to short positions in option contracts with the same series, on a random basis.
For index options contracts, exercise style is European style, while for options
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BASICS OF DERIVATIVES
of the relevant broker with the respective Clearing Bank, from where it is passed
to the client.
Final settlement loss/ profit amount for option contracts on Index is debited/
credited to the relevant broker clearing bank account on T+1 day (T = expiry
Final settlement loss/ profit amount for option contracts on Individual Securities is
debited/ credited to the relevant broker clearing bank account on T+3 day (T =
Open positions, in option contracts, cease to exist after their expiration day.
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BASICS OF DERIVATIVES
The same is true of India. In India, a committee was set up under Dr L C Gupta
to study the introduction of the derivatives market in India. The report of the LC
This committee formulated the guidelines and framework for the derivatives
market and paved the way for the derivatives market in India.
There other committee that has far reaching implications in the derivatives
for trading in the exchange. A lot of emphasis has been laid on margining and
As for the taxation aspect, the CBDT is treating gains from derivative
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BASICS OF DERIVATIVES
In the earlier part, we saw how useful derivatives are as hedging and risk
the risks inherent in using derivatives. Spectacular losses have been made and
some companies have even come to the point of collapse after using derivative
• In 1994, American consumer products giant Procter and Gamble (P&G), lost
an estimated US$ 200 million on a complex interest rate Swap. The Swap
was intended to lower funding costs for P&G if interest rates moved in a
future interest rate changes. It was the result of speculation and lax controls.
The company ought not to have betted on interest rate changes. This case
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BASICS OF DERIVATIVES
derivatives.
• Barings, Britain’s oldest merchant bank lost 900m pounds sterling on Nikkei
ultimately leading to the bank’s near collapse in 1995. The main person
• In 1994, Orange County, USA’s richest local authority went bankrupt after
derivatives. The market moved against him and the county faced losses of
around US$ 1.6 billion. Afterwards, Merrill Lynch agreed to pay Orange
County over US$ 400m rather than face trial, in a friendly agreement.
The above examples are enough to make any potential user of derivatives
apprehensive. However, the stories not told about derivatives represent the
majority of cases where derivatives effectively reduce risk. Today, almost all
users is fast increasing. Derivatives are no different than the majority of modern
inventions: if used in a proper way they are powerful and, indeed valuable tools.
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BASICS OF DERIVATIVES
In wrong hands, they can cause tremendous destruction as the above examples
people with inadequate knowledge and who do not fully understand the complex
structure of derivatives. Derivatives are highly complex instruments and are often
derivatives amply demonstrates this. It is clear that the derivative products used
A careful study of the Barings case brings to light several issues. Extensive data
obtained by Singapore inspectors show that Nick Leeson lost 4.8m pounds
sterling between July and October 1992. Leeson covered all the losses by July
’93. But it appeared that Leeson recovered his losses by selling options in a way
that stored up trouble. He used a strategy called “Straddling”. Simply put, Leeson
traded in a way that he was severely exposed to the market movement and a
slight movement against him would lead to huge losses. After the Kobe
earthquake, the volatility of the Nikkei increased sharply and Leeson and
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BASICS OF DERIVATIVES
Leeson did not take the relatively small losses he would have made had he sold
the contracts when the market started to go against him, but waited in the hope
that the situation would reverse and he would make good the losses. But this
What Leeson did was to engage in highly speculative trading. He primarily used
speculative profits. The downside risk was huge and the risk of losses was great.
Derivatives have acquired a myth of danger and mystery. One reason is the
se, rarely, if ever, cause disasters. It is to be noted that most companies use
derivatives for risk reduction and only very few businesses with poor
value. In other words, contracts, which may be worth millions, if the market
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BASICS OF DERIVATIVES
Usually, the market will not move that much and the contract will be settled or
sold to somebody else for a small gain or loss. However, if it does shift
significantly, big losses can be incurred, which are magnified due to the gearing
effect.
Banks have complex computer programmes to tell them how much they could
lose if the market moves by a certain amount. Regulations require them to put
On exchanges, traders have to pay any losses incurred on their position at the
end of each day. This "margin" payment is to prevent risks getting out of hand.
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BASICS OF DERIVATIVES
discrepancy.
2. Backwardation – The price differential between spot and back months when
directions with the centre delivery month common to both. The perfect
a longer-term option is bought both having the same striking price. Either puts
5. Call option – An option that gives the buyer right to buy a futures contract at a
6. Contango – The price differential between spot and back months when the
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BASICS OF DERIVATIVES
metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the
9. Double option – An option that gives the buyer the right to buy and/or sell a
10. Futures contract – A legally binding agreement for the purchase and sale of a
11. Hedge fund – A large pool of private money and assets managed
aggressively and often riskily on any futures exchange, mostly for short-term
gain.
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BASICS OF DERIVATIVES
12. In-the money option – An option with intrinsic value. A call option is in-the-
money if its strike price is below the current price of the underlying futures
13. Kerb trading - Trading by telephone or by other means that takes place after
the official market has closed. Originally it took place in the street on the kerb
14. Margin call – A demand from a clearing house to a clearing member or from a
against the ruling price of the contract at that time, in order to determine the
16. Naked option – An option granted without any offsetting physical or cash
17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock
at a set price on or before a given date. Investors who purchase call options
bet the stock will be worth more than the price set by the option (the strike
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BASICS OF DERIVATIVES
price), plus the price they paid for the option itself. Buyers of put options bet
the stock's price will go down below the price set by the option.
18. Out-of-the money option – An option with no intrinsic value. A call option is
out-of-the money if its strike price is above the underlying and a put option is
which the buyer of the option pays to the option writer for the rights to the
option contract.
20. Spread – The difference between the bid and asked prices in any market.
21. Stop-loss orders – An order placed in the market to buy or sell to close out an
open position in order to limit losses when the market moves the wrong way.
22. Straddle – The simultaneous purchase and sale of the same commodity to
23. Swap – An agreement to exchange one currency or index return for another,
the exchange of fixed interest payments for a floating rate payments or the
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BASICS OF DERIVATIVES
24. Underlying – The currency, commodity, security or any other instrument that
perform a certain obligation in return for the price of the option. Also known as
Option Writer.
26. All-or nothing Option – An option with a fixed, predetermined payoff if the
27. Average Options - A path dependant option that calculates the average of the
the difference between the average price of the underlying asset, over the life
28. Barrier Options - These are options that have an embedded price level,
(barrier), which if reached will either create a vanilla option or eliminate the
option makes the probability of pay off all the more difficult. Thus the reason a
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BASICS OF DERIVATIVES
buyer purchases a barrier option is for the decreased cost and therefore
increased leverage.
30. Bermuda Option – Like the location of the Bermudas, this option is located
maturity and an American style option which can be exercised any time the
dates,
33. Digital Options - These are options that can be structured as a "one touch"
barrier, "double no touch" barrier and "all or nothing" call/puts. The "one
touch" digital provides an immediate payoff if the currency hits your selected
price barrier chosen at outset. The "double no touch" provides a payoff upon
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BASICS OF DERIVATIVES
expiration if the currency does not touch both the upper and lower price
barriers selected at the outset. The call/put "all or nothing" digital option
34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii)
down and in. With knock-in options, the buyer starts out without a vanilla
option. If the buyer has selected an upper price barrier and the currency hits
that level, it creates a vanilla option with maturity date and strike price agreed
upon at the outset. This would be called an up and in. The down and in option
is the same as the up and in, except the currency has to reach a lower
barrier. Upon hitting the chosen lower price level, it creates a vanilla option.
37. Rainbow Options - This type of option is a combination of two or more options
combined each with its own distinct strike, maturity, etc. In order to achieve a
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the-money Nikkei index call option upon expiration, the quanto option terms
would trigger by converting the yen proceeds into dollars which was specified
at the outset in the quanto option contract. The rate is agreed upon at the
beginning without the quantity of course, since this is an unknown at the time.
41. Tandem Options – A sequence of options of the same type, usually covering
42. Up-and-Out Option – The call pays off early if an early exercise price trigger is
hit. The put expires worthless if the market price of the underlying risks is
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BASICS OF DERIVATIVES
43. Zero Strike Price Option – An option with an exercise price of zero, or close to
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The derivatives market in India has rapidly grown and is fast becoming very
The table below indicates the growth witnessed in the derivatives market.
Month/ Index Futures Stock Futures Index Options Stock Options
Year
No. of Turnover No. of Turnover Call Put Call Put
contracts (Rs. cr.) contracts (Rs. cr.)
No. of Notional No. of Notional No. of Notional No. of Notional
contracts Turnover contracts Turnover contracts Turnover contracts Turnover
(Rs. cr.) (Rs. cr.) (Rs. cr.) (Rs. cr.)
Jun.00 1,191 35 - - - - - - - - - -
Jul.00 3,783 108 - - - - - - - - - -
Aug.00 3,301 90 - - - - - - - - - -
Sep.00. 4,376 119 - - - - - - - - - -
Oct.00 6,388 153 - - - - - - - - - -
Nov.00 9,892 247 - - - - - - - - - -
Dec.003 9,208 237 - - - - - - - - - -
Jan.01 17,860 471 - - - - - - - - - -
Feb.01 19,141 524 - - - - - - - - - -
Mar.01 15,440 381 - - - - - - - - - -
00-01 90,580 2,365 - - - - - - - - - -
Apr.01 13,274 292 - - - - - - - - - -
May.01 10,048 230 - - - - - - - - - -
Jun.01 26,805 590 - - 5,232 119 3,429 77 - - - -
Jul.01 60,644 1,309 - - 8,613 191 6,221 135 13,082 290 4,746 106
Aug.01 60,979 1,305 - - 7,598 165 5,533 119 38,971 844 12,508 263
Sep.01 154,298 2,857 - - 12,188 243 8,262 169 64,344 1,322 33,480 690
Oct.01 131,467 2,485 - - 16,787 326 12,324 233 85,844 1,632 43,787 801
Nov.01 121,697 2,484 125,946 2,811 14,994 310 7,189 145 112,499 2,372 31,484 638
Dec.01 109,303 2,339 309,755 7,515 12,890 287 5,513 118 84,134 1,986 28,425 674
Jan.02 122,182 2,660 489,793 13,261 11,285 253 3,933 85 133,947 3,836 44,498 1,253
Feb.02 120,662 2,747 528,947 13,939 13,941 323 4,749 107 133,630 3,635 33,055 864
Mar.02 94,229 2,185 503,415 13,989 10,446 249 4,773 111 101,708 2,863 37,387 1,094
01-02 1,025,588 21,482 1,957,856 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383
Apr.02 73,635 1,656 552,727 15,065 11,183 260 5,389 122 121,225 3,400 40,443 1,170
May.02 94,312 2,022 605,284 15,981 13.07 294 7,719 169 126,867 3,490 57,984 1,643
Source: www.nseindia.com
2.Index options and stock options were started only in June and July 2001 respectively
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3000
Value Rs Crores
2500
2000
1500
1000
500
0
Jun.00
Jun.01
Aug.00
Aug.01
Feb.01
Feb.02
Dec.003
Apr.01
Apr.02
Oct.00
Oct.01
From June 2000 to May 2002 Dec.01
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BASICS OF DERIVATIVES
The options price for a Call, computed as per the following Black Scholes
formula:
C = S * N (d1) - X * e- rt * N (d2)
where :
d1 >OQ6;U12
W@1
VTUWW
d2 >OQ6;U12
W@1
VTUWW
= d11
VTUWW
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BASICS OF DERIVATIVES
EXECUTIVE SUMMARY
provide the facility for hedging in the most cost-efficient way against market risk. This is
an important economic purpose. At the same time, it recognises that in order to make
hedging possible, the market should also have speculators who are prepared to be
2. The Committee is of the opinion that there is need for equity derivatives, interest rate
derivatives and currency derivatives. In the case of equity derivatives, while the
determined by market forces under the general oversight of SEBI and that both futures
and options will be needed, the Committee suggests that a beginning may be made with
3. The Committee favours the introduction of equity derivatives in a phased manner so that
the complex types are introduced after the market participants have acquired some
degree of comfort and familiarity with the simpler types. This would be desirable from the
envisage two-level regulation, i.e. exchange-level and SEBI-level. The Committee’s main
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BASICS OF DERIVATIVES
SEBI, it is necessary that SEBI should review the working of the governance system of
stock exchanges and strengthen it further. A much stricter governance system is needed
for the derivative exchanges in order to ensure that a derivative exchange will be a totally
6. The Committee is of the opinion that the entry requirements for brokers/dealers for
derivatives market have to be more stringent than for the cash market. These include not
only capital adequacy requirements but also knowledge requirements in the form of
sales practices.
prevention of fraud, investor protection, etc., are of general and over-riding nature and
8. The Committee has recommended that the regulatory prohibition on the use of
derivatives by mutual funds should go. At the same time, the Committee is of the opinion
that the use of derivatives by mutual funds should be only for hedging and portfolio
balancing and not for speculation. The responsibility for proper control in this regard
should be cast on the trustees of mutual funds. The Committee does not favour framing
of detailed SEBI regulations for this purpose in order to allow flexibility and development
of ideas.
9. SEBI, as the overseeing authority, will have to ensure that the new futures market
operates fairly, efficiently and on sound principles. The operation of the underlying cash
markets, on which the derivatives market is based, needs improvement in many respects.
The equity derivatives market and the equity cash market are parts of the equity market
mechanism as a whole.
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BASICS OF DERIVATIVES
10. SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and Economic
Research Wing. It would need to develop a competence among its personnel in order to
Chapter 1
OF DERIVATIVES
1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by
a Board resolution dated November 18, 1996 in order "to develop appropriate regulatory
framework for derivatives trading in India". List of the Committee members is shown in
the end
2. The Committee’s concern is with financial derivatives in general and equity derivatives in
particular.
3. The development of futures trading is an advancement over forward trading which has
existed for centuries and grew out of the need for hedging the price-risk involved in many
commercial operations. Futures trading represents a more efficient way of hedging risk.
4. As both forward contracts and futures contracts are used for hedging, it is important to
understand the distinction between the two and their relative merits. Forward contracts
are private bilateral contracts and have well-established commercial usage. They are
contract size, expiration date and the asset type/quality. The contract price is not
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BASICS OF DERIVATIVES
transparent, as it is not publicly disclosed. Since the forward contract is not typically
5. In contrast, futures contracts are standardized tradable contracts. They are standardized
in terms of size, expiration date and all other features. They are traded on specially
safeguards. They are liquid and transparent. Their market prices and trading volumes are
regularly reported. The futures trading system has effective safeguards against defaults
in the form of Clearing Corporation guarantees for trades and the daily cash adjustment
Futures are far more cost-efficient than forward contracts for hedging.
6. Forward contracts are being used in India on a fairly large scale in the foreign exchange
market for covering currency risk but there are neither currency futures nor any other
financial futures in India at present. This report deals only with exchange-traded
worldwide long-term historical process. In this process, the emergence of futures has
significance. A vast economic literature has been built around this subject. From
financial futures is a more recent phenomenon and represents an extension of the idea of
8. Among financial futures, the first to emerge were currency futures in 1972 in U.S.A.,
followed soon by interest rate futures. Stock index futures and options first emerged in
1982 only. Since then, financial futures have quickly spread to an increasing number of
developed and developing countries. They are recognized as the best and most cost-
efficient way of meeting the felt need for risk-hedging in certain types of commercial and
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BASICS OF DERIVATIVES
financial operations. Countries not providing such globally accepted risk-hedging facilities
9. The Committee noted that derivatives are not always clearly understood. A few well-
widespread apprehensions in Indian public mind also. While the economic literature
the financial markets in particular, the Committee feels that there is need for educating
the public opinion as also the need to ensure effective regulatory checks. Such regulation
should be aimed not only at ensuring the market’s integrity but also at enhancing the
Derivatives concept
10. The term "derivative" indicates that it has no independent value, i.e. its value is entirely
"derived" from the value of the cash asset. A derivative contract or product, or simply
"derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset
option contract of pre-determined fixed duration, linked for the purpose of contract
11. Derivatives are meant essentially to facilitate temporarily (usually for a few months)
certain period. In practice, every derivative "contract" has a fixed expiration date, mostly
in the range of 3 to 12 months from the date of commencement of the contract. In the
market’s idiom, they are "risk management tools". The use of forward/futures contracts as
Their application to financial transactions is relatively new, having emerged only about 25
years ago.
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BASICS OF DERIVATIVES
12. In order to illustrate the use of this risk hedging technique, we may take the familiar
fluctuation in the market price of his main raw material. For instance, a maker of gold
jewellery may have accepted an export order to be delivered over the next three months.
If, in the meanwhile, the cash price of gold (the raw material) rises, the jewellery maker’s
manufacturing and exporting activity can become economically unviable. The availability
of gold futures alleviates the manufacturer-exporter’s problem. He can buy gold futures.
Any loss caused by rise in the cash price of gold purchased for the export order will then
be offset by profit on the futures contract. Any extra profit due to fall in gold price will also
be offset as there will be loss on the futures contract. Thus, hedging is the equivalent of
insurance facility against risk from market price variation. A world without hedging facility
is like a world without insurance with respect to the particular kind of risk.
13. The manufacturer-exporter in the example given above could, of course, have bought all
the raw material requirement in advance but that would have entailed heavy interest,
insurance and storage costs. Thus, the facility of futures trading offers a cost-efficient and
14. Apart from the risk from variation of raw material price, the manufacturer-exporter, in the
above example, also faces another risk from variation of exchange rate. If the rupee
appreciates before he is able to bring the export proceeds into India, his rupee receipts
15. Futures and options have many similarities and serve similar purposes but the risk profile
to futures contract. Options are contracts giving the holder the right (but not the
obligation) to buy (known as "call option") or sell (known as "put option") securities at a
pre-determined price (known as "strike price" or "exercise price"), within or at the end of a
specified period (known as "expiration period"). American options are exercisable at any
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BASICS OF DERIVATIVES
time prior to expiration date while European options can be exercised only at the
expiration date. For the call option holder, it is worthwhile to exercise the right only if the
price of the underlying securities rises above the exercise price. For the put option holder,
it is worthwhile to exercise the right only if the price falls below the exercise price. There
can be options on commodities, currencies, securities, stock index, individual stocks and
16. In order to acquire the right of option, the option buyer pays to the option seller (known as
"option writer") an Option Premium, which is the price paid for the right. The buyer of an
option can lose no more than the option premium paid but his possible gain in
unbounded. On the other hand, the option writer’s possible loss is unbounded but his
maximum gain is limited to the "option premium" charged by him to the holder. The most
critical aspect of options contracts is the evaluation of the fairness of option premium, i.e.
option pricing.
17. The Committee feels that the availability of both financial futures and options would
provide to the users a wider choice of hedging instruments than any of them alone.
18. Hedging is the key aspect of derivatives and also its basic economic purpose. In the U.S.,
the Commodity Futures Trading Commission (CFTC), the futures regulatory authority,
examines the ability of the product to provide hedging. While the Committee has also
emphasized the hedging aspect of derivatives, it fully recognises that the derivatives
19. For the above reason, decisions about many aspects of derivatives trading, e.g., contract
size, design and duration, would have to strike a balance between the needs of the
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BASICS OF DERIVATIVES
who are prepared to take upon themselves the price risk which hedgers want to give up.
The fact is that a futures market, to be able to operate and be liquid, should have both
hedging participation and speculative appeal. Some studies of futures markets in the U.S.
have shown that hedging activity accounts for about 50-60 per cent of the market’s total
volume.
20. The Committee is of the opinion that a futures market based wholly or mostly on
speculation will not be a sound economic institution. There presently exist in India legal
themselves.
21. In the case of a hedger, seeking to offset the price risk on his holding of inventory of
bonds, equities, foreign currency or commodities by selling futures in the same, his
Inventory transactions
If price falls There will be loss There will be profit Hedger wants to
loss
If price rises There will be Profit There will be loss The inventory profit
and is neutralised
by loss on futures.
reduce or transfer risk. On the contrary, he is accepting risk in the pursuit of profit. It
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BASICS OF DERIVATIVES
regard to future prices of the particular commodity or financial asset traded in the
futures market.
21. The test of whether a futures transaction is for hedging or for speculation hinges on
whether there already exists a related commercial position which is exposed to risk of
loss due to price movement. The distinction between hedging and speculation is of great
regulatory restriction, are allowed to hedge but not to speculate in the forward or futures
markets.
18. The Committee’s main concern is with equity based derivatives but it has tried to
transactions and asset-liability positions are exposed to three broad types of price risks,
viz:
b. interest rate risk (as in the case of fixed-income securities, like treasury
bond holdings, whose market price could fall heavily if interest rates shot up),
and
The above classification of price risks explains the emergence of (a) equity
futures, (b) interest rate futures and (c) currency futures, respectively. Equity
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23. The recent report of the RBI-appointed Committee on Capital Account Convertibility
(Tarapore Committee) has expressed the view that "time is ripe for introduction of futures
in currencies and interest rates to facilitate various users to have access to a wide
spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tarapore
Committee has also opined that "a system of trading in futures ... is more transparent and
24. There are inter-connections among the various kinds of financial futures, mentioned
above, because the various financial markets are closely inter-linked, as the recent
financial market turmoil in East and South-East Asian countries has shown. The basic
principles underlying the running of futures markets and their regulation are the same.
1
Having a common trading infrastructure will have important advantages. The Co mmittee,
therefore, feels that the attempt should be to develop an integrated market structure.
25. As all the three types of financial derivatives are set to emerge in India in the near future,
formal mechanism be established for such coordination between SEBI and RBI in respect
of all financial derivatives markets. This will help to avoid the problem of overlapping
jurisdictions.
Chapter 2
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May 1997, the number of replies received was 112, comprising 67 brokers
and 45 others.
In addition, the Committee held a full day session to interact with groups
2. The survey clearly revealed that there was wide recognition of the need for
all the three major types of financial derivatives, viz., equity derivatives,
interest rate derivatives and currency derivatives. The results of the survey
3. Interestingly, the survey findings showed that stock index futures ranked as
the most popular and preferred type of equity derivative, the second being
stock index options and the third being options on individual stocks.
mentioned above. The fourth type, viz. individual stock futures, was favoured
much less. It is pertinent to note that the U.S.A. does not permit individual
stock futures. Only one or two countries in the world are known to have
futures on individual stocks. Stock Index Futures are internationally the most
who placed stock index futures as first represented 65% of the sample,
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compared to 39 per cent who placed stock index options as first (see Table
2.1).
5. The survey also showed that there exists widespread demand for hedging
facility, as indicated by the finding that nearly 70% of the respondents in our
sample indicated that they would like to use the various types of equity
dealer/speculator, 64% as broker and only about 36% as option writer. Many
6. In terms of contract duration of Stock Index futures and options, the 3 months
duration was the most favoured, as may be expected. As regards the choice
between the American and European types of options, the former was
favoured overwhelmingly.
expected it to grow moderately and the remaining 16% expected slow growth
of trading. On the whole, the survey findings are very positive about the need
There are many reasons for the wide international acceptance of stock index
futures and for the strong preference for this instrument in India too compared to
Hence, index-based derivatives are more suited to them and more cost-
U.S.A. are known to use stock index futures for risk hedging purposes.
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BASICS OF DERIVATIVES
influencing the cash prices of its component securities. While the possibility
3. Stock index futures enjoy distinctly greater popularity, and are, therefore,
likely to be more liquid than all other types of equity derivatives, as shown
experience.
4. Stock index, being an average, is much less volatile than individual stock
prices. This implies much lower capital adequacy and margin requirements in
the case of index futures than in the case of derivatives on individual stocks.
The lower margins will induce more players to join the market.
accepted principle everywhere. The futures and the cash market prices have
physically deliverable asset, they are cash settled all over the world on the
premise that the index value is derived from the cash market. This, of course,
and the index values based on it can be safely accepted as the settlement
price.
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than for other kinds of equity derivatives, such as stock index options, or
1. The objective of SEBI is to make both derivatives market and cash market
equity cash market and equity derivatives market are of one piece. Their
objective in view and would like to ensure that the new derivatives market is
separating cash market and futures market and thereby regulating them
effectively. At present, almost 90 per cent of the trading volume in the cash
market does not settle in deliveries of the stock. The great bulk (over 85 per
cent) of such trading is in 5 scrips only. The Committee noted that several
majority of listed shares and the practice of switching of positions from one
cycles.
2. The Committee hopes that some of the speculative transactions, which are
efficient futures market. The Committee also recognises the danger that if the
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market, based on such a cash market, will fail to give a correct indication of
future spot prices and its usefulness for price discovery will be reduced.
4. The Committee is of the opinion that the following revisions could lead to a
a. uniform settlement cycle among all the stock exchanges moving towards
rolling settlement cycles to prevent the cash market from effectively being
number of securities.
The Committee is of the view that arbitrage transactions between the index
futures market and the cash market for equities is likely to have a beneficial
adequately enter into the price discovery process in the cash market and,
through it, in the futures market. In this connection, the Committee noted that
dissemination of all relevant market information about the "real" factors, such
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BASICS OF DERIVATIVES
Committee feels that there are two important ways of promoting its linkage to
ratio of the index used for futures trading should be made available by the
the arbitrage between the index futures market and the cash market for the
be traded in the depository mode and also by making available the facility of
derivatives, not for generating speculative profits, but for strategic purposes
institutional representatives :
balanced mutual fund scheme decides to reduce its equity exposure from,
say, 40% to 30% of the corpus. Presently, this can be achieved only by
likely to depress equity prices to the disadvantage of the Scheme and the
whole market; second, it cannot be achieved speedily and may take some
same objective can be achieved through index futures at once, at much less
cost and with much less impact on the cash market. The scheme may
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BASICS OF DERIVATIVES
ii. Investing the funds raised by new schemes: When a new scheme is floated,
the money raised does not get fully invested for considerable time. Suitable
quantity. Rushing to invest the whole money is likely to drive up prices to the
the market situation may change. The availability of stock index futures can
a part of the portfolio but there are problems in executing such liquidation.
cash market to liquidate would drive down prices. The price actually realised
may be different from the price used in NAV computation for repurchase. The
unitholders.
iv. Preserving the value of portfolio during times of market stress: There are
times when the main worry is the possibility that the value of the entire equity
portfolio may fall substantially if, say, event "X" occurs. Sale of Stock Index
Futures can be used to insure against the risk. Such insurance is specially
important if the accounts closing date is nearby because the yearly results
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BASICS OF DERIVATIVES
will get affected if the risk materialises. Stock index futures can neutralise
such risk.
transactions are through the cash market only. This is an important factor
making the Indian equities market highly volatile from day to day. The FIIs'
Indian equities market. In other words, what the FIIs buy/sell is a "piece" of
the whole Indian equities market. If stock index futures are available, this can
be carried out with greater speed and less cost and without adding too much
to market volatility. The FII flows show sudden changes from time to time.
While trying to maximise the net inflow of FII portfolio investment, its
disturbing effects on the cash market for Indian equities can possibly be
Phasing needed
in India should ultimately be left to the market forces under over-all general
the case in other countries. The experience in other countries also shows
and survive for long. The market decides which ones will succeed.
2. The consensus in the Committee was that stock index futures would be the
best starting point for equity derivatives in India. The Committee has arrived
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BASICS OF DERIVATIVES
would favour the introduction of other types of equity derivatives also, as the
derivatives market grows and the market players acquire familiarity with its
individual stocks. There may also be room for more than one stock index
the over-all supervision of SEBI. One member of the Committee, i.e. Mr. P.S.
futures.
withdrawn by the Securities Laws Amendment Act with effect from January
25, 1995.
Table 2.1
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affirmative replies
(Total respondents=112)
Number % to total
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i. hedger 78 69.64
dealers/speculators 44 39.29
broker 72 64.29
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BASICS OF DERIVATIVES
popular in India?
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trading in:
3 months 93 83.04
6 months 70 62.50
9 months 37 33.04
12 months 35 31.25
3 months 88 78.57
6 months 60 53.57
9 months 27 24.11
12 months 31 27.68
i. American 79 70.54
European 30 26.79
Note: Questions 2b, 3b and 4c expected respondents to tick against one type only
but some respondents ticked more than one, resulting in double counting. Hence, the
percentages add to more than 100. This does not, however, vitiate the relative
Chapter 3
Regulatory objectives
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following objectives :
overall exposure was not controlled and the use of derivatives was
iii. Competent and honest service: The eligibility criteria for trading
base.
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iv. Market integrity: The trading system should ensure that the market's
framework should not stifle innovation which is the source of all economic
2. Leaving aside those who use derivatives for hedging of risk to which they are
leverage. For this reason, the risk involved for derivative traders and
trading, in all its aspects, has to be much stricter than what exists for cash
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on the one hand and SEBI on the other. The committee envisages that this
issues, some of which have a direct bearing on the design of the regulatory
both framing and enforcing the regulations, between SEBI and the
derivatives exchange?
c. How should we ensure that the derivatives exchange will effectively fulfill its
regulatory responsibility.
d. What criteria should SEBI adopt for granting permission for derivatives
trading to an exchange?
e. What conditions should the clearing mechanism for derivatives trading satisfy
1. A major issue raised before the Committee for its decision was whether
trading. The Committee has examined various aspects of the problem. It has
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BASICS OF DERIVATIVES
the same in all countries. Interestingly, in U.S.A., for reasons of history and
currency, bonds and equities, was started in early 1970s, under the auspices
the underlying bonds and equities were being traded. This may have
U.S.A. and partly because derivatives were not "securities" under U.S. laws.
Cash trading in securities and options on securities were under the Securities
and Exchange Commission (SEC) while futures trading was under the
b. The recent trend in other countries seems to be towards bringing futures and
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and cash markets is greatly facilitated if both are parts of the same
exchange.
a. The trading rules and entry requirements for futures trading would have to be
be greater if cash and futures trading are conducted in the same exchange.
c. A separate exchange will start with a clean slate and would not have to
restrict the entry to the existing members only but the entry will be thrown
Recommendation
From the purely regulatory angle, a separate exchange for futures trading seems to
facilities, the existing stock exchanges having cash trading may also be permitted to
trade derivatives provided they meet the minimum eligibility conditions as indicated
below :
1. The trading should take place through an online screen-based trading system, which
also has a disaster recovery site. The per-half-hour capacity of the computers and
the network should be at least 4 to 5 times of the anticipated peak load in any half-
hour, or of the actual peak load seen in any half-hour during the preceding six
months. This shall be reviewed from time to time on the basis of experience.
corporation, which satisfies the conditions listed in a later chapter of this report.
3. The exchange must have an online surveillance capability which monitors positions,
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exchange in real-time over at least two information vending networks which are
a separate segment with a separate membership; i.e., all members of the existing
cash market would not automatically become members of the derivatives market.
7. The derivatives market should have a separate governing council which shall not
whatever percentage SEBI may prescribe after reviewing the working of the present
shall not carry on any Broking or Dealing Business on any Exchange during his
tenure as Chairman.
9. The exchange should have arbitration and investor grievances redressal mechanism
12. If already existing, the Exchange should have a satisfactory record of monitoring its
3.9 The next chapter will elaborate how the regulatory responsibilities placed on the
derivative exchange and the SEBI are to be carried out in a dovetailed manner.
Chapter 4
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regulations and (2) SEBI rules and regulations with which the exchange and
its members must comply. The Committee feels that since the Securities
Contracts (Regulation) Act, 1956 and the Rules framed thereunder, SEBI Act
being in day to day touch with the market, will be in a position to spot a
problem and take prompt corrective action. As a statutory body, SEBI will first
have to enquire, collect all the facts and go through a certain statutory
possible to the exchanges which are the beneficiaries from the business
way.
3. The Committee was informed about the regulatory concerns regarding the
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that SEBI should review its own experience of the present stock exchange
governance system in terms of how far the system has been able to ensure
and what further improvements, if any, are needed. As most of the regulatory
4. Most of the new regulations required for derivatives trading are exchange-
and guidance to the exchange and to act as the regulator of last resort.
5. The Committee is of the view that all the above regulations have to be much
stricter for derivatives trading than the existing regulations for cash trading.
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BASICS OF DERIVATIVES
6. The Committee also feels that every derivative trader/member (not just 10
both to provide guidance in the initial years and to check compliance. This is
7. SEBI should approve the rules, bye-laws and regulations of the derivative
exchange and should also approve the proposed derivative contracts before
8. The Committee feels that SEBI need not be involved in framing exchange-
level rules but it should evaluate them, identify deficiencies and suggest
the theory and practice of financial derivatives so that it can provide guidance
closely involved in guiding this new and complex development along right
Such success will be beneficial for the country's economy and will bring
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USAID's FIRE Project, more than 90 per cent of countries with established
exchange.
10. The Committee suggests that before starting trading in a new derivatives
product, the derivatives exchange should submit the proposal for SEBI's
traded (b) the economic purposes it is intended to serve (c) its likely
this regard.
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11. In view of what has been said above, the Committee recommends the
personnel.
expertise for independent advice on many problems which are bound to arise
cash market volatility and price discovery. Many such questions have been
unlikely to have the time to study and analyse data. They can be usefully
4.12 The division of regulatory responsibility at two levels as suggested above by the
flexibility, (b) maximising regulatory effectiveness and (c) minimising regulatory cost.
Chapter 5
BROKERS/DEALERS
1. The Committee feels that the derivatives market will have to be subjected to
more stringent requirements than is the case with present cash markets. This
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the members of the existing cash market will not automatically become
members of the derivatives market. Only those who satisfy the stricter
trading.
Capital adequacy
2. The experience of Indian exchanges has been that the credibility of the
any case, a broker’s or dealer’s stated networth is very often not available to
meet the claims payable to the exchange. Hence, for effectively ensuring
note of the above, the views of the Committee regarding capital adequacy
Guiding considerations
and sufficient competition. Too high a requirement may keep most Indian
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The advantage of the two-level system is that it can help to bring in more
exchange should have a minimum net worth of Rs. 300 lakh as per SEBI’s
definition and shall make a deposit of Rs.50 lakh with the Exchange/Clearing
lieu of such deposit may also be accepted. The Clearing Corporation can
Certification Requirement
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SEBI.
Chapter 6
CLEARING CORPORATION
responsible for guaranteeing settlement for all open positions. Hence, if any Clearing
Member defaults, settlement for other Clearing Members would not be affected. This
would protect the reputation of the Exchange and would minimise the default risk of
6.2 The Clearing Corporation will collect initial (i.e. upfront) margin to which the
exposure limits of the broker/dealer would be linked, as explained later. The Clearing
the Clearing/trading member from trading in order to stop further increase in his
exposure.
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6.3The requirements for capital adequacy and upfront margin should be set taking
into account the volatility of the underlying market. For this purpose, normally, daily
volatility (as measured by standard deviation of average return from one-day holding
periods) is taken into account. Such daily volatility in India for major stock indices is
around 1.3-1.4 per cent compared to just around 1 per cent for the S&P 500 Index in
U.S.A.. In addition, we have to take into account two more facts, viz., first, the
collection of daily mark-to-market margin may take more than one day because
electronic funds transfer facility is not yet universal in India; and second, the worst
scenario possibility, i.e. largest 1-day or 2-day fluctuation experienced over the last
few years.
6.4 Since market volatility changes over time, the Committee feels that the Clearing
Corporation should continuously analyse this problem and may modify the margin
requirements to safeguard the market. The dual objective has to be guaranteeing its
for the stock exchanges would be most effective arrangement. However, since this
may be difficult to achieve in the immediate future, it should remain as the ultimate
goal to be achieved. Efforts should continue to be made in this direction. Until such
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The Committee strongly urges SEBI to take the initiatives with potential promoters to
6.7 Apart from the minimum networth requirement, there should be a maximum
exposure limit computed on gross basis for each broker/dealer. Such exposure
in Indian context, the minimum networth requirement has not proved adequate.
Mark-to-market margins
6.8 The Committee feels that even the system of mark-to-market margins on
daily basis will not be adequate for safeguarding the market’s integrity unless the
margins are actually collected before the start of the next day’s trading. Even a
threat to the market’s integrity. The Committee noted that electronic funds
transfer (EFT) was not yet pervasive in India. If the mark-to-market margins
cannot be collected before the start of next day’s trading, the networth
requirement and initial deposit with the exchange would have to be higher. The
margins before the next day’s trading starts. For this purpose all derivatives
finally decided after taking into account both the extent of volatility and the time
Cross-margining
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6.9 At the initial stage of derivatives market in India, the Committee does not favour
cross-margining which takes into account a dealer’s combined position in the cash
and derivative segments and across all stock exchanges. The Committee recognises
that cross-margining is logical and would economise the use of a trading member’s
capital, but a conservative approach would be more advisable until the reliability of
systems has been fully established. The systems capability has to emerge before
brokers from their clients should be insisted upon in the case of derivatives trading. In
other words, margin collection from clients should not be left to the discretion of
systems of inspection, reporting, etc., that margins are actually collected from all
the high leverage and consequently higher risk involved in derivatives trading. Two
indirect methods of ensuring this should also be adopted, viz. (1) exposure limits for
should be fixed on gross basis and (2) brokers/dealers should be required to disclose
to the exchange the trading done on their own behalf separately from trading on
clients’ behalf at the time of order entry. The trading volume should also be divided
11. The Committee further recommends that the Clearing Corporation should
trades on their own account from the margins deposited with it on client
account. The Clearing Corporation shall not utilise the margins deposited
with it on client account for fulfilling the dues which a Clearing Member may
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account. The principle which the Committee would like to advocate regarding
client moneys is that these should be regarded as held in trust for client
purpose only and should not be allowed to be diverted to any other purpose.
Such moneys are sacrosanct as they usually represent the client’s hard
earned savings.
12. The following process may be adopted by the Clearing Corporation for
segregating the margin money held against a broker’s own position from that
held against the client position. At the time of opening a position, the
dealer/broker should indicate whether the position is for the client or for the
broker himself. On all client positions, both buy or sell, margins should be
collected on gross basis (i.e. on buy and sell positions separately without
margin paid by such Member on his own account only would be allowed to
be used by Clearing Corporation for realising its own dues from the Member.
of Member default.
6.13 The Committee feels that a clearing corporation must have SEBI approval
for functioning as such. To be eligible for such approval, it should satisfy the
following conditions :
1. The clearing corporation must perform full novation, i.e. the clearing
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2. The clearing corporation should have the capacity to monitor the overall
position of members across both cash and derivatives markets for those
3. The level of initial margin required on a position should be related to the risk
calculating required levels of initial margin. The initial margin should be large
enough to cover the one-day loss that can be encountered on the position on
99% of the days. These capital adequacy norms should apply intra-day, so
that there is no instant of time where the good funds deposited by the
member to the clearing corporation are smaller than the value at risk of the
position at that point in time. The clearing corporation should have intra-day
monitoring software to ensure that this condition is met at every single instant
within the day. "Good funds" here are defined as the initial margin and the
should charge special margin over and above the normal margins.
5. The clearing corporation must establish facilities for electronic funds transfer
initial margin to cover the potential for losses over the time elapsed in
moving funds, then the value at risk should be calculated based on the
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6.14 The clearing mechanism is the centre-piece of a derivatives market, both for
implementing the margin system and for providing trade guarantee. Hence, the
arrangements must require SEBI approval. The policy should be to nudge the
system towards a single national clearing corporation for all stock exchanges.
Chapter 7
disputes between broker-dealer and the client have arisen in U.S.A. on some
exercise care to ensure that the derivative product being sold by them to a
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profitability on the margin money invested and high risk. The concept of
3. The risk and complexity vary among derivative products. While some
4. In order to give some idea in this regard, the Committee enquired into sales
highly complex. Hence, there is a special regulatory regime for options. This
derivatives, may involve, some special features found in the U.S. are
enumerated below:
to any client any options transaction unless they have reasonable grounds to
believe that the entire recommended transaction is not unsuitable for the
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options transaction unless they have a reasonable basis for believing that the
customer has such knowledge and financial experience that he or she can be
the transaction.
information about its customers including, but not limited to, their net worth,
made only by a senior options supervisor who must ensure that investors are
e. The derivatives exchange also requires that all the supervisory and sales
or foreign currency also must pass a separate interest rate options or foreign
currency examination.
complaint log for all options-related complaints which include: (a) the name of
the complainant; (2) the date when the complaint was received; (3) the sales
person servicing the account; (4) a description of the complaint; and (5) a
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g. In addition, the broker-dealer firm is required to submit all sales literature and
dealer must provide a copy of this document at or prior to the time such
i. There are also special trading rules applicable to the options markets. These
position limits.
Exchange’s responsibility
sales practices for derivatives from the very beginning. It should be the
to take the necessary steps in this regard under the general oversight of
strictly the "know your customer" rule and requires that every client trading in
clients should be available with the broker. Customers should be given a risk
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funds, they should be allowed to trade derivatives only if and to the extent
etc.), over-all limits for derivative exposure, the authority level for giving
broker/dealer may execute orders for such clients only if the orders are
Directors/Trustees.
shareholders and investors can know how such involvement fits into the
organisation’s objectives and affects its revenues, financial position and risk
bodies.
5. The SEBI (Mutual Fund) Regulations presently prohibit the use of derivatives
by mutual funds. The Committee is of the opinion that mutual funds need
hedging facility. They will be among the most important users of equity
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It is, therefore, all the more important that the regulatory prohibition on the
immediately.
policy framework and rules laid down by their Board of Trustees who should
specify what derivatives are allowed to be used, within what limits, for what
purposes, for which schemes, and also the authorisation procedure. The
7. At this stage, the Committee does not consider it advisable to frame detailed
SEBI regulations about the use of derivatives by mutual funds as this would
stifle the development of ideas. The Committee prefers that the responsibility
for proper control in this regard should be placed on the trustees of mutual
funds. This would help evolution of practices on sound lines without creating
a strait jacket.
8. Further, what has been said earlier about internal control, accounting
apply to mutual funds also. The offer documents of mutual fund schemes
should disclose whether the scheme permits the use of derivatives and the
details in this regard. Also the income and balance sheet of each mutual fund
scheme would have to disclose the impact of derivatives trading and of any
Concluding observations
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9. There is no doubt that equity derivatives and other financial derivatives have
10. At the same time, derivatives trading inherently involves high leverage. For
speculators. Also some users may not fully understand derivatives and use
11. In drawing up a regulatory framework for derivatives, the Committee has kept
in view not only the need for allowing adequate flexibility in order to permit
the derivatives market to develop in India but also the need for strict watch so
Chairman :
Director
Member-Secretary :
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MUMBAI-400 021.
Other Members :
MUMBAI-400 065.
MUMBAI-400 021.
MUMBAI-400 021.
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BASICS OF DERIVATIVES
MUMBAI-400 021.
MUMBAI-400 056.
Oxford International
MUMBAI-400 005.
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BASICS OF DERIVATIVES
MUMBAI-400 021.
BANGALORE-560 027.
MUMBAI-400 021.
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BASICS OF DERIVATIVES
MUMBAI-400 002.
24 BD Rajabahadur Compound
MUMBAI-400 023.
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BASICS OF DERIVATIVES
128