RESEARCH PROJECT REPORT

SUBMITTED TOWARDS THE PARTIAL FULFILLMENT OF MASTER IN BUSINESS ADMINISTRATION

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET

SUBMITTED BY:

TARUN JAJU
MBA (2009-2011)

SUBMITTED TO Mrs. SHWETA SIKKA (FACULTY GUIDE)

DELHI INSTITUTE OF MANAGEMENT AND RESEARCH NEW DELHI
(Affiliated to M. S. University) STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 1

PREFACE
It is evident that work experience is an indispensable part of every professional course. In the same manner practical training in any organization is a must for every individual who is undergoing management course. Without practical experience, one cannot consider oneself as a qualified, potential & capable manager. The well planned, properly executed and evaluated industrial training helps a lot in inoculating good work culture. It provides linkage between the student and the industry in order to develop the awareness of industrial approach to problem solving based on broad understanding of plant, process, product and mode of operations of industrial organization. EDELWEISS is a broking company which deals in investment banking,

securities broking, and investment management. It is very big organization in
which the new technology is used. I prepared myself for work in any condition during the training period and understood the various processed used there. I worked under the department of demat open at Edelweiss broking limited, New Delhi.

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET

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ACKNOWLEDGEMENT

First of all it is my privilege to acknowledge with gratitude to Edelweiss broking limited, New Delhi for granting me to take practical training in this esteemed organization.
I wish to thank the College Authority for giving me a golden opportunity to take practical training on

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET
I am overwhelmed with rejoice to avail this rare opportunity to evince our profound sense of reference and gratitude to Mr. Praveen kumar, Branch Manager (Finance), Ms. Sachin arora & Mr. mujeeb ul hasan for providing facilities and material to carry out this project and for constant encouragement throughout this project. I would like to express our sincere gratitude to Dr. Ashok Jeph, Director of DELHI INSTITUTE OF Management & RESEARCH NEW DELHI, Ms. NAVDEEP KAUR & SHWETA SIKKA for their support, precious guidance and constructive encouragement. No acknowledge would suffice for the support of my family members, my training colleagues, classmates and friends.

TARUN JAJU

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET

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8. 13. 4. 7. 11. 5. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 4 . 12. 2. 10.NO.INDEX TOPICS Introduction Research Objective Research Methodology Indian Capital Market Overview Derivative Market Pros & Cons of Derivatives Indian Derivative Market Users of Derivatives Conclusion Recommendations Limitations Bibliography Annexure PAGE NO. 1. 6. 9. 05 11 12 14 24 48 59 65 85 89 91 92 93 S. 3.

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In 1848. although favorable prices could be obtained during period of over supply. However. a merchant with an ongoing requirement of grain too would face a price risk and that of having to pay exorbitant prices during dearth. he would have to dispose off his harvest at a very low price. which would enable both parties to eliminate the price risk. What they would then negotiate happened to be a futures-type contract. and in 1925 the first futures clearing house came into existence. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. On the other hand.INTRODUCTION TO DERIVATIVES The origin of derivative can be traced back to the need of formers to protect themselves against fluctuation in the price of their crops. These were eventually standardized. or CBOT. was established to bring farmers and merchant together. Through the use of simple derivatives products. Under such circumstances. A group of traders got together and create the ‘to-arrive’ contract that permitted farmers to lock in to price un front and deliver the grain later. it clearly made sense for the farmer and the merchant to come together and enter in a contract whereby the price of the grain to be delivered in September could be decided earlier. it was possible for the farmers to partially or fully transfer price risk by locking – in assets prices. From th time it was sown to the time it was ready for harvest. A farmer who sowed his crops in June face uncertainty over the price of he would receive for his harvest in September. during times of over supply. In years of scarcity. farmers would face price uncertainty. he would probably obtain attractive prices. These were simple contracts developed to meet the needs of farmers and basically a means of reducing risks. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 6 . Clearly this meant that the farmer and his family were exposing to a high risk of uncertainty. the Chicago Board of Trade.

Initially. Hedging is the most important aspect of derivatives and also its basic economic purpose. wheat. whose values are derived from the value of an underlying primary financial instrument. Thus for a sound derivatives market. Derivatives are risk shifting instruments. interest rate. besides commodities. they were used to reduce exposure to changes in foreign exchange rates. There has to be counter party to hedgers and they are speculators. derivatives contracts also exist on a lot of financial underlying like. both hedgers and speculators are essential.  Speculator A speculator is a one who accepts the risk that hedgers wish to transfer. Derivatives defined Derivatives are financial contracts of pre-determined fixed duration.Today. cotton. commodity or index. Speculators don’t look at derivatives as means of reducing risk but it’s a business for them. silver. Participants in Derivatives Markets  Hedgers These are market players who wish to protect an existing asset position from future adverse price movements. and equities. derivative contract exist on a variety of commodities such as corn. Speculators have no position to protect and do not necessarily have the physical resources to make delivery of the underlying asset nor do they STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 7 . exchange rates. exchange rate etc. Rather he accepts risks from the hedgers in pursuit of profits. or stock indexes or commonly known as risk hedging. etc. commodities. pepper. such as: interest rates. interest rates.

 Options: An Option gives holder the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 8 . swaps etc. Types of Derivatives The common derivatives are futures. forward contracts.necessarily need to take delivery of the underlying asset. Futures are similar to Forward Contracts. In general they buy futures contracts when they expect futures prices to rise and sell futures contract when they expect futures prices to fall. the counterparty to a Futures contract is the clearing corporation on the appropriate exchange.  Arbitrageurs These are traders and market makers who deal in buying and selling futures contracts hoping to profit from price differentials between markets and/or exchanges. and settlement of financial obligation happens at the end of each trading day under the terms of future. These are described below. Unlike Forward Contracts. options. rather than requiring physical delivery of the underlying asset. They take positions on their expectations of futures price movements and in order to make a profit. but are standardized and traded on an exchange. Futures often are settled in cash or cash equivalents. Futures: A Future represents the right to buy or sell a standard quantity and quality of an asset or security at a specified date and price.

Option premium is calculated using option pricing models like Black Scholes Model etc. the purchaser and its counter party are obligated to trade a security or other asset at a specified date in the future. An Option to buy is known as a Call Option and an Option to sell is called a Put Option. the option buyer pays to the option seller (known as "option writer") an Option Premium. The price paid for the security or asset is agreed upon at the time the contract is entered into.  Swaps: A Swap is a simultaneous buying and selling of the same security or obligation. or may be determined at delivery. This is the most common type of Swap and also known as plain vanilla swap. one would become obligated to sell a security to or buy a security from the party that purchased the Option.called the 'Strike' price. The buyer of an option can lose an amount no more than the option premium paid but his possible gain in unlimited. It can be an agreement in which two parties exchange interest payments based on an identical principal amount. called the notional principal amount. On the other hand. In order to acquire the right of option. Forward Contracts generally are traded OTC. the option writer’s possible loss is unlimited but his maximum gain is limited to the option premium charged by him to the holder. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 9 . One can purchase Options (the right to buy or sell the security) or sell (write) Options.  Forwards: In a Forward Contract. As a seller.

providing economic agents a wider choice of risk management strategies.  Leaps: the acronym LEAPS means long term Equity Anticipation Securities. A payer swaption is an option to pay fixed and received floating. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 10 . 3. These are option having a maturity of up to thee years. A receiver swaption is an opinion to receive fixed and pay floating. Increased integration of national financial markets with the international markets. Longer-dated options are called warrants and are generally traded over the counter. 4. Factors driving the growth of financial derivatives 1. the Swaptions market has receiver swaption and payer Swaptions. and 5. Innovations in the derivatives markets. Increased volatility in asset prices in financial markets. 2. Development of more sophisticated risk management tools.  Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options thus a swaption is an option on a forward swap. which optimally combine the risks and returns over a large number of financial assets leading to higher returns. Marked improvement in communication facilities and sharp decline in their costs. Warrants: options generally have the life of upto one year. reduced risk as well as transactions costs as compared to individual financial assets. Rather than have calls and puts. the majority of options traded on options exchange having a maximum maturity of nine months.

RESEARCH OBJECTIVE Research problem “Study of Derivatives in the India capital market” The main objective of the study is to do the detailed analysis of the trading of derivatives in the capital market in Indian context and this is also includes the study of:  Meaning  Type  Trading  Clearing & settlement  Regulatory framework STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 11 .

The research design of my study is “Exploratory” STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 12 . income. research design con be grouped into three categories. EXPLORATORY: Focuses on discovery on ideas and generally based on secondary data.RESEARCH METHODOLOGY Research Design A research design specifies the methods and procedure for conducting a particular study. Broadly speaking. CAUSAL: It is undertaken when the researcher is interested in knowing the cause and effect relationship between two or more variables. occupation etc. One has to specify the approach he intends to use with respect to the proposed study. DISCRIPTIVE: It is undertaken when the research wants to know the characteristics of certain groups such as age. sex. educational level.

It is an elaborate process through which the researcher makes a planned search for all relevant data and gathers the entire data required for the assignment. (see Bibliography also) Data collection is the heart of all research work. magazines and books etc.DATA SOURCES Research is based on secondary data that has been collected from various sources like internet. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 13 . journals.

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The number of brokers increased to about 200 to 250. the 'Share Mania' in India begun. In 1887. Its history dates back to nearly 200 years ago. 87). By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in Bombay. at the end of the American Civil War. At the end of the American Civil War. in 1865. However.INDIAN CAPITAL MARKET: AN OVERVIEW Evolution Indian Stock Markets are one of the oldest in Asia. In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was stopped. they formally STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 15 . the brokers who thrived out of Civil War in 1874. Thoh the trading list was broader in 1839. there were only half a dozen brokers recognized by banks and merchants during 1840 and 1850. The 1850's witnessed a rapid development of commercial enterprise and brokerage business attracted many men into the field and by 1860 the number of brokers increased into 60. thus. a disastrous slump began (for example. The earliest records of security dealings in India are meagre and obscure. found a place in a street (now appropriately called as Dalal Street) where they would conveniently assemble and transact business. The East India Company was the dominant institution in those days and business in its loan securities used to be transacted towards the close of the eighteenth century. Bank of Bombay Share which had touched Rs 2850 could only be sold at Rs.

the need for a Stock Exchange at Ahmedabad was realized and in 1894 the brokers formed "The Ahmedabad Share and Stock Brokers' Association". After 1880. many mills originated from Ahmedabad and rapidly forged ahead. the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899. which was followed by a boom in tea shares in the 1880's and 1890's. Indian cotton and jute textiles. the jute industry was to Calcutta. and with the inauguration of the Tata Iron and Steel Company Limited in 1907. the industrial revolution was on the way in India with the Swadeshi Movement. some leading brokers formed "The Calcutta Stock Exchange Association". the Stock Exchange at Bombay was consolidated. As new mills were floated. in the 1870's there was a sharp boom in jute shares. On June 1908. sugar. Other leading cities in stock market operations Ahmedabad gained importance next to Bombay with respect to cotton textile industry. due to the First World War. and a coal boom between 1904 and 1908. paper and flour mills and all companies generally enjoyed phenomenal prosperity. an important stage in industrial advancement under Indian enterprise was reached. the "Native Share and Stock Brokers' Association" (which is alternatively known as “The Stock Exchange ").established in Bombay. under the name and style of "The Madras Stock Exchange" STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 16 . After the Share Mania in 1861-65. In the beginning of the twentieth century. What the cotton textile industry was to Bombay and Ahmedabad. In 1895. In 1920. steel. the then demure city of Madras had the maiden thrill of a stock exchange functioning in its midst. Thus. Also tea and coal industries were the other major industrial groups in Calcutta.

which was incorporated in 1936. However. by 1923. in 1943.Delhi Stock and Share Brokers' Association Limited and the Delhi Stocks and Shares Exchange Limited . when boom faded. It was merged with the Punjab Stock Exchange Limited. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 17 .were floated and later in June 1947. In 1935. They were anxious to join the trade and their number was swelled by numerous others. (In 1957 the name was changed to Madras Stock Exchange Limited). Lahore Stock Exchange was formed in 1934 and it had a brief life.An Umbrella Growth The Second World War broke out in 1939. Many new associations were constituted for the purpose and Stock Exchanges in all parts of the country were floated. bullion. It gave a sharp boom which was followed by a slump. the situation changed radically. seeds and other commodities.with 100 members. In 1937. a stock exchange was once again organized in Madras Madras Stock Exchange Association (Pvt) Limited. Indian Stock Exchanges . the stock market activity improved. But. those dealing in them found in the stock market as the only outlet for their activities. amalgamated into the Delhi Stock Exchange Association Limited. especially in South India where there was a rapid increase in the number of textile mills and many plantation companies were floated. when India was fully mobilized as a supply base. the number of members stood reduced from 100 to 3. On account of the restrictive controls on cotton. The Uttar Pradesh Stock Exchange Limited (1940). and so it went out of existence. Nagpur Stock Exchange Limited (1940) and Hyderabad Stock Exchange Limited (1944) were incorporated. In Delhi two stock exchanges .

there are totally twenty one STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 18 . Gauhati Stock Exchange Limited (1984). Uttar Pradesh Stock Exchange Association Limited (at Kanpur. Thus. Madras. 1986). 1989). Bhubaneswar Stock Exchange Association Limited (1989). 1990) and recently established exchanges . however. Bangalore Stock Exchange Limited was registered in 1957 and recognized in 1963. Kanara Stock Exchange Limited (at Mangalore. Vadodara Stock Exchange Limited (at Baroda. 1982). Lahore Exchange was closed during partition of the country and later migrated to Delhi and merged with Delhi Stock Exchange. but acting on the principle of unitary control. Some of the members of the other Associations were required to be admitted by the recognized stock exchanges on a concessional basis. Hyderabad and Indore. the well established exchanges. Delhi. Only Bombay. Magadh Stock Exchange Association (at Patna. 1956. and Pune Stock Exchange Limited (1982). Calcutta.Coimbatore and Meerut. During eighties. The number virtually remained unchanged. Saurashtra Kutch Stock Exchange Limited (at Rajkot. Ludhiana Stock Exchange Association Limited (1983). many stock exchanges were established: Cochin Stock Exchange (1980). Ahmedabad. Jaipur Stock Exchange Limited (1989). were recognized under the Act. Thus. at present. for nearly two decades. during early sixties there were eight recognized stock exchanges in India (mentioned above). Most of the other exchanges languished till 1957 when they applied to the Central Government for recognition under the Securities Contracts (Regulation) Act. 1985). all these pseudo stock exchanges were refused recognition by the Government of India and they thereupon ceased to function.Post-independence Scenario Most of the exchanges suffered almost a total eclipse during depression.

Rs. but also in number of listed companies and in capital of listed companies. of Stock Exchanges No. and this was due to the favouring government policies towards security market industry. Capital of Listed Cos. It is quite evident from the Table that Indian stock markets have not only grown just in number of exchanges.) Market value of Capital of Listed Cos.recognized stock exchanges in India excluding the Over The Counter Exchange of India Limited (OTCEI) and the National Stock Exchange of India Limited (NSEIL).) Market Value of Capital per Listed Cos. (Cr. 1 2 3 4 5 6 As on 31st December No. (4/2) (Lakh Rs. The remarkable growth after 1985 can be clearly seen from the Table.) (5/2) 1946 1961 1971 1975 1980 1985 1991 7 7 8 8 9 14 20 1995 22 8593 11784 1125 1203 1599 1552 2265 4344 6229 1506 2111 2838 3230 3697 6174 8967 270 753 1812 2614 3973 9723 32041 59583 971 1292 2675 3273 6750 25302 110279 478121 24 63 86 113 168 175 224 514 1770 693 5564 107 167 211 298 582 7 Trading Pattern of the Indian Stock Market STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 19 . (Lakh Rs. The Table given below portrays the overall growth pattern of Indian stock markets since independence. of Stock Issues of Listed Cos.) Capital per Listed Cos. of Listed Cos. Growth Pattern of the Indian Stock Market Sl.No. (Cr. Rs. No.

The latter is permitted only in the case of specified shares. buy and sell securities for his clients on a commission basis and also can act as a trader or dealer as a principal. Two types of transactions can be carried out on the Indian stock exchanges: (a) spot delivery transactions "for delivery and payment within the time or on the date stipulated when entering into the contract which shall not be more than 14 days following the date of the contract" : and (b) forward transactions "delivery and payment can be extended by further period of 14 days each so that the overall period does not exceed 90 days from the date of the contract". Equity shares of dividend paying. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 20 . A member broker in an Indian stock exchange can act as an agent. where a member can act as a jobber or a broker only. The brokers who carry over the outstandings pay carry over charges (cantango or backwardation) which are usually determined by the rates of interest prevailing. namely. in contrast with the practice prevailing on New York and London Stock Exchanges.000 shareholders are. put in the specified group and the balance in nonspecified group.50 million and a market capitalization of atleast Rs. growth-oriented companies with a paid-up capital of atleast Rs. They are broadly divided into two categories. specified securities (forward list) and non-specified securities (cash list).100 million and having more than 20. normally.Trading in Indian stock exchanges are limited to listed securities of public limited companies. However. The nature of trading on Indian Stock Exchanges are that of age old conventional style of face-to-face trading with bids and offers being made by open outcry. there is a great amount of effort to modernize the Indian stock exchanges in the very recent times. buy and sell securities on his own account and risk.

Industrial Credit and Investment Corporation of India. Trading members STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 21 . On the basis of the recommendations of high powered Pherwani Committee. public sector unit bonds. commercial paper. Trading at NSE takes place through a fully automated screen-based trading mechanism which adopts the principle of an order-driven market. Participants include trading members and large players like banks who take direct settlement responsibility. Recognized members of NSE are called trading members who trade on behalf of themselves and their clients. treasury bills. etc. selected commercial banks and others. certificate of deposit. Trading at NSE can be classified under two broad categories: (a) Wholesale debt market and (b) Capital market. the National Stock Exchange was incorporated in 1992 by Industrial Development Bank of India. There are two kinds of players in NSE: (a) trading members and (b) participants. Industrial Finance Corporation of India.National Stock Exchange (NSE) With the liberalization of the Indian economy. it was found inevitable to lift the Indian stock market trading system on par with the international standards. Wholesale debt market operations are similar to money market operations institutions and corporate bodies enter into high value transactions in financial instruments such as government securities. all Insurance Corporations.

In this regard NSE gains vital importance in the Indian capital market system. • • Delays in communication. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 22 . The prices at which the buyer and seller are willing to transact will appear on the screen. And capital market being one of the major source of long-term finance for industrial projects.can stay at their offices and execute the trading. since they are linked through a communication network. with the support of total computerized network. Investors can trade at the same price from anywhere in the country since intermarket operations are streamlined coupled with the countrywide access to the securities. small investors and foreign investors will not be interested in capital market operations. NSE has several advantages over the traditional trading exchanges. late payments and the malpractice’s prevailing in the traditional trading mechanism can be done away with greater operational efficiency and informational transparency in the stock market operations. They are as follows: • NSE brings an integrated stock market trading network across the nation. When the prices match the transaction will be completed and a confirmation slip will be printed at the office of the trading member. India cannot afford to damage the capital market path. Unless stock markets provide professionalised service.

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 23 .

The contract is usually between two financial institutions or between a financial institution and its corporate client. This delivery price is chosen so that the value of the forward contract is equal to zero for both transacting STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 24 .INTRODUCTION TO “FUTURES & OPTIONS” Forward Contracts A forward contract is a simple derivative – It is an agreement to buy or sell an asset at a certain future time for a certain price. One of the parties in a forward contract assumes a long position i. agrees to sell the asset on the same date at the same price.e. A forward contract is not normally traded on an exchange. This specified price is referred to as the delivery price. agrees to buy the underlying asset on a specified future date at a specified future price. The other party assumes a short position i.e.

This is explained in the following note on payoffs from forward contracts. it costs nothing to the either party to hold the long or the short position. Options A options agreement is a contract in which the writer of the option grants the buyer of the option the right purchase from or sell to the writer a designated instrument for a specified price within a specified period of time. A forward contract can therefore. the value of the contract becomes negative for the party holding the short position. To explain further. An option that grants the buyer the right to buy some instrument is called a call option. the value of the contract is positive for her. An options that grants the buyer the right to sell an instrument is called a STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 25 . Conversely. if the price of the asset rises sharply after the two parties have entered into the contract.parties. The concept of Forward price is also important. assume a positive or negative value depending on the movements of the price of the asset. Over the duration of the contract. the forward price and the delivery price are equal on the day that the contract is entered into. the party holding the long position stands to benefit. The holder of the short position delivers the asset to the holder of the long position in return for cash at the agreed upon rate. A forward contract is settled at maturity.e. Therefore. a key determinant of the value of the contract is the market price of the underlying asset. i. For example. In other words. The forward price for a certain contract is defined as that delivery price which would make the value of the contract zero. the forward price is liable to change while the delivery price remains the same. The writer grants this right to the buyer for a certain sum of money called the option premium.

 Put Option A Put option gives the holder (buyer/ one who is long Put). Options are available on a large variety of underlying assets like common stock. The price at which the buyer an exercise his option is called the exercise price. exchange rates. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 26 . commodity prices etc. Options Terminology  Call Option A call option gives the holder (buyer/ one who is long call). strike price or the striking price. Options also provide a way for individual investors with limited capital to speculate on the movements of stock prices.  Strike Price (also called exercise price) The price specified in the option contract at which the option buyer can purchase the currency (call) or sell the currency (put) Y against X. Also traded are options on stock indices and futures contracts – where the underlying is a futures contract and futures style options. debt instruments and commodities. the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date.put option. Options have proved to be a versatile and flexible tool for risk management by themselves as well as in combination with other instruments. the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The biggest advantage in this context is the limited loss feature of options. currencies.

 Maturity Date The date on which the option contract expires is the maturity date.  Time value of the option STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 27 .  American Option An option. the intrinsic value is Max [(X-S). If the buyer does not exercise the option. the concept of intrinsic value is notional as these options are exercised only on maturity. In other words. 0]. 0]. that can be exercised by the buyer on any business day from initiation to maturity. it is defined as Max [(S-X). call or put.  Premium (Option price. Option value) The fee that the option buyer must pay the option writer at the time the contract is initiated. the intrinsic value is positive and is S is less than X. for a call option.  European Option A European option is an option that can be exercised only on maturity date. where s is the current spot rate and X is the strike rate. In the case of European options. If S is greater than X. the intrinsic value will be zero. Exchange traded options have standardized maturity dates.  Intrinsic value of the option The intrinsic value of an option is the gain to the holder on immediate exercise of the option. For a put option. he stands to lose this amount.

Futures contracts in physical commodities such as wheat. the way the markets are organized. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 28 . This is because there is some possibility that the spot price will move further in favor of the option holder. gold. It is in-the-money is S>X and out-of-the-money is S<X. In this. In-the-Money and Out-of-the-Money Options A call option is said to be at-the-money if S=X i. there are a number of differences between forwards and futures. it is similar to a forward contract. currencies. prior to expiration. kinds of participants in the markets and the ways in which they use the two instruments. profiles of gains and losses. in-the-money if S<X and out-of-the-money if S>X. etc. have existed for a long time. These relate to the contractual features. However. a put option is at-the-money is S=X. interest bearing instruments like T-bills and bonds and other innovations like futures contracts in stock indexes are a relatively new development dating back mostly to early seventies in the United States and subsequently in other markets around the world. cotton. silver. the spot price is equal to the exercise price. cattle.  At-the-Money. Typically. it will be greater than the intrinsic value. corn.The value of an American option. FUTURES A futures contract is an agreement between two parties to buy or sell an asset at a certain specified time in future for a certain specified price.e. Conversely. must be at least equal to its intrinsic value. The difference between the value of an option at any time "t" and its intrinsic value is called the time value of the option. Futures in financial assets.

Are used for hedging and physical delivery 5. Are used for hedging speculating 5. Are not transparent as they are all are reported by the exchange private deals FUTURES & OPTIONS STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 29 . Are standardised and published FUTURES 1. Are transparent . Are dependent on the negotiated contract conditions 6. Are traded on an exchange provides protection for both parties 3. Are private and are negotiated guarantee 3.Major Features Of Futures Contracts The principal features of the contract are as follows:  Organized Exchanges  Standardization  Clearing House  Marking To Market  Actual Delivery Is Rare DISTINCTION BETWEEN FORWARD AND FUTURES CONTRACTS FORWARDS 1. Are not traded on an exchange between the parties with no exchange 2. Require a margin to be paid 4. Involve no margin payments and 4. Use a Clearing House which 2.futures contracts 6.

which is free to enter into. but can generate very large losses. product  Price is zero. This is attractive to many people. which reimburses the full extent to which Nifty drops below the strike price of the put option. At a practical level.An interesting question to ask at this stage is – when could one use options instead of futures? Options are different from future in several interesting senses.  Price uis always positive. This characteristics makes options attractive to many occasional market participants.  Same as futures  Strike price is fixed. the option buyer faces a interesting situation. There is no possibility of the options position generating any further losses to him (other than the fund already paid for option). price moves. and to mutual funds creating “guaranteed return product”. After this. strike price moves  Price is zero  Linear payoff STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 30 . To buy a put option on Nifty is to buy insurance. Buying put options is buying insurance. Distinction between futures and options Futures  Exchange novation  Exchange traded defines with the Options  Same as futures. he only have an upside. He pays for option in full at the time it is purchased. who can not put in the time to closely monitor their futures positions.  Nonlinear payoff. This is different from futures.

In simple words. In this section we shall take a look at the payoffs for buyers and sellers of futures and options. Payoff for Futures Futures contracts have linear payoffs. it means that the losses as well as profits for the buyer and the sellers of a future contract are unlimited. PAYOFF FOR DERIVATIVES CONTRACTS A pay off is likely profit/loss that would accrue to a market participants with change in the price of the underlying asset. which show the price of the underlying asset on the X-axis and the profit/loss on the Y-axis. This is generally depicted in the form of payoff diagrams. Both long and short at risk  Only short at risk. These STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 31 .

the short futures positions start making profits and when the index moves up.the following diagram shows the payoff diagram for the seller of a futures contract. PAYOFF FOR A BUYER OF FUTURE Payoff for a seller on Nifty Futures The pay off for a person who sells a future contract is similar to the payoff for a person who shorts an assets. When the index moves down. He has a potentially unlimited upsides as well as a STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 32 . He has a potentially unlimited upside as well as a potentially unlimited downside. Profit 1220 0 Nifty Loss FIG.linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. The underlying asset in this case is the Nifty portfolio. it starts making losses . Payoff for a Buyer on Nifty Future The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. Take the case of speculator who sells two-month Nifty index futures contracts when the Nifty stands at 1220.

the short futures positions start making profits. Payoff for a seller on Nifty futures STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 33 . it starts making losses. Take the case of a speculator who sells thea twomonth Nifty index future contract when the nifty stands at 1220. Profit 1220 Nifty Loss Fig. When the index moves down.potentially unlimited downside. the underlying asset in this case is the Nifty portfolio. and when the index moves up.

however the profits are potentially unlimited. Nifty for instance. for 1220. it means that the losses for the buyer of an option are limited.Option Payoffs The optionality characteristics of options results in a non –linear payoff for the options. We look here at the six basic payoffs. an investor buys the underlying asset. the payoff is exactly the opposite. Once it is purchased. In simple words. Following figure show the pay off for a long position of Nifty. and sells it at a future date at a unknown price.  Payoff profile of buyer of asset: Long asset In this basic position. the investor is said to be “long” the asset. however his losses are potentially unlimited. For a writer. His profits are limited to the options premium. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combination of options and underlying. Profit +60--------------------------------------------------------1160 1220 1280 Nifty -60 ----------------------------- Loss STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 34 .

Payoff for investor who went short Nifty at 1220 STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 35 . the investor is said to be “short” the asset. Payoff for investor who went long nifty at 1220 Payoff profile for seller of asset: Short asset In this basic position.Fig. Profit 1160 1220 1280 Nifty Loss Fig. an investor shorts the underlying asset. Once it is sold. Following figure show the pay off for a long position of Nifty. for 1220 and buys it back at a future date at an unknown price. Nifty for instance.

the spot price exceeds the strike price. If upon expiration. Profit 1250 0 86. he lets his option expire un-exercised. The profit/loss that the buyer makes on the options depends on the spot price of the underlying.60 STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 36 . His loss in this case is the premium he paid for buying the option. Payoff for buyer of a call Payoff for the buyer of a three-month call option (often referred to as long call) with a strike of 1250 bought at a premium of 86.60 Nifty loss Fig. Higher the spot price. more is the profit he makes.Payoff profile for buyer of call option: Long run A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. If the spot price of the underlying is less than the strike price. he makes a profit.

Hired the spot price. For selling the option. Figure gives the pay off for the writer of three-month call option (often referred to as short call) with the strike of 1250sold at premium of 86. Hence as the spot price increase the writer of option starts making losses. Payoff for a writer of calls options STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 37 . Payoff profile for buyer of call option: Short call Call option gives the buyer the right to buy the underlying at the strike price specified in the option. the spot price exceeds the strike price. the buyer lets his option expire unexercised and the writer gets to keep the premium. the buyer wills exercise the option on the writer. Whatever is the buyer’s profit/loss? If upon expiration.60 1250 0 Nifty Loss Fig. more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price.60 Profit 86. the writer of the option charges a premium. The profit/loss that the buyer make on the option depends upon the spot price of the underlying.

he let his option expire unexercised. he makes a profit. For selling the options. If upon expiration. Lower the spot price.Payoff for buyer of put option: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. Payoff for buyer of put option Payoff profile for writer of put option: short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. If the spot price is higher than the stike price.70 loss Fig. more is the profit he makes. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. His loss in this case is the premium he paid for buying the option. Profit 1250 Nifty 0 61. the spot price is below the strike price . the writer of the option charges a STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 38 .

If upon expiration.premium. Payoff for writer of put option Fig shows the payoff for the writer of a three-month put option (often referred as short put) with a strike price of 1250 sold at a premium of 61.70 STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 39 . Profit 61. the buyer lets his option expired un exercised and the writer gets to keep the premium. If upon the expiration the pot price of the underlying is more than the strike price. the spot prices happens to be below the strike price. Whatever is the buyer’ profit is the seller loss.70 0 1250 Nifty Loss Fig. the buyer will ecercise the option at write. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.

CLEARING AND SETTLEMENT National Securities Clearing council Limited (NSCCL) undertakes clearing and settlement of all trades executed on the futures and options (O&P) segment of the NSE. the CM performs the following functions: 1. Clearing Entities Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help of the following entities:  Clearing Members A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members (TM) on NSE. Clearing – Computing obligations of all his TM's i. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 40 . determining positions to settle. who clear and settle such deals through them.e. Primarily. It also act as legal counter party to all trades on the F&O segment and guarantees their financial settlement.

Kotak Mahindra Bank and Union Bank of India. Typically banks or custodians could become a PCM and clear and settle for TM’s. their clients’ trades as well as trades of other TM’s. Settlement .. Types of Clearing Members • Trading Member Clearing Member (TM-CM) A Clearing Member who is also a TM. UTI Bank. Standard Chartered Bank. HDFC Bank. Such CMs may clear and settle their own proprietary trades. • Professional Clearing Member (PCM) A CM who is not a TM. Risk Management – Setting position limits based on upfront deposits / margins for each TM and monitoring positions on a continuous basis. Hongkong & Shanghai Banking Corporation Ltd. Such CMs may clear and settle only their own proprietary trades and their clients’ trades but cannot clear and settle trades of other TM’s. IndusInd Bank.2. Clearing Banks NSCCL has empanelled 11 clearing banks namely Canara Bank. ICICI Bank. Only funds settlement is allowed at present in Index as well as Stock futures and options contracts 3. • Self Clearing Member (SCM) A Clearing Member who is also a TM.Performing actual settlement. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 41 . Bank of India. IDBI Bank.

and the final settlement. which happen on a continuous basis at the end of each day. it has been currently mandated that stock options and futures would also be cash settled. The underlying for index futures /options of the Nifty index cannot be delivered. However. Futures and options on individual securities can be delivered as in the spot market. These contracts. Daily Mark-to-Market Settlement STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 42 . have to be settled in cash. i. which happens on the last trading day of the futures contracts.Every Clearing Member is required to maintain and operate a clearing account with any one of the empanelled clearing banks at the designated clearing bank branches.e. The clearing account is to be used exclusively for clearing & settlement operations. with respect to their obligations on MTM. Settlement Mechanism All futures and options contracts are cash settled. therefore. premium and exercise settlement. Settlement of future contracts Futures contracts have two types of settlement. the MTM settlement. 1. The settlement amount for a CM is netted across all their TMs/ clients. through exchange of cash.

The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn passed on to the members who have made a profit. and the current day’s settlement price. The pay-in and payout of the mark-to-market settlement is on T+1 days (T = Trade day). After daily settlement. is currently the price computed as per the formula detailed below: F = S x e rt where: F = theoretical futures price S = value of the underlying index r = rate of interest (LIBOR) t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. as the case may be. The mark to market losses or profits are directly debited or credited to STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 43 . This is known as daily mark-to-market settlement. The profits/ losses are computed as the difference between the trade price or the previous day’s settlement price. all the open positions are reset to the daily settlement price. Theoretical daily settlement price for unexpired futures contracts.The position in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. which are not traded during the last half an hour on a day. CMs are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs and their clients clearing and settling through them.

NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash.The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. and the final settlement price of the relevant futures contract. The premium payable position and premium receivable positions are netted across all option contracts for each CM at the client level to determine the net premium payable or receivable amount. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 44 . Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day).. as the case may be. The final settlement profit / loss is computed as the difference between trade price or the previous day’s settlement price. at the end of each day. 2. Final Settlement On the expiry of the futures contracts.the CMs clearing bank account. Open positions in futures contracts cease to exist after their expiration day SETTLEMENT OF OPTIONS CONTRACTS Daily Premium Settlement Premium settlement is cash settled and settlement style is premium style.

The premium payable amount and premium receivable amount are directly debited or credited to the CMs clearing bank account. The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day). Interim Exercise Settlement Interim exercise settlement for Option contracts on Individual Securities is effected for valid exercised option positions at in-the-money strike prices. on the day of exercise. Valid exercised option contracts are assigned to short positions in option contracts with the same series. CMs are responsible to collect and settle for the premium amounts from the TMs and their clients clearing and settling through them. The interim exercise settlement value is the difference between the strike price and the settlement price of the relevant option contract. on a random basis. on the expiration day of an option STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 45 . Final Exercise Settlement Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours. Exercise settlement value is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= exercise date ). at the close of the trading hours. This is known as daily premium settlement.The CMs who have a premium payable position are required to pay the premium amount to NSCCL which is in turn passed on to the members who have a premium receivable position.

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 contracts on individual securities, exercise style is American style. Final Exercise is Automatic on expiry of the option contracts.Option contracts, which have been exercised, shall be assigned and allocated to Clearing Members at the client level. Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the relevant Clearing Members with the respective Clearing Bank.Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day).

Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Open positions, in option contracts, cease to exist after their expiration day. The pay-in / pay-out of funds for a CM on a day is the net amount across settlements and all TMs/ clients, in F&O Segment.

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PROS & CONS OF DERIVATIVES
Financial innovation that led to the issuance and trading of derivatives products has been an important boost to the development of financial market. Derivatives products such as options, futures or swaps contract have become a standard risk management tool that enable risk sharing and thus facilitate the efficient allocation of capital to productive investment opportunities. While the benefits stemming from the economic function performed by derivative securities have been discussed and proven by academics, there is increasing concern within the financial community that the growth of the derivative markets-whether standardize or not-destabilize the economy. In particular, one often hears that the widespread use of derivatives have been reduced long term investment since it concentrates capital in short term speculative transactions. In this study, I have tried to look at the various pros and cons that the derivatives trading pose.

BENEFITS OF DERIVATIVES MARKETS AND THE ECONOMY

FOR

FIRMS,

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET

47

The recent studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to end –users.

 Derivatives as means of hedging
Derivatives provide a low cost, effective method for end users to hedge and manage their exposure to interest rate, commodity price, or exchange rates. Interest rate future and swaps, for example, help banks for all sizes better manage the repricing mismatches in funding long term assets, such as mortgages, with short term liabilities, such a certificate of deposits. Agricultural futures and options helps farmers and processors hedge against commodity price risk. Similarly, multi national corporations can hedge against currency risk using foreign exchange forwards, futures and options.

 Improves market efficiency and liquidity
Well functioning derivatives improves the efficiency and liquidity of the cash market. The launch of derivatives has been associated with substantial improvements in the market quality on the underlying equity market. This happens because of the law transaction cost involved and arbitrageurs will face low cost when they are eliminating the mispricings. Traders in individual stock who supply liquidity to these stock use index futures to offset their exposure and hence able to function at lower level of risk.

 Allows institution to raise capital at lower costs
Corporations, governmental entities, and financial institutions also benefit from derivatives through lower funding costs and more diversified funding sources. Currency and interest rate derivatives provide the ability to borrow in the

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In contrast.  Allows exchange to offer differentiated products In spot market. The growth in derivatives activities yields substantial benefits to the economy and by facilitating the access of the domestic companies to international capital market and enabling them to lower their cost of funds and diversify their funding STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 49 . lowering the cost of capital formation and stimulating economic growth. in the case of derivatives. without regard to currency in which the debt is denominated or the form in which interest is paid. there are numerous avenues for product differentiation. choice of expiration dates. American Vs European options. derivatives improve the allocation of credit and sharing of risk in the global economy. choice of contract size.cheapest capital market.  Assists in capital formation in the Economy By providing investors and issuers with a wider array of tools for managing risk and raising capital. It improves the market’s ability to carefully direct resources toward the projects and the industries where the rate of return is highest. domestic or foreign. the ability for the exchanges to differentiate their product is limited by the fact that they are trading the same paper. Derivatives can convert the foreign borrowing into a synthetic domestic currency financing with their fixed or floating interest rate. This improves the allocative efficiency of the market and thus a given stock of investable funds will be better used in procuring the highest possible GDP growth for the economy. Each exchange trading index option has to take major decision like choice of index. rules governing strike price etc.

 Information gathering: In a perfect market with no transaction cost.  Improve ROI for institutions Derivatives are basically off. a fund that corresponds to the principal sum in traditional financial transactions (on balance trading) is unnecessary. competitive. However. in the presence of trading costs and marketing liquidity. global economy.balance trading in that no transfer of principal sum occurs and no posting in the balance sheet will be required. the risk ratio of assets that form the basis for calculating the net worth in off balance trading is assumed to be lower than that in the traditional on balance trading. which have already mentioned are illustrative. In this respect. Examples of risk management. derivatives improve the position of domestic firms in an expanding. Looking at the restriction on the ratio of net worth.source. ther would be no benefit stemming from the use of derivatives instruments.  Risk sharing The major economic function of derivatives is typically seen in risk sharing: derivatives provide a more efficient allocation of economic risks. Consequently. but they don’t address the question why derivatives are necessary to attain a better social allocation of risks. no friction and no informational asymmetries. In practice. it is provided that the credit risk equivalence calculated by multiplying the assumed amount of principal of an off-balance trading by a risk to value ratio is to be weighted by the credit worthiness of the other party. on the other hand. thus substantially improving the return on investment. portfolio strategies are often implemented or supplemented with derivatives at substainial lower cost compare to cash market transactions. the welfare effect of derivative STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 50 .

this is only a part of the real economic benefits of the derivatives. derivatives markets also affect the information structure of the financial syatem DISADVANTAGES OF DERIVATIVES  Risk associated with the derivatives Apart from the explicit risk. If risk allocation is the major function of these instrument. and because risk is also related to information. Ut. Concern has been expressed that financial institutions may have used derivatives to take on an excessive level of credit risk that is poorly managed. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 51 . Concern has been expressed that derivatives expose firm to new market risk while increasing the overall level of exposure. asset.instrument result from a reduction in the transaction cost.or porflio will decline when market conditions change. • Market risk is the risk that the value of a position in a contract. other implicit risks also associated with derivatives • A credit risk is the risk that a loss will be incurred because a counter party fails to make payment as due. which arises from various market risk exposure stemming from the pure service or position taken in a derivative instrument.financial instrument.

and the economic theory that is used for pricing STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 52 . Accounting practices measure values and not risk exposure and thus remain poor figure for risk management purpose  Lack of knowledge Lack of knowledge about derivatives: derivatives are complex. The legal uncertainty can result in significant unexpected losses. accounting standard is not homogenized across countries and/or market player thereby suggesting that lack of precision or ambiguous cross-comparisons may be common. of course.  Implication in global world Global market for trade and finance has become increasingly integrated and accessible. and thus their absence prevent marketing-tomarketing of derivatives positions as well as their proper collateralization. human error. being reinforce rather than damped. some observed fear that derivatives make it possible for shocks in one part of the global finance system to be transmitted farther and faster than before.  Accounting standard for derivatives As far as derivatives are concerned.• Operational risks is the risk that losses will be incurred as a result of inadequate system and control. In this circumstances. Market values are not uniformly accepted in accounting rules. is as old as contracting itself. Derivatives have both benefited from and contributed to this development. • Legal risk is the risk of loss because a contract cannot be enforced or because the contract term fails to achieve the intended goals of the contracting parties. The payoffs and risks that buyer and seller face. however. Concern also have been expressed that derivatives activity may exacerbated market moves through positive feedback trading. or management failure. inadequate disaster or contingency planning. This risk.

What are these myths behind derivatives? STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 53 .  Monetarily Zero sum game It is impossible for the both the parties in the derivatives transactions to profit concurrently regardless of the fluctuation of value of underlying assets. Today. when the US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations.derivatives are considerably more difficult than that seen on the equity market. including stock index futures. There are also many myths though the reality is different especially for exchange-traded derivatives which are well regulated with all the safety mechanisms in place. Thus one party has to accept the unprofitable position Myths behind derivatives In less than three decades of their coming into vogue. Thus at times lack of knowledge on part of traders leads to disaster. derivatives have become part of the day-to-day life for ordinary people in most parts of the world. derivatives markets have become the most important. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970. There are still apprehensions about derivatives.

This situation led to the development derivatives as effective risk-management tools for the market participants. This period is marked by remarkable innovations in the financial markets. both in the private and public sectors. Derivatives are a low-cost. By providing investors and issuers with a wider array of tools for managing risks and raising capital. the accompanying risk factors grew. effective method for users to hedge and manage their exposures to interest rates. for example. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 54 . that derivatives provide substantial benefits to the users. and on-line trading in the capital markets. such as introduction of floating rates for currencies. An equity fund. As the complexity of instruments increased. The need for derivatives as hedging tool was felt first in the commodities market. Numerous studies have led to a broad consensus. derivatives improve the allocation of credit and the sharing of risk in the global economy. Derivatives increase speculation and do not serve any economic purpose. can reduce its exposure to the stock market quickly and at a relatively low cost without selling part of its equity assets. commodity prices. or exchange rates. the financial markets in the world started undergoing radical changes. by using stock index futures or index options. Looking at the equity market. lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated. Agricultural futures and options helped farmers and processors hedge against commodity price-risk. After the collapse of the Bretton Wood agreement. derivatives have strengthened these important linkages among global markets. increased trading in a variety of derivatives instruments. derivatives allow corporations and institutional investors to manage effectively their portfolios of assets and liabilities through instruments such as stock index futures and options.

such as the Barings collapse.increasing market liquidity and efficiency. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 55 . but derivatives make headlines. not only in derivatives-related instruments. for normal equity or debt trading as much as in derivatives trading and the participants need to be more careful in implementing and operating good back-office and control systems to avoid any internal control failures. Careful observation will show that these disasters. sophisticated margining system and a well-laid-out regulatory framework. Metallgesellschaft. foreign exchange trading and commodities trading. we look into the prerequisites needed for the introduction of derivatives and how the Indian market fares. Disasters can happen in any system. Here. but also in bonds. these examples suggest that scandals have occurred in the recent past. except in the case of Barings. Daiwa Bank scandal (not related to derivatives) and Orange County. Most failures have taken place on the `over the-counter' deals. occurred due to the lack of internal controls and/or outright fraud either by employees or promoters. without the problems associated with the OTC deals. where it was a case of internal fraud. and facilitating the flow of trade and finance. In that sense.  Indian market is not ready for derivative trading Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. these derivatives have been found to be the most useful in allowing participants to transfer their risk. `Over-the-counter' (OTC) deals lack transparency. The 1992 security scam is a case in point. Disasters are not necessarily due to dealing in derivatives. Internal controls would be important in any case. as also with Daiwa Bank. In essence. Many of the failures happened because of the complex nature of transactions while the exchange-traded derivatives are simple and easy to understand. which lost more than $1 billion in debt portfolio. which is not the case with the exchangetraded derivatives.

Indian exchanges are inviting foreigners to participate for which the approvals have also been granted. in Mumbai. Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding Trading in standard derivatives such as forwards. official history of the Native Share and Stock Brokers Association. In that sense. A clearing house for clearing and settlement of these trades was set up in 1918. In oilseeds. The Reserve Bank of India allows forward trading in rupee-dollar forward contracts. complex strategies of options are traded in many exchanges which are called tejimandi. India has a long history of derivatives trading. The first commodity futures exchange was set up in 1875.'' This amply proves that the concept of options and futures is well-ingrained in the Indian equities market and is not as alien as it is made out to be. which is now known as the Bombay Stock Exchange suggests that the concept of options existed from early as in 1898. A quote ascribed to Mr. McAllen.India being the original home of options. bhav-bhav at different places. futures and options is already prevalent in India and has a long history.. MP.. Derivatives in commodities markets have a long history. is: ``. the derivatives are not new to India and are current in various markets including equities markets. derivatives have existed for long. at the time of the inauguration of BSE's new Brokers Hall in 1898. In the equities markets also. James P. In fact. under the aegis of Bombay Cotton Traders Association. which has become a liquid market. Even today. Futures market in raw jute was set up in Calcutta in 1912 and the bullion futures market in Bombay in 1920. a native broker would give a few points to the brokers of the other nations in the manipulations of puts and calls. In fact. a futures market was established in 1900. jota-phatak. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 56 . The RBI also allows cross currency options trading. in commodities markets. Wheat futures market began in Hapur in 1913.

that is. Is capital market safer than derivatives? WORLD OVER. which was prevalent in the UK. But this way. This system is prevalent in France. in the monthly settlement market. one has to settle these trades on the third working day from the date of trading (T+3). one or three months and net the transaction for the settlement at the end of the period. while internationally. there is a daily mark-to-market STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 57 . additionally. creates discrepancies. this system has become quite prone to systemic collapse. Given the volatility of the equities market in India. the spot market in equities operates on a principle of rolling settlement. In this system. This way. Futures market allows you to trade for a period of. allow futures and options to trade. In the futures market. introduce rolling settlement in all exchanges and. the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants. It allows one to even further increase the time to settle for almost three months. In that sense. most stock exchanges allow the participants to trade over a one-week period for settlement in the following week. say. the existing system does not ask for any margins from the clients. simultaneously. under the current regulations. The Indian capital market operates on a account period system which is actually a seven-day futures market. In this kind of trading. The trades are netted for the settlement for the entire one-week period. In India. many exchanges also allow the forward-trading called badla and contango. the Indian market is already operating on the futures-style settlement. a curious mix of futures style settlement with the facility to carry the settlement obligations forward. The more efficient way will be to separate the derivatives from the cash market. In addition. the cash market operates on T+3 rolling settlement basis _ one of the G-30 recommendations for an efficient clearing and settlement mechanism. if one trades on a particular day (T).

leading to faster settlement and risk reduction. Client positions are not segregated from the trading member's proprietary role and clearing members are not segregated. unlike the cash market where settlement takes seven days. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 58 . affecting the system.settlement (T+1).

L. 1995.R.Gupta on November 18.C. however. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI set up a 24–member committee under the Chairmanship of Dr. 1996 to develop appropriate regulatory framework for derivatives trading in India.Derivatives Market in India Approval For Derivatives trading The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance. did not take off.Varma. which withdrew the prohibition on options in securities. The committee submitted its report on March 17. 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India.J. The market for derivatives. SEBI also set up a group in June 1998 under the Chairmanship of Prof. as there was no regulatory framework to govern trading of derivatives. to recommend measures for risk containment in derivatives market STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 59 .

in India. SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. broker net worth. deposit requirement and real–time monitoring requirements. 2001. Futures contracts on individual stocks were launched in November 2001. The government also rescinded in March 2000. 2001 and trading in options on individual securities commenced on July 2. Single stock futures were launched on November 9. thus precluding OTC derivatives. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules. The trading in BSE Sensex options commenced on June 4. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework was developed for governing derivatives trading. 2000. To begin with. and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. NSE and BSE. 2001 and the trading in options on individual securities commenced in July 2001. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in index options commenced on June 4. methodology for charging initial margins. The report. worked out the operational details of margining system. which was submitted in October 1998. SEBI permitted the derivative segments of two stock exchanges. 2001. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. the three– decade old notification. byelaws. and regulations of the respective exchanges and their clearing STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 60 . The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12. which prohibited forward trading in securities.

There are no formal centralized limits on individual positions. The management of counter-party (credit) risk is decentralized and located within individual institutions. While both exchange-traded and OTC derivative contracts offer many benefits. There are no formal rules for risk and burden-sharing. leverage. and STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 61 . 2. OTC (Over The Counter) derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. which has accompanied the modernization of commercial and investment banking and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. 4. and for safeguarding the collective interests of market participants. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998.house/corporation duly approved by SEBI and notified in the official gazette.These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. or margining. the former have rigid structures compared to the latter. Exchange-traded vs. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. 3. There are no formal rules or mechanisms for ensuring market stability and integrity.

and their clearing house/corporation to commence trading and settlement in approved derivative contracts. banking supervision and market surveillance. SEBI permitted the derivative segments of two stock exchanges. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization. The 3 trading in index options commenced in June 2001 and those in options on individual securities commenced in July 2001. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 62 . viz NSE and BSE. although they are affected indirectly by national legal systems. This was followed by approval for trading in options based on these two indices and options on individual securities.5. Futures contracts on individual stock were launched in November 2001. DERIVATIVES MARKET AT NSE Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. To begin with. SEBI approved trading in index futures contracts based on S&P CNX Nifty Index and BSE−30 (Sensex) Index.

s 4746 12508 33480 43747 31484 28425 44498 33055 37387 40443 57984 48919 65530 65630 of Turnover (Rs.Crore) 106 263 690 801 683 674 1253 846 1094 1107 1643 1317 1837 1725 of Turnover No. Stock Call Option of Turnover Stock Put Option No.Crore) contract 290 844 1322 1632 2327 1986 3836 3635 2863 3400 3490 3325 4341 3437 STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 63 .Cror e) -------------2811 7515 13261 13939 13989 15065 15981 16178 21205 17881 contrac Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 ts ----------------125946 309755 489793 528947 503415 552727 605284 616461 789290 726310 contract s 13082 38971 64344 85844 112499 84134 133947 133630 101708 121225 126867 123493 154089 147646 (Rs.Table 1 – growth of options &future trading at NSE Month & Stock Future year No. (Rs.

Banks All India Financial institution (FIs) Mutual Funds Foreign Institutional Investor Life & General Insurers The intensity of derivatives usage by any institutional investor is a function of its ability and willingness to use derivatives for one or more of the following purposes: a) Risk containment: Using derivatives for hedging and risk containment purpose. 5. without retaining any net risk on the Balance Sheet (except credit risk). STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 64 . 2. b) Risk Trading /Market Making: Running derivatives trading book for profits and arbitrage. 3.USERS OF DERIVATIVES The institutional investor in India could be meaningfully classified into: 1. and / or c) Covered Intermediation: On-Balance Sheet derivatives intermediation for client transaction. 4.

though it has the potential to develop. Private Sector Banks(Old generation). Use of equity derivatives by banks ought to be inherently limited to risk containment (hedging) and arbitrage trading between the cash STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 65 . at best. Credit derivatives seek to transfer credit risk and returns of an asset from one counter party to another without transferring its ownership. credit derivatives. business practices and organizational ethos. Foreign Banks( with banking and authorized dealer license) Credit Derivatives The market of fifth type of derivatives namely. and the attendant regulatory concerns of their investment in equities. Public Sector Banks(PSBs) II. it is meaningful to classify the Indian banking sector into the followings: I. hence has been dealt with in brief here. be turned as marginal investor in equities. III. is currently non–existent in India. banks in India can. IV. The market for credit derivatives is currently nonexistent in India. Private Sector Banks (new generation). Equity Derivatives in Banks Given the highly leveraged nature of banking business.BANKS Types of Banks Based on the differences in governance structure.

market and options and futures markets. banks with direct and indirect equity market exposure are yet to use exchange traded equity derivatives (viz. for the following reasons. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 66 . RBI guidelines also do not authorized banks to undertake securities lending and/ or borrowings of equities. index futures. security specified futures r options) currently available on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE). 3) The internal resources and processes in most bank treasuries are inadequate to mange the risk of equity market exposure. and mange related risks. and monitor use of equity derivatives. 2) Direct and indirect equity exposure of banks is negligible and does not warrant serious management attention and resources for hedging purpose.. This disables also banks possessing arbitrage trading skills and institutionalized risk management process for running an arbitrage trading book to capture risk free pricing mis–match spread between the equity cash and options and futures marketan activity banks currently any way undertake in the fixed income and FX cash and forward markets. 1) RBI guidelines on investment by the banks in capital market instruments do not authorize banks to use equity derivatives for any purpose. However. index options.. 4) Inadequate technological and business process readiness of their treasuries to run equity arbitrage trading book.

Fixed Income Derivatives in Bank Scheduled Commercial banks. 2) Inadequate of willingness of bank managements to ‘risk’ being held accountable for bonafide trading losses in the derivatives book. Most PSBs are either unable or unwilling of PSB majors seemingly stem from the following key are yet to overcome. Primary Dealers (PDs and All India Financial Institution (FIs have been allowed by RBI since July 0993 to write Interest Rate product Swaps(IRS) for their and own Forward assets Rate Agreement(FRAs)as liability management (ALM) or for market making (risk trading)purpose. Commodity Derivatives in Banks STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 67 . 3) Inadequate readiness of their Board of Directors to permit the bank to run a derivatives trading book. The presence of Public Sector Banks major in the rupee IRS market is marginal. 1) Inadequate technological and business process readiness of their treasuries to run a derivatives trading books. partly for reasons cited above and partly due to their own ‘discomfort of the unfamiliar’. and manage related risks.

for this purpose. forward contract on gold are prohibited. Equity Derivatives in FIs STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 68 . ALL INDIA FINANCIAL INSTITUTIONS (FIs) The All India FIs Universe With the merger of ICICI into ICICI Bank. EXIM. The quantum of gold Imported through bullion banks is in the region of 500 tones per annum. In fact. These gold deposits carry interest ranging from 3% to 4% per annum. IIBI. In the context of use of financial derivatives. NABARD and IDFC. the universe of all India FIs comprises IDBI. RBI permitted seven banks to import and resell gold as canalizing agencies. at the end of which the deposit is repayable at the price of gold as on date of maturity. There is no forward market for gold in India. SIBDI. It is understood that now about 13 banks (. in brief. And. a contract settled later than T+11 days is treated as a forward contract. SBI is a market leader in this segment with a market share of over 90%. IFCI. for short) are active in this business. these bullion banks accept assayed gold as a deposit for 3 to 7 years tenures. the universe of FIs could perhaps be extended to include a few other financially significant players such as HDFC and NHB.In 1997. The commodity risk accepted by banks is limited to price risk of gold accepted by 5 bullion banks that launched their schemes under the RBI guidelines on the Gold Deposit Scheme 1999 announced in the union budget of 1999-2000. bullion banks’.

use of equity derivatives by FIs could be for risk containment (hedging purpose. albeit on a fully covered back-to. For reason identical to those outlined earlier vis-à-vis banks. Commodities Derivatives Fis FIs have no proximate exposure to commodities. There are also no credit products whose interest rate is benchmarked to any commodity price. However. the issue of they using commodity derivatives (whether in the overseas or Indian market) does not rise. and often limited-to-limited to equity developed on them under underwriting commitments they made in the era upto mid 1990s. Also.back basis. However. even FIs are permitted to write RIS and FRA for their asset liability management (ALM) as well as for market making purpose. and for arbitrage trading purposes between the cash market and options and futures market. to begin with. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 69 . Some FIs actively use IRS and FRA for their ALM. there are no RBI guidelines disabling FIs from running equities arbitrage. Therefore. none are yet to run a rupee derivatives trading book. like Banks. a few have plans to offer IRS and FRA as products to their corporate customer (to hedge their liabilities). Fixed income Derivatives Since July 1999. FIs too are not users of equity derivatives.Equity risk exposure of most FIs is rather insignificantly.trading book to capture risk free pricing mismatch spreads between the equity cash and options and futures markets.

there are no tax issues relating to use of equity derivatives by them. SEBI (Mutual Funds) Regulation restrict use of exchange traded equity derivatives to ‘hedging and portfolio rebalancing purpose’. and. 3. However. most mutual funds are not yet active in use of equity derivatives available on the NSE and BSE. 2. The following impediments seem to hinder use of exchange trade equity derivatives by mutual funds: 1. SEBI (Mutual Funds) Regulations also authorize use of exchange traded equity derivatives by mutual funds for hedging and portfolio rebalancing purpose. The popular view in the mutual fund industry is that this regulation is very open to interpretation. and the trustees of mutual funds do not wish to be caught on the wrong foot. being tax exempt. The regulatory prohibition on the use of equity derivatives for portfolio optimization return STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 70 . Inadequate technological and business process readiness of several players in the mutual fund industry to use equity derivatives and manage related risks.MUTUAL FUNDS Equity Derivatives in Mutual Funds Mutual Funds ought to be natural players in the equity derivatives market.

Several mutual funds had obtained the requisite approvals from SBI and RBI for making such investments. given that most ADRs /GDRs of Indian companies traded in the overseas market at a STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 71 . Foreign Currency Derivatives in Mutual Funds In September 1999.enhancement strategies. However. and 4. IRS and FRA transactions entered into by mutual funds are not construed by SEBI as derivatives transaction covered by the restrictive provisions which limit use of derivatives by mutual funds to exchange traded derivatives for hedging and portfolio balancing purposes. Mutual funds are emerging as important users of IRS and FRA in the Indian fixed income derivatives market. Evidently. subject to maximum of US $ 50 million per mutual fund. and arbitrage strategies constricts their ability to use equity derivatives. Fixed Income Derivatives in Mutual Funds SEBI (Mutual Funds) regulations are silent about use of IRS and FRA by mutual funds. Relatively insignificant investor interest in equity funds ever since exchange traded options and futures were launched in June 2000(on NSE. later on BSE). Indian mutual funds were allowed to invest in ADRs/GDRs of Indian companies in the overseas market within the overall limit of US $ 500 million with a sub ceiling for individual mutual funds of 10% of net assets managed by them (at previous year end).

premium to their prices on domestic equity markets. applicable SEBI & RBI Guidelines permitted FIIs to trade only in index future contracts on NSE & BSE. the issue of they using commodity derivatives overseas Indian market)does not arise. In absence of any financial security linked to commodity prices. Commodity derivatives in Mutual Funds Under SEBI (Mutual Funds) Regulations. mutual funds can not offer a fund product that entails a proximate (whether exposure in the to the price or of any commodity. mutual fund can invest only in the transferable financial securities. With the enabling regulatory framework available to FIIs from Feb 2002. their activity in the exchange traded equity derivatives market in India should increase noticeably in the STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 72 . It is only since 4 February 2002 that RBI has permitted (as a sequel to SEBI permission in December 2001) FIIs to trade in all exchange traded derivatives contract within the position limits for trading of FIIs and their sub-accounts. Therefore. this facility has remained largely unutilized. FOREIGN (FIIs) INSTITUTIONAL INVESTORS Equity Derivatives in FIIs Till January 2002.

Foreign Currency Derivatives in FIIs Equity investing FIIs leave their foreign currency risk largely unhdged since they believe that the currency risk can be readily absorbed by the expected returns on the equity investments. the two years of successful track record of the NSE in managing the systematic risk associated with its futures and options segment would also pave way for greater FIIs activity in the equity derivatives market in India in the emerging future. Consequently. However. And. with individual sub ceilings allocated by SEBI to each FII or sub accounts. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 73 . FIIs are permitted to invest in domestic sovereign or corporate debt market under the 100% debt rout subject to an overall cap under the external commercial borrowing (ECB) category. FII investment in the domestic sovereign and corporate debt market has been negligible. as indicated above. FII in the foreign currency derivative market in India has also been negligible till now. barring in periods of unforeseen volatility (such as the Far Eastern crisis). investment by FIIs in the domestic sovereign or corporate debt market has been negligible till now. Fixed Income Derivatives in FIIs Since May 2000. Perhaps. FIIs are also permitted to enter into foreign exchange derivatives contract by RBI to hedge the currency and interest rate risk to the extent of market value of their debt investment under the 100% debt route.emerging future.

Fixed Income Derivatives in Life and General Insurers As indicate earlier. It is the view of the IRDA that life & general insurers are not permitted to use equity (or other financial) derivatives until IRDA frames guideline/ regulation related to their use. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 74 . Life or general insurers would have to wait for these guidelines /regulations to fall in the place before they can use equity (or other financial) derivatives. it is view of the IRDA that use of rupee fixed income derivatives (including IRS and FRA) by Life & General insurers too would have to wait for IRDA guidelines/regulations on the use of financial derivatives. And IRDA is yet to frame this guidelines/ regulation. though it is seized of the urgent need to frame them.LIFE & GENERAL INSURERS Equity Derivatives in Life & General Insurers The Insurance Act as well as the IRDA (Investment) Regulation 2000 is silent about use of equity (or other) derivatives by life or general insurance companies.

REGULATORY FRAMEWORKS Evolution of a Legal Derivatives Trading Framework for Derivatives are supposed to be defined as security under Section 2(h) of SC(R) Act. bonds. since there was no regulatory framework to govern trading of securities. the derivatives STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 75 . such other instrument as may be declared by the central government to be securities. insurance regulations in the many parts of the world apply currency –matching principle for assets and liability under life insurance contracts. 2001). Indian insurance law too prohibits investment of fund from insurance business written in India. 1956. stocks. 1995. debentures stocks or other marketable securities in or of any incorporated company or other body corporate Government securities Rights or interest in securities. An important step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. debentures. into overseas or foreign securities.Foreign Currency Derivatives in Life & General Insurers Given the long term nature of life insurance contracts. which lifted the prohibition on "options in securities" (NSEIL. However. Present definition of securities includes shares.

Regulatory objectives The Committee believes that regulation should be designed to achieve specific. the appropriate regulatory framework of "securities" could also govern trading of derivatives.R. The Bill suggested that derivatives may be included in the definition of "securities" in the SCRA whereby trading in derivatives may be possible within the framework of that Act. starting with stock index futures. Varma in 1998 to recommend risk containment measures for derivatives trading.market could not develop. Consequently. The Government decided that a legislative amendment in the securities laws was necessary to provide a legal framework for derivatives trading in India. Securities Exchange Board of India (SEBI) the oversight regular for the securities market appointed a Committee on derivatives under the Chairmanship of Dr. L. Gupta on 18. It is inclined towards positive STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 76 . SEBI also set up a group under the chairmanship of Prof. L. The committee suggested that if derivatives could be declared as "securities" under SCRA.C. SEBI set up a committee in November 1996 under the chairmanship of Dr. The said Committee submitted the report on 17th March 1999.C. November 1996 to develop appropriate regulatory framework introducing of derivatives trading in India. J. Gupta to develop appropriate regulatory framework for derivatives trading. the Securities Contracts (Regulation) Amendment Bill 1998 was introduced in the Lok Sabha on 4th July 1998 and was referred to the Parliamentary Standing Committee on Finance for examination and report thereon. well-defined goals.

Investor Protection: Attention needs to be given to the following four aspects: 1. Safeguard for clients' moneys: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients' account but should also not be attachable for meeting the broker's own debts. These experiences provide useful lessons for us for designing regulations. In this context. It should be ensured that trading by dealers on own account is totally segregated from that for clients. sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere. Experience in other countries shows that in many cases. Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner.regulation designed to encourage healthy activity and behavior. the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. derivatives brokers/dealers failed to disclose potential risk to the clients. 2. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 77 . It has been guided by the following objectives: A.

such as cost-efficiency. B.3. Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. more so because financial derivatives represent a new rapidly developing area. Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important market qualities. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 78 . Market integrity: The trading system should ensure that the market's integrity is safeguarded by minimizing the possibility of defaults. margins. C. Clearing Corporation. 4. This is a much broader objective than market integrity. etc. and price-discovery. This requires framing appropriate rules about capital adequacy. the regulatory framework should not stifle innovation which is the source of all economic progress. aided by advancements in information technology. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base. Innovation: While curbing any undesirable tendencies. price-continuity.

B. products.  The Exchange before commencement of Derivatives Exchange should have investor grievance and redressal Mechanism operative from all four regions of the country. Derivatives Exchange information in real –time through at least two information vendors  Existing Stock exchange can carry out derivatives trading as a separate segment. trading and clearing regulations. L. Gupta Committee were made with relation to Exchange operations.Gupta Committee The recommendations of the L. Bye-laws and Regulation of the Derivatives trading. and participants. A.  The Derivatives Exchange should inspect every broker/member annually.C. membership.C.Recommendations of Dr. The main recommendation relating to a derivatives exchange are as follows:  The derivatives Exchange should have online screen based  The trading system with online shall surveillance disseminate capabilities. Main recommendations relating to membership of a derivatives exchange are as follows: STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 79 .  SEBI to approve Rules.

Recommendations relating to introduction and trading of derivatives product are as follows  SEBI shall approve any new derivatives product if it serves an economical function.  Membership shall be trading members being a member of the Exchange and Clearing member being of Clearing Corporations  Clearing members should have minimum net worth of Rs.50 lakhs with clearing corporations. for protection of Interest of Investor and for the purpose of maintaining a fair and orderly market. The Derivatives Exchange should have at least 50 trading members to start Derivatives trading. D.300 lakhs and make a deposit of Rs.  Membership norms include certain net worth criterion passing SEBI approved certification.  Existing members cannot automatically become derivative members.  The Exchange may suspend any derivatives contract due to suspension of Trading in underlying securities. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 80 . C. Recommendation relating to participants in the derivatives market is as follows:  Restriction on investment institutions on uses old derivatives should be removed.

E.  Level of Initial margin will be calculated using “Value at risk” concept and will be large enough to cover one-day loss 99% of the days.  Employees of broker/members should be adequately qualified and trained (certified). he fails to pay within specified times. Recommendations relating to trading regulations are as follows:  Investor should read the Risk Disclosure document made available to him by the broker/ member and sign the Client Registration form. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 81 .  Margin collection will be mandatory from all clients including institutions.  Clearing members may be cleared defaulter if he is unable to fulfill obligations.  Contract note that must be stamped with time of orderreceipt and order execution (trade). damages and money differences due to compulsory closeout and fails to abide arbitration proceedings. F. Corporate and mutual funds allowed trading in derivatives to the extent authorized by Board of Directors or Trustees as the case may be. Recommendations relating to clearing regulations are as follows:  Exposure limit of clearing member linked to deposit maintained with Clearing Co-operation.

1 lakh. It is suggested that the bankruptcy and insolvency laws should 10 clearly prescribe providing due concern to rights of securities holders on winding up or on insolvency of intermediaries and multilateral netting procedures in novation. POLICY ISSUES FOR DEVELOPMENT OF THE MARKETS 1. some elements of financial infrastructure need to be strengthened. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 82 .SEBI board has accepted the LC Gupta report’s recommendations and further prescribed that all derivatives contract should have a minimum contract size of Rs. Transparency of Derivatives Transactions and Financial Stability The Basel Committee on Banking Supervision and IOSCO Technical Committee have presented recommendations for public disclosure of trading and derivatives activities of banks and securities firms which could also be used by such non−financial companies that make material use of complex financial products. Strengthening of Financial Infrastructure While the Indian regulatory framework for derivatives is mostly consistent with the international practices. 2.

both qualitative and quantitative. Institutions should. primary dealers and All India Financial Institutions by RBI in July 1999. to all scheduled commercial banks. Enhanced transparency would also benefit bank and securities firms themselves by enhancing their ability to evaluate and manage their exposures to counter parties. therefore. provide meaningful information. This goes beyond simple accounting treatment of derivatives in the books of the clients or participants. what is being suggested is that the IOSCO principles would need to be suitably incorporated (through a statutory mandate) in the public disclosure of trading and derivatives activities of banks and securities firms. It is observed that transparency based on meaningful public disclosure plays an important role in reinforcing the efforts of supervisory authorities in encouraging the sound risk management practices and promoting financial market stability (IOSCO 1999). Declaring Transactions in Derivatives as Non−speculative STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 83 . Accounting and valuation and reporting requirements for forward rate agreements and interest rates swaps have been prescribed in the RBI guidelines (for regulatory reporting). on the scope and nature of trading and derivatives activities and elaborate how these activities contribute to their earning profile. However.These recommendations emphasize the importance of transparency in promoting financial stability. 3.

Thus. 1961 defines a speculative transaction where the contract for purchase or sale of any commodity. i. a balance needs to be struck between the interests of hedgers as well as speculators (Sahoo. Viewed from the perspective of risk management. There are exceptions given to jobbing/arbitrage transactions and hedging of underlying positions. 1961 any losses on speculative business are eligible for set off against profits and gains of speculative business only. accounting etc. However. such as taxation. The hedging and arbitrage transactions. That is why it is absolutely essential that while taking decisions about various aspects of derivatives trading. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 84 .The derivatives markets have three categories of participants− hedgers. those who are risk averse need to have a counter party who are risk takers. (iii) The participant has no underlying position. up to a maximum of eight years. 3. some provisions have indirect relevance for derivatives transactions. which is (i) A transaction in commodities/ shares.e. It follows that a transaction is speculative if it is settled otherwise than by actual delivery. is settled otherwise than by actual delivery. derivatives markets are an inter play of hedgers and speculators. and (iv) The transaction is not for jobbing/arbitrage. (ii) Settled otherwise than actual delivery. are considered non−speculative. 1961.. speculators and arbitrageurs. 2000). even though not settled by actual delivery. Under section 73(1) of the Income Tax Act.2 There are no specific tax provisions for derivatives transactions under the Income Tax Act. including share. The section 43(5) of the Income Tax Act. a speculative transaction is one.

a transaction is construed as speculative. This is contrary to capital asset pricing model. may be treated as speculative. These must. To summaries. however. It is possible that an investor does not have all the 30 or 50 stocks represented by the index. (ii) Innate nature of a derivative contract requiring its settlement otherwise than by actual delivery. which states that portfolios in any economy move in sympathy with the index although the portfolios do not necessarily contain any security in the index. in view of (i) Practical difficulties in administration of tax for different purposes of the same transaction. Further.. This would be fiscally more prudent since it STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 85 . and (iv) And the need to promote the economic purpose of future price discovery. hedging and risk management in the securities market. (iii) Need to provide level playing field to all the parties to derivatives contracts (which includes hedgers as well as speculators and treating the income of all parties to a derivatives contract equitably). As a result. it is apprehended that an investor’s losses or profits out of derivatives transactions. be taxed as normal business income or capital gains at the option of the assesses. if a participant enters into a hedging transaction in shares outside his holdings. even though they are of hedging nature. it is suggested that the exchange traded derivatives contracts are exempted from the purview of speculative transactions.

Legality of OTC Derivatives: International Experience and Lessons for India Pursuant to the amendment made through the Securities Laws (Amendment) Act. primary dealers and All−India financial institutions in July 1999." a doubt was raised about the legality of the OTC derivatives such as forward rate agreements and interest rate swaps permitted under RBI guidelines issued to banks. Efforts need to be made to examine solution to the issue so that the legality of OTC derivatives can be ensured. The US efforts are documented in the report of the President’s Working Group on Financial Markets (Report of The President’s Working Group on 13 Financial Markets 1999) entitled "Over the Counter Derivatives Markets and the Commodity Exchange Act" and the Commodity Futures Modernization Act (CFMA) of 2000.would avoid arbitrary exercise of discretion and possible resultant litigation. In this connection. This suggestion would need to be flagged to the tax authorities. 1999 in SCRA regarding legally permitted "derivatives. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 86 . it would be instructive to study the US experience of the recent past when the US Government was involved in clarifying the uncertainty in the OTC derivatives markets. It was felt that these OTC derivatives could be deemed as illegal in view of express exemption to only exchange based derivatives from wagering contracts under SCRA.

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 87 .

one would need to know. To determine demand. which would need hedging.CONCLUDING REMARKS For the genuine portfolio (non. as most of the share do not have a high correlation with the index. If trading in index futures is advocated on the basis of hedging needs an investors. Even tracking the index portfolio would be non efficient. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 88 .strategic). the percentage share available to the public is so little and varied that it is impossible for anybody to hold any significant amount of index portfolio. Given this scenario. one must assess the market demand and supply source of trading in the market risk before introducing the index futures. And even this small correlation varies a great deal over a period of time. it was imperative on the committee to have done some credible and verifiable investigation to support their demand hypothesis for hedging.

For arbitrageurs to function properly. then only speculators are going to dominate the futures markets. on the supply side the question is : would there be a sufficient number of hedgers who would like to offset the opposite risks or liquidate another hedge as a result of a change in their positions in the cash markets? And if hedgers are few in number and if all hedge seekers are on same side. If the above is not possible in our existing cash markets. an appetite to risk and decisive edge in expertise. How many investors (individual and/ or institutional hold the index portfolio)?  What are the objectives of these investors in holding such a portfolio?  What is the size of their portfolio?  What are their hedging needs given the stated objective of their business?  What price they would be willing to pay for such hedging?  Would it be possible to have a reasonably continuous demand curve given the number of hedge seekers and their stated price preferences?  Would it be possible to have reasonably continuous demand curve given the number of hedge seekers and their stated price preference? Similarly. the STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 89 . which is most often the case. Speculators who are going to specifically benefit from futures trading are those who have access to large funds. we would need to examine the working of the cash market. arbitrageurs and speculators would be needed to provide the other side of the transactions.

was mainly because SEBI did not think system risk was being satisfactory managed by SROs. severe restrictions put while reintroducing it indicate that STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 90 . We would not able to have a competitive market. However. SEBI has reintroduced it realizing that it serve much need functions like margin trading and short sale which are not available in India. A significant achievement by any standards. the actual investment deliveries would not be more than one or two percent. However. which is akin to a weekly forward. showing a growth of 184%. a well-established BADLA SYSTEM. if one take out the deliveries made on account of arbitrage business between BSE and NSE (both have different trading period). Even in this small percentage of derivatives. As a report by SEBI. The BSE shows a growth of 148% and the NSE 442%. trading volumes on 22 bourses in India increased from Rs. Few speculators would be able to dictate the markets because there would not be many left to provide the opposite side of the transactions.227.rest would first losers and then mere speculators. one also noticed that delivery percentage is only 10 to c5 percent of the volume of trade.116 crore during 199798. In 1994. 368 crore to Rs. The rest of the business is squared off during the same valance system. This question becomes much more crucial when settlements are done in cash and not by actual delivery. Now.644. One would have no choice but to enter the settlement contract at dictated prices.

SEBI either does not trust the independent functioning or capabilities of SROs to supervise the system risk as a regulator. short sale. RECOMMENDATION STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 91 . To make cash market robust and effective. first let us put in place the mechanism of margin trading. as well as the reputation of the entities involved in introducing these products. dematerialized settlement and electronic transfer of funds among market participants. depends crucially on the solidity and maturity of cash market in underlying securities. The desirability of successful derivatives. Undue haste may well result in a major scandal that may undermine both the confidence in and acceptance of equity derivatives in the country. such as futures trading.

the market should also have recognizes that in order to make hedging possible. it is difficult to quantify such hedging needs without STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 92 . The above recommendation makes sense if there is a genuine demand for hedging by a large number of investor in India. is unlikely to be a sound economic institution. A derivatives market. A soundly based derivatives market requires the presence of both hedger and speculators. And if sufficient numbers of hedgers with genuine hedging needs are not there and we still introduce future market. does Indian investor need futures trading? The Committee should have made an endeavor to estimate the hedging needs of portfolio owners in the country. Such a futures market would be devoid of any connection with the cash or th spot market and would have its own life full of speculation and bubbles.The Derivatives committee strongly favors the introduction of financial derivatives in order to provide the facility for hedging in the most cost-efficient way against market risk. it recognizes that in order to make hedging possible. This is an important economic purpose. For an academician. wholly or mostly consisting of speculator. At the same time. So now the question arises. the market should also have speculator who are prepared to be counter parties to hedgers. then we would end up having only speculators.

or by multinationals (Hindustan lever. genuine hedging needs are not there. etc) or by promoters (Tatas. one can easily conclude that such numbers are not very large and given there mandate.). Colgate. if one examines the security holding structure and the market operation in India. In India. Birlas. Bajaj. Mahindras) or by a few developmental financial institutions (like ICICI. However.IFCI etc. among the index stock most of the shareholding is strategic holding. BHEL. MTNL etc). owned either by the government (SBI. These strategic shareholders are certainly not seeking a hedging facility because they are not having genuine hedging needs. Nestle.resources and an authority to procure information. STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 93 . BPCL. IDBI.

LIMITATIONS
As per the researcher following are the limitations of this study:-

1. Time Factor
As we know that nobody can hold time therefore in my study of derivatives in Indian capital market, researcher find less time to expose his efforts and knowledge to collect thorough details of the topic.

2. Source of data
According to researcher this study is completely based on secondary data and does not involve any personal interaction with any financial entities.

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BIBLIOGRAPHY

I. II.

Futures & Options by N.D. VOHRA & B.R. BAGRI Financial Derivatives by V.K. BHALLA by DR. L.C. GUPTA

III. Regulatory framework for financial derivatives in India http://www.derivativesindia.com http://www.igidr.ac.in http://www.nseindia.com http://www.rediff/money/derivatives https://www.sebi.gov.in http://www.bseindia.com http://google.com http://www.edelweiss.in http://www.capitalmarket.com

IV. V. VI. VII. VIII. IX. X. XI. XII.

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4.INDIA’S LISTED DERIVATIVES EXCHANGES 1. 3. 2. 6. The Bombay stock exchange (BSE) The Cochin stock exchange (CSE) The Delhi Stock Exchange (DSE) The National Stock Exchange (NSE) The Over The counter Exchange of India (OTCEI) The Stock Exchange Of Ahmedabad (SEA) STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 97 . 5.

LISTED FUTURES AND OPTIONS EQUITY  Equity Futures and Options  Index Futures and Options FIXED INCOME  Fixed Income Deposit Futures / Options  Interest Rate Futures and Options CURRENCY  Currency Futures / Options COMMODITY  Commodity futures and Options STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 98 .

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