A Project Report Entitled

Financial Weapon for Mass Destruction: Derivatives with special reference to Anand Rathi Securities Ltd.

SUBMITTED IN PARTIAL FULFILLAMENT FOR AWARD OF POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT (PGDBM)

Organization Guide:

Submitted By: Abhijeet A. Marathe

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CERTIFICATE

I here by certify that this project report entitled Financial Weapon for Mass Destruction: Derivatives submitted by Abhijeet A. Marathe to International School of Business & Media, Bangalore, is a bonafide and original research work carried out under my guidance and supervision. It is piece of research of sufficiently high standard to warrant its submission to college for the award of said diploma. No part of the thesis has been submitted any degree or diploma or published in any other form. The assistance and the help rendered during the course of his investigation in the form of basic source material and information have been duly acknowledged.

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DECLARATION

I hereby declare that the project report entitled Financial Weapon for Mass Destruction: Derivatives is a bonafide and authentic work done by me under the guidance of Mr.. The project is entirely original and not been submitted to any university for the award of any degree, diploma or any other similar title. The sources of material & data used in this study have been duly acknowledged.

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ACKNOWLEDGMENT

The completion of project on "Financial Weapon for Mass Destruction: Derivatives" has given us immense pleasure and knowledge. We would like to thank , who helped us in each and every step in completion of this project. I am greatly indebted to Mr. Nitin Goel (Asst. Manager), sincerely acknowledge the cooperation of Mr. Vaibhav Shrivastava (Equity Manager), Anand Rathi Financial Services Ltd., Nagpur, Who guided us and gave us their valuable time. We owe our heartiest thank to Mr. Ravindra Maloo (Vice President, ARSL) who provided us such a platform and guided us with his valuable information. We must acknowledge our gratitude towards all the employees of ARSL for their help and last but not the least, to all our family members and friends for their constant help and support.

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OBJECTIVE OF SUMMER INTERNSHIP

The objective with which I undertook this internship is mentioned as follows: To observe the processes, methods and system

followed in the organisation to achieve its aim. To understand the organisational processes, goals,

organisational

hierarchy,

organisational

communication channels in the particular organisation. To get a hands-on experience of the corporate world. To undertake a project and get a practical exposure of any financial sector. To acquire thorough knowledge base on a particular subject.

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To learn various pre requisite qualities expected of a manager.

COMPANY PROFILE
Overview
ANAND RATHI is a premier integrated financial services provider, and ranked among the top five in South Asia in all its business segments, services over 200 thousands individual investors in various capacities, and provides investor services to over 300 corporate. ANAND RATHI covers the entire spectrum of financial services such as Stock broking, Depository Participants, Distribution of financial products - mutual funds, bonds, fixed deposit, equities, Insurance Broking, Commodities Broking, Personal Finance Advisory Services, Merchant Banking & Corporate Finance, placement of equity, IPOs, among others. ANAND RATHI has a professional management team and ranks among the best in

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technology, operations and research of various industrial segments.

Anand Rathi Early Days

Anand Rathi is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. Anand Rathi, today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. AR provides a breadth of financial and advisory services including wealth management, investment banking, corporate advisory, brokerage & distribution of equities, commodities, teams. The firm's philosophy is entirely client centric, with a clear focus on providing long term value addition to clients, while maintaining the highest standards of excellence, ethics and professionalism. The entire firm activities are divided across distinct client groups: Individuals, Private Clients, Corporate and Institutions and was recently ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the ultra-rich. In year 2007 Citigroup Venture Capital International joined the group as a financial partner. mutual funds and insurance, structured products - all of which are supported by powerful research

Name: Abhijeet Marathe

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Course: PGPBM Year of Passing: 2009 Project Title: Financial Weapon For Mass Destruction: Derivatives Subject: Finance Project Type: Summers

EXECUTIVE SUMMARY
I undertook my summer Internship with Anand Rathi Stock Broking Ltd. ANAND RATHI is a premier integrated financial services provider, and ranked among the top five in the country in all its business segments, services over 16 million individual investors in various capacities, and provides Abhijeet Marathe -08 Summer Internship Report -8-

investor services to over 300 corporate. ANAND RATHI covers the entire spectrum of financial services such as Stock broking, Depository Participants, Distribution of financial products - mutual funds, bonds, fixed deposit, equities, Insurance Broking, Commodities Broking, Personal Finance Advisory Services, Merchant Banking & Corporate Finance, placement of equity, IPOs, among others. I got an opportunity to work on project titled Financial Weapon for Mass Destruction: Derivative.

ANAND RATHI GROUP COMPANIES

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Anand Rathi is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. Anand Rathi, today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. AR provides a breadth of financial and advisory services including wealth management, investment banking, corporate advisory, brokerage & distribution of equities, commodities, teams. The firm's philosophy is entirely client centric, with a clear focus on providing long term value addition to clients, while maintaining the highest standards of excellence, ethics and professionalism. The entire firm activities are divided across distinct client groups: Individuals, Private Clients, Corporate and Institutions and was recently ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the ultra-rich. In year 2007 Citigroup Venture Capital International joined the group as a financial partner. mutual funds and insurance, structured products - all of which are supported by powerful research

Milestones:

1994: Started activities in consulting and Institutional equity sales with staff of 15

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1995: Set up a research desk and empanelled with major institutional investors 1997: Introduced investment banking businesses Retail brokerage services launched 1999: Lead managed first IPO and executed first M & A deal

2001: Initiated Wealth Management Services 2002: Retail business expansion recommences with ownership model 2003: Wealth Management assets cross Rs1500 crores Insurance broking launched Launch of Wealth Management services in Dubai Retail Branch network exceeds 50

2004: Commodities brokerage and real estate services introduced Wealth Management assets cross Rs3000crores Institutional equities business re launched and senior research team put in place Retail Branch network expands across 100 locations within India

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2005: Real Estate Private Equity Fund Launched Retail Branch network expands across 200 locations within India

2006: AR Middle East, WOS acquires membership of Dubai Gold & Commodity Exchange (DGCX) Ranked amongst South Asia's top 5 wealth managers for the ultra-rich by Asia Money 2006 poll Ranked 6th in FY2006 for All India Broker Performance in equity distribution in the High Net worth Individuals (HNI) Category Ranked 9th in the Retail Category having more than 5% market share Completes its presence in all States across the country with offices at 300+ locations within India

2007: Citigroup Venture Capital International picks up 19.9% equity stake Retail customer base crosses 200 thousand Establishes presence in over 450 locations

SWOT Analysis (Strength, weakness, opportunities & threats)

Anand Rathi Core strengths:

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Breadth of Services
In line with its client-centric philosophy, the firm offers to its clients the entire spectrum of financial services ranging from brokerage services in equities and commodities, distribution of mutual funds, IPOs and insurance products, real estate, investment banking, merger and acquisitions, corporate finance and corporate advisory. Clients deal with a relationship manager who leverages and brings together the product specialists from across the firm to create an optimum solution to the client needs.

Management Team
AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience.

In-Depth Research
Our research expertise is at the core of the value proposition that we offer to our clients. Research teams across the firm continuously track various markets and products. The aim is however common - to go far deeper than others, to deliver incisive insights and ideas and be accountable for results.

Weakness:
1) Motivational Forces The motivational factors to the greater extent were missing in the organization. There was not much of motivation provided to most of the employee base. The method that was followed to encourage the employees to improve there performance was more inclined towards the fear of not

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missing on there targets particularly in context of sales and marketing people. 2) Knowledge There were handful of people who had high level of knowledge about Derivatives. Anand Rathi group should arrange training sessions for their employees.

Opportunities:
1) Huge Client Base There are great opportunities for the Anand Rathi employees to generate the targeted business because they have large cliental in central India. 2) Awareness in Retail Segment Continuously rising awareness about the market and derivatives in retail segment is beneficial for the firm as they dont have to educate clients about the business. 3) Strong Growing Economy Because of the strong growing economy, Indian market became fundamentally strong and Foreign institutional investors also find it beneficial to invest in Indian Market.

Threats:
1) Cut throat Competition: There is a cut throat competition amongst the broking houses for the acquisition of clients. This has increased the

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client switchovers from one broking house to another because of the additional services from other broking houses. 2) Decreasing Brokerages: Broking houses mainly work for generating brokerage through equity markets. Nowadays it is not as easy as it was because each broking house is decreasing its brokerage levels to acquire more clients. Because of this employees have to work more to generate the same amount of brokerage.

COPS

Analysis

(culture

,organization

,people ,system)
During the six months internship, I got many opportunities to interact with the employees as well as other interns from different institutions, who had joined the organization with me, which gave a lot of opportunity to understand more about the various organizational processes in the Company. The overall environment in the office was very friendly. During the period of my internship I observed the various organizational processes taking place at the work place. Some of these were based on my own experiences and others were the observations as an independent observer. The various organizational processes observed in the company were as follows:

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As I observed that stock trading involves the sentiments and emotions of the people. The traders were very focused on their job and hardly had the time to gauge on others emotions. The trading section required just to give the requisite services to the client but the PR department needed to chase the clients and had the targets to be achieved on a regular basis. So the trading section people were more or less involved in providing services in their responsibility areas. Whereas in the PR department was more concerned to chasing the targets. At the time of my internship, there were some students perusing their internship in the PR department on the same project and under some other guide. The first step in the project was collecting the data. I was supposed to collect at least database of 15 people in a day without fail. In case of any default the students were required to get the pending databases the next day. This attitude towards the interns encouraged them to avoid the reporting heads to the extend possible. Many of them switched over their profiles and guides. On the other hand at the trading section did not required too much of reviewing and also the clients had little grievances from them, so the employees in this section were more relaxed and satisfied with their work and work environment. Thankfully no such thing happened with me. My guide Mr. was a very cooperative man. He always encouraged me to

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ask any doubts and suggested me to do self study. He never demotivated me. He understood that I was keen on learning many things about the market and the companies, so he always focused on discussing all the issues which otherwise not dealt properly with would have discouraged me from thinking of going ahead with finance. I even observed that when markets soared high, he would encourage and cheer the trading staff for their job. Many times the juniors came with their problems and he handled them with utmost detail and concern. Communication Process The communication process happening in the organization was very direct and informal. The seniors and subordinates communicated directly to each other. The bosses and other staff members were very approachable even to the interns. I was accompanied by six of my class mates in the same project, so we were pretty comfortable with ourselves as a team. We were initially introduced to all the employees of the trading department as the interns for the coming two months and all were requested to provide all support that was needed. The trading hours of the Stock markets are till 3.30 in the afternoon, so employees are usually free in the evening hours, which gave me a huge opportunity to have long discussion with my boss and other member of the staff, which definitely added to my learning during the internship.

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Apart from this also most of the communication like reporting, problems etc happened directly. Nobody could even get a clue about the designation of the people based on the communication pattern followed in the company. When market was in a better condition, there would be lot of cheerfulness in the environment, where everybody would be discussing about the profit their clients have made. Just the reverse situation happens when there is a down trend in market. The environment would be tensed. Senior employees shouting at the traders or the juniors for not taking due care about it. A lot of analysis as well as instruction is given through word of mouth. Even most of the clients used to order directly to the personal relations department either through telephone or meeting in person.

Interaction Influence Process

The intra departmental interaction was pretty smooth in terms of conveying the ideas to the administrative heads of the one department. My most of the time went away in the Trading Section and so every discussion regarding the internal problems, decision etc happened only after the market hours i.e. 3.30 pm. The jobs in this particular department were so divided that everyone was given a different responsibility, which did not required much of interference by others.

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One of the phenomenon's that I observed in the company was that if there was a minor problem in the working in any section then all the employees will assemble and discuss the issue may be accompanied by the branch coordinator or technical support manager. So, every one was willing to support and help in the issues which may not be pertaining to their function directly. As far as influencing the decisions of the top management is concerned the employees were given enough autonomy to work in their own way, so I did not came across any such incidence where the middle level were forced into something.

Decision Making Process: The decision-making process was carried out in a top down hierarchy. The company head office is situated in Bangalore and all the decisions are taken there and later on communicated to the branch offices. For example if the stock market crashed severely in a span of very short duration, which will cause a default for margin for various brokerage houses. To access the position of its clients, the HO will decide to call off the trading across all offices in the country on open market day.

The

decisions

like

recruitment,

training,

business

development etc. were delegated at the branch level. The head of the respective department would take a call on such issues. The decision pertaining to the limits offered to the Abhijeet Marathe -08 Summer Internship Report - 19 -

clients were taken by the senior staff and some of the decisions were further delegated to the junior staff. At the time of my internship, all the interns were give a basic training seven days; this training was managed and guided by the most junior staff of the company. They decided the schedule of training based on the availability of the trainer etc.

Goal Setting Process: There was hardly any goal activity happening in company. The organization is quite bureaucratic in nature. In fact I did not found any instance where the employees were ever reminded of the company objectives or goals leave apart the setting of the goals. The work atmosphere was too casual. The employees use to just dispose off their responsibilities, doing only what is required with no connection to the goals or objectives of the company at large. I could not see any intensity in the work done by the employees there. This is in particular to the trading section that there was no incentive for performance and no punishment for underperformance. And at the Personal Relations department, the Sales and Marketing executives had their own targets, which were decided by the management, and most of them followed a similar style of working. This also suggested that the employees had lackadaisical attitude towards the work, though they had performance incentives for their better performance. The sales people

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used to compete against each other, which lead to hiding of information from each other. I dont know whether it was positive or negative for the company. Control Process No importance was given to any control process in the marketing department. The things used to be ignored till the time they became a problem. The decisions were taken on ad-hoc basis and no proper planning was one on these fronts. In the initial phase of internship, the interns were given training but it was carried out in a completely haphazard manner. On the other hand in the in the trading section most of the control was exercised through the technological systems. For all the important parameters the systems were in place. For example the computer software would generate the limits available in each clients account on a day to day basis. In case the limit fell below a certain limit the system gave alert for the same. In case of purchase of shares in the account of client who had inadequate balance in his account, the delivery was his shares were always given only after the payment was collected.

Performance characteristics The performance characteristics that were classifiable were mostly result oriented. There were some concrete parameters defined for each profile. The employees had to perform well along these parameters to get a positive performance rating. For the sales people it was there

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monthly, half yearly and yearly targets. For dealers it was about getting business of five times their own salary. So, these parameters ensured the productive of the employees. The quality of work done could be rated as above average because the performance parameters were predetermined so every employee had too achieve this bare minimum level of standards and these standards were pretty realistic and achievable. The absenteeism was quite low as the work was not too hectic or rigorous. Expect for the markets most of the staff could move in and out of the office. No strict control over the office in and out time was exercised. The trading section staff would reach office before the markets open without fail and worked till late evening without fail. The marketing and sales staff would usually come bit late in the morning but the kind of there job did not allowed them to have a fixed off time from the job. As stated earlier the work environment was such that no one valued time and punctuality. I never observed that anybody cared about any sort of deadlines, in fact most of the time there were no deadlines either. So, definitely there was a lot of wastage of time. Apart from the time factor, other resources were utilized with minimal wastage.

PROBLEMS FACED DURING THE INTERNSHIP

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The initial problem faced by me was my complete ignorance about the stock market. Moreover when I was given this project on Derivatives, I was not able to understand even a bit of it. I used to go through a lot of books. Most of the books language was not properly understood by me. I felt that I was getting nowhere. The theories and what in practicality I was asked to do in derivatives was completely different. Later on I found that the theories are for supporting the assumptions taken. Everything has logic to it. My guide helped me to look at these issues from a very rational point of view. Another problem faced was that there were a lot of mathematical calculations and statistical tools to be used in the derivatives or even the mutual funds comparison. Every term had different computations given in different books or from different net based tutorials. It really confused many times till they were discussed before my guide and other team mates.

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LEARNING AND EXPERIENCE

I was able to learn and experience a lot of things during the period of my internship at ANAND RATHI. These learning were not only restricted to the responsibilities that I handled but also in terms of the interaction patterns that happen within the organization. Knowledge about the Financial Markets Prior to my summer training, I had zilch knowledge on financial markets. But by undergoing this training I got to know many things in greater clarity and detail about how the markets operate, how derivatives are used with calculated risk, what are the jobs of the equity managers, what all tools and techniques backed by theories exist. Investment Principle I got my first practical knowledge on finance and that too on investments. I learnt that it is risk and reward that any investor will take into consideration before parting away with his money. Before designing or planning anything for the client one needs to gauge upon the clients risk taking ability and risk tolerance. Therefore in Anand Rathi whenever a new client is approached they first try to canalize the client and understand his need and expectation form his investments.

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Only them they decide what better avenues are open for the client. Teamwork The importance of forming self managed teams and getting the work done through a proper channel was one of my most important learning.

Your work matters at the end of the day. When my guide knew about my suffering owing to my ignorance on this subject and being badly handled by my teammates, he came to my rescue. He gave lot of god advices. He said that at the end of the day what matters is your work and contribution towards the objective. He said that management in its real sense is getting ones work done either by hook or crook. Though he cleared that crook doesnt mean unethical practices all the way. One needs to focus on the objective rather than get disturbed by the obstacles in the way. He encouraged me to quench my inquisitiveness, even though that might be trivial for all others. I learned to be patient, tactful and perseverance All through this project, I learnt the basic aspects that were missing on my part. Earlier I used to be impatient when my efforts were not given due recognition. But when I worked here, I learnt that patience is very important in this field. At

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one point of time you may be gaining by the increased prices of your shares or assets and at another time you may be losing all the money you have. So, one needs to strike a balance between sudden gain and loss. My interactions with my teammates made me more tactful in delivering what I am supposed to convey and what I am not supposed to convey in the corporate world where we have to first perceive the thin line of competition and collaboration. And perseverance is something that every one of us has to develop in order to strive in volatile tempered industry like Anand Rathi or so to say any stock broking firm.

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INTRODUCTION OF DERIVATIVES
Derivative is a product whose value is derived from the value of one or more basic variables, called underlying. The underlying asset can be equity, index, foreign exchange (forex), commodity or any other asset. Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products.

Definition:
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative as: "A contract, which derives its value from the prices or index of prices, of underlying securities." Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example; wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. Abhijeet Marathe -08 Summer Internship Report - 27 -

Derivatives are securities under the SC(R) A and hence the regulatory framework under the SC(R) A governs the trading of derivatives.

Emergence of Derivatives Market

Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalization process and Reserve Bank of India's (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalization process to manage risk. NSE gauging the market requirements initiated the process of setting up In July 1999, derivatives trading commenced in India.

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Milestones 1991 14-Dec-95 18-Nov-96 Liberalization process initiated NSE asked SEBI for permission to trade index futures. SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Nifty futures trading commenced at SGX. Individual Stock Options & Derivatives
Emergences of Derivatives

11-May-98 L.C.Gupta Committee submitted report. 07-Jul-99 24-May-00 25-May-00 09-Jun-00 12-Jun-00 25-Sep-00 02-Jun-01

Derivative Markets in India

Trading takes place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange.

Derivative Exchange or segment operates as a self regulatory Securities and Exchange Board of India (SEBI) acts as the guardian. - 29 -

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Clearing & settlement of all derivative trades made on a Derivative Exchange or Segment are done through a Clearing Corporation - an independent body set to act as a regulatory.

Types of Derivatives Forwards: A forward contract is a customized contract between two

entities, where settlement takes place on a specific date in the future at todays pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts, such as futures of the Nifty index.

Options: An Option is a contract, which gives the right, but not an

obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him. Options are of two types - Calls and Puts options:

Calls give the buyer the right, but not the obligation to buy a given quantity of the underlying asset at a given price on or before a given future date.

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Puts give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date.

Warrants: Options generally have lives of up to one year. The majority of

options traded on exchanges have maximum maturity of nine months. Longer dated options are called Warrants and are generally traded over-the counter.

Baskets: Basket options are options on portfolios of underlying assets. The

underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest

related cash flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and

interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. (London interbank offered rate)

Participants
Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in the derivatives market.

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Hedgers face risk associated with the price of an asset. They use futures or
options markets to reduce or eliminate this risk.

Speculators wish to bet on future movements in the price of an asset.

Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between

prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Commodity derivatives market

Commodity derivatives market trade contracts for which the underlying asset is commodity. It can be an agricultural commodity like wheat, soybeans, cotton, etc or precious metals like gold, silver, etc.

Difference between Commodity and Financial derivatives

The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets.

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In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. The concept of varying quality of asset does not really exist as far as financial underlings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary at times.

Exchange-traded vs. OTC derivatives markets

Derivatives that trade on an exchange are called exchange-traded derivatives, whereas privately negotiated derivative contracts are called OTC (Over the Counter) contracts. The OTC derivatives markets have witnessed rather sharp growth over the last few years, which have 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. While both exchangetraded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions,

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2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.

5. A

regulatory

authority

and

the

exchanges

self-regulatory

organization do not regulate the OTC contracts, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

Exchange traded Vs. OTC Market.

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NSEs derivatives market

The derivatives trading on the NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. Today, both in terms of volume and turnover, NSE is the largest derivatives exchange in India. Currently, the derivatives contracts have a maximum of 3month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry.

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Total Traded Volume (Rs in Crores)

30000 25000 20000 15000 10000 5000 0 8/4/2008 8/5/2008 8/6/2008 8/7/2008 8/8/2008 Total Index Futures Stock Futures Indeex Options Stock Options

F&O Trade Volume index options European options, stck optAmerican opt. euro opt can not be exercised. And American opt can be.

Derivative Contracts
Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, the parties to the contract negotiate price Abhijeet Marathe -08 Summer Internship Report - 36 -

and quantity bilaterally. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counterparty risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to raise, and then take a reversing transaction to book profits.

Limitations of forward markets

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Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, Illiquidity, and Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

Futures
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference

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purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

Distinction between futures and forwards

Futures vs. Forwards

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Sr. No. Futures 1. Trade on an exchange 2. 3. 4. 5. Standardized contract terms Terms more liquid Requires margin payments Follows daily settlement

Forwards organized OTC in nature

Customized contract Less liquid No margin payment Settlement happens at end of period

Futures terminology

Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the
futures market.

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Contract cycle: The period over which a contract trades. The

index futures contracts on the NSE have one-month, two-months and three-month expiry cycles, which expire on the last Thursday of the month.

Expiry date: It is the date specified in the futures contract. This is

the last day on which the contract will be traded, at the end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered less

than one contract. For instance, the contract size on NSEs futures market is 50 Nifties.

Basis: In the context of financial futures, basis can be defined as the

futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot

prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin

account at the time a futures contract is first entered into is known as initial margin.

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Marking-to-market: In the futures market, at the end of each

trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket.

Maintenance margin: This is somewhat lower than the initial

margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

Options
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin

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requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.

Option terminology Index options: These options have the index as the underlying. Some
options are European while others are American. Like, index futures contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options

currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who

receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Call option: A call option gives the holder the right but not the obligation
to buy an asset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to
sell an asset by a certain date for a certain price.

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Option price/premium: Option price is the price, which the option

buyer pays to the option seller. It is also referred to as the option premium. The option premium can be broken down into two components:-

Intrinsic value: - The option premium can be broken down into

two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

Time value: - The time value of an option is the difference

between its premium and its intrinsic value

Expiration date: The date specified in the options contract is known as

the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the
strike price or the exercise price.

American options: American options are options that can be exercised at

any time up to the expiration date. Most exchange-traded options are American.

European options: European options are options that can be exercised

only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that

would lead to a positive cash flow to the holder if it were exercised Abhijeet Marathe -08 Summer Internship Report - 44 -

immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price).

At-the-money option: An at-the-money (ATM) option is an option that

would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an

option that would lead to a negative cash flow, it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price).

Futures and options

An interesting question to ask at this stage is - when would one use options instead of futures?
Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in Abhijeet Marathe -08 Summer Internship Report - 45 -

full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance, which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating guaranteed return products.

Distinction between futures and options

Futures vs. Options

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Sr. No. Futures 1. Exchange novation 2. 3. Exchange defines the product traded,

Options with Same as futures

Same as futures

Price is zero, strike price Strike price is fixed, moves price moves No margin payment Only short at risk.

4. 5.

Price is zero Both long and short at risk

RESEARCH
The term research can be defined as A Scientific and systematic search for pertinent information on a specific topic. A research is a careful investigation or inquiry especially through search for new fact in branch of knowledge. It is an increase in the existing stock of knowledge making for advancement. We decided to do the project in two parts. The first part of the project is comprised of the brief detail of stock exchange i.e. BSE and NSE and their indices and the second part deals with the study of Derivative market and its instruments. Abhijeet Marathe -08 Summer Internship Report - 47 -

The first part of the project i.e. stock exchange gives a very short detail about the role of exchange, Bombay Stock exchange and National Stock Exchange. There is also a short description of Sensex and about Nifty 50. It also has the list of companies, which has a major impact over these indices. The second part of the project is about Derivatives. Indian stock market has undergone tremendous changes over the years. The derivative market has its own dynamics. So we tried to cover the introductory part of Derivatives. It covers the definition, types and the other basic details about it.

SOURCE OF DATA COLLECTION Primary Data: - is the first hand information collected directly from the
employees of ARSL. They explained us the basics of Derivative market and also shared their experience with their F&O clients.

Secondary Data: - is collected through Internet and Books

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SUGGESTIONS
The study done was a tool to study the Derivative market's setup and to know WORKING OF A Brokerage firm. The study proved fruitful and many facts came into light. Following are some of the recommendations for ARSL:

ARSL should provide recreation facility to their employees.

ARSL should organize some promotional campaigns for making people aware about Derivatives. Abhijeet Marathe -08 Summer Internship Report - 49 -

 They can also arrange some training and educational programs for their employees.

BIBLIOGRAPHY
BOOKS:
Financial Management: I M Pandey. NCFM's Derivatives Market Module: NSE

WEBSITES: www.rathi.com

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 www.derivativesIndia.com www.bseindia.com www.nseindia.com

www.moneycontrol.com

www.valueresearchonline.com

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