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CHAPTER 1

INTRODUCTION

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INTRODUCTION TO DERIVATIVE

A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly important in the field of finance, Options and Futures are traded actively on many exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as over-the-counter markets in other words, there is no single market place or organized exchanges. The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk.

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In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the to-arrive contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

DERIVATIVE DEFINED A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price 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 in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term security in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.

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TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

Over The Counter Derivatives

National Stock Exchange

Bombay Stock Exchange

National Commodity & Derivative Exchange

Index Future

Index option

Stock option

Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Derivatives Future Option Forward Swaps

Figure.2 Types of Derivatives

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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, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are n o r m a l l y traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT


They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract expiration date and the asset type and quality. The contract price is generally not available in public domain. 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, whi ch often results in high prices being charged. However forward contracts incertain markets have become very standardized, as in the size,

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 often confused with futures contracts. The confusion is primarily becaus e both serve essentially t h e same economic funct i ons of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.

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FUTURE CONTRACT
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT


1. Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.

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The last trading date. Other details such as the tick, the minimum permissible price fluctuation.

2. Margin: Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. 3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by

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purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. PRICING OF FUTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the future/forward, , will be found by discounting the present value at time to maturity

by the rate of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher: 1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower: 1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds.
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2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. 3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.

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OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

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SWAPS Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a SWAP. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.

FINANCIAL SWAP: Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

OTHER KINDS OF DERIVATIVES


The other kind of derivatives, which are not, much popular are as follows:
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BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.

LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.

WARRANTS Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

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. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

HISTORY OF DERIVATIVES:

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The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralised location to negotiate forward contracts. From forward trading in commodities emerged the commodity futures. The first type of futures contract was called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation
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that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealers Association was set up in early 1900s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

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INDIAN 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 liberalisation process and Reserve Bank of Indias (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India Table 2. Chronology of instruments 1991 14 December 1995 Liberalisation process initiated NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. 11 May 1998 7 July 1999 L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. 24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index. 25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading. 9 June 2000 12 June 2000 Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX. 2 June 2001 Individual Stock Options & Derivatives

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Need for derivatives in India today


In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-today life for ordinary people in major part of the world. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of Indias financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of Indias efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.

4. BENEFITS OF DERIVATIVES Derivative markets help investors in many different ways: 1.] RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. 2.] PRICE DISCOVERY

Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset. 3.] OPERATIONAL ADVANTAGES

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

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4.]

MARKET EFFICIENCY

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

5.]

EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

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5. National Exchanges In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. National Status implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively.

MCX MCX (Multi Commodity Exchange of India Ltd.) an independent and de-mutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank Canera Bank, of India, Bank of Corporation Baroda, Bank

Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure.

MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of-the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading.
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NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz., warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intraday clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement.

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NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal.

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CHAPTER 2

LITERATURE REVIEW

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LITERATURE REVIEW
Srisha (2001) opines derivatives allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging, speculating, arbitraging price differences and adjusting portfolios risks. (T, 1999) (I., 2012) (Billio, Measuring Systemic Risk in the Finance and Insurance Sectors., 2010) (Billio, 2010) According to Jiwarajika (2000), Derivatives are used as a tool of risk management; the risks are associated with derivatives including marke (Brown, 2012)t risk, credit risk and liquidity risks. The risks are directly related to size and price volatility of the cash flows they represent they are to the size of the notional amounts on which the cash flows are based. Volker (2004) defines derivatives as financial instruments which can be traded (e.g. options, warrants, rights, futures contract, options on futures, etc.) on various markets. They are called derivatives because they are derived from some real, underlying item of value (such as company share or other real, tangible commodity.) A derivative is a tradable contract, created by exchangers and dealers. A warrant or option is the simplest form of derivative. The most common usage relates to the trading Gregory W. Brown (2012) Like derivatives, hedge funds are often blamed for causing or at least contributing to economic and financial disruptions, regardless of whether any factual evidence supports that conclusion. The entire financial system was affected in Fall 2008, which then raised the general question of whether hedge funds are a source of systemic risk, and more specifically, whether they engaged in predatory trading that caused or exacerbated the market crash. Jan De Spiegeleer and Wim Schoutens (2012) A major question raised in the 2008 financial crisis and its aftermath has been how a bank, or any financial institution, can strengthen its balance sheet after a major loss during a period of market unrest, when selling stock in the equity market on reasonable terms is unfeasible. Contingent convertible securities (CoCos) have been proposed as one solution.

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Robert Brooks (2012) The Samuelson Hypothesis holds that volatility of futures prices increases as maturity approaches. Samuelsons explanation for this effect in a 1965 paper is not widely known, even by authors who tried to test for it empirically.

Massimo Costabile, Ivar Massab, and Emilio Russo (2012) One of the most common sources of path dependency in derivatives arises when the volatility is stochastic. This is apparent in the basic binomial model, where time-varying volatility causes the lattice to splinter rather than recombine, leading to n2 different nodes at the nth time step instead of n + 1 nodes in a tree that recombines.

Ray Popovic and David Goldsman (2012) The BlackScholes model for pricing a European option written on a lognormal returns process was easy. Unfortunately, real world markets dont try to make life easy for financial econometricians.

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. 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. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.

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Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-vis derivative products based on individual securities is another reason for their growing use. As in the present scenario, Derivative Trading is fast gaining momentum, I have chosen this topic.

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CHAPTER 3

RESEARCH DESIGN

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The objectives of the study are as follows:


To have an overview of the Indian Derivative Market. To assess risk management tools and its strategies. To evaluate products of derivatives i.e. Forwards, Futures, Swaps and Options. To critically analyse its participants i.e. Hedgers, Speculators and Arbitrageurs. To evaluate the functions of derivatives. To analyse the trends of working and the future trends of Equity Derivatives. To propose conclusion and recommendation based upon the findings.

LIMITATIONS OF STUDY
1. LIMITED TIME: The time available to conduct the study was only 2 months. It being a wide topic had a limited time. 2. LIMITED RESOURCES: Limited resources are available to collect the information about the commodity trading. 3. VOLATALITY: Share market is so much volatile and it is difficult to forecast any thing about it whether you trade through online or offline 4. ASPECTS COVERAGE: Some of the aspects may not be covered in my study.

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RESARCH METHODOLOGY Method of data collection:Secondary sources:It is the data which has already been collected by some one or an organization for some other purpose or research study .The data for study has been collected from various sources: Books Journals Magazines Internet sources

Statistical Tools Used: Simple tools like bar graphs, tabulation, line diagrams have been used.

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CHAPTER 4

ANALISYS AND INTERPRETATION

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Derivatives are key parts of the financial system. They are financial instruments which are derived from underlying items of values and it does play a vital role in the equity markets in many forms such as Forwards, Futures, Swaps and Options. Derivatives do revolve around these above-mentioned variants/products with the help of its participants which are Hedgers, Speculators and Arbitrageurs.

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TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN INDIA WITH RESPECT TO THE VARIOUS EXCHANGES IN INDIA:-

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The Present Status: Presently futures trading is permitted in all the commodities. Trading is taking place in about 78 commodities through 25 Exchanges/Associations as given in the table below:TABLE 4 Registered commodity exchanges in India No. 1. Exchange COMMODITY (both domestic and

India Pepper & Spice Trade Association, Pepper Kochi (IPSTA)

international contracts) Chambers Ltd., Gur, Mustard seed

2.

Vijai

Beopar

Muzaffarnagar 3. Rajdhani Oils & Oilseeds Exchange Ltd., Gur, Mustard seed its oil & Delhi 4. oilcake

Bhatinda Om & Oil Exchange Ltd., Gur Bhatinda

5. 6.

The Chamber of Commerce, Hapur

Gur, Potatoes and Mustard seed

The Meerut Agro Commodities Exchange Gur Ltd., Meerut

7.

The Bombay Commodity Exchange Ltd., Oilseed Complex, Castor oil Mumbai international contracts

8.

Rajkot Seeds, Oil & Bullion Merchants Castor seed, Groundnut, its oil Association, Rajkot & cake, cottonseed, its oil & cake, cotton (kapas) and RBD palmolein.

9.

The Ahmedabad Commodity Exchange, Castorseed, cottonseed, its oil Ahmedabad and oilcake

10.

The East India Jute & Hessian Exchange Hessian & Sacking Ltd., Calcutta

11.

The East India Cotton Association Ltd., Cotton Mumbai

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Table-5: Fact file of July-September 2008-09 with respect to the previous quarter APRIL-JUNE 2008-09 No. of Turnover PRODUCT Contracts(La (Rs. 000) kh) VOLUME & TURNOVER Index Future 415.7 935.6 Index Option Single Stock Future Stock Option Total Market Share ( %) Index Future 240.1 514.5 25.5 1,195.8 1,077.5 571.3 1,093.1 58.3 2,658.4 35.20 21.49 JULY-SEPTEMBER2008-09 No. of Turnover Contracts(Lakh) (Rs. 000)

542.6 521.2 599.0 35.9 1,698.7 31.94 30.68 35.26 2.11

1,077.5 1,130.9 1,039.3 69.1 3,317.0 32.48 34.09 31.33 2.08 4.19

Market Concentration

Index Option 1,130.9 Single Stock 41.12 1,039.3 Future Stock Option 2.19 69.1 Turnover in F&O as multiple of turnover in cash 3.26 segment - Reliance Five most active - Reliance Petro. Ltd. scrips in the - Tata Steel F&O Segment - Reliance Capital Ltd active scrips in - Infosys Tech. Ltd Depth the F&O Segment Contribution of the above f i ve to total derivatives 23.72 turnover (%) Client (excluding FII trades) Proprietary n 27.88

Market Depth

- Reliance - Reliance Capital Ltd - Reliance Petro. Ltd - State Bank of India - ICICI Bank Ltd

25.12 59.77 31.07 60.17

of

three months

(avg.

12.35 8.76 FII Table-6: Data for Shorter Dated and Longer Dated derivative contracts

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Time

Period Trades in Shorter Dated Trades in Longer derivative contracts (up t o 3 derivative contracts Dated more months) Turnover (Rs. 000 cr.)

(Quarter)

Months) No contracts (lakh)

of

Turnover (Rs. 000 cr.)

than No contracts (lakh)

3 of (more

July-September 2008-09 Apr-Jun 09 20081,694.64 3,307.11 3.99 9.87

1,194.97

2,655.88

4.83

12.5

Table-7: Data for Mini Nifty derivative contracts

Time (Quarter)

Period No of contract (lakh)

Turnover (Rs. 000 cr.)

July-September 2008-09 Apr-Jun 09 200843.8 36.9

29.4

27.7

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Table-8: Minimum, Maximum and Average Daily Volatility of the F&O segment at

NSE for S&P CNX Nifty since April 2008 Average volatility Month April-08 May-08 June-08 July-08 August-08 September-08 (%) 2.47 1.71 1.80 2.85 2.27 2.28 2.98 1.99 2.28 3.08 2.61 2.51 2.05 1.56 1.61 2.38 2.10 2.09 Maximum Volatility (%) Minimum Volatility (%)

Table-9: SGX volume as a percentage of NSE volume for Nifty Future in terms of no. of contracts for the period April September, 2008-09 NSE Month (Nifty volume) JulySeptember 2008-09 Apr-Jun 200809 37,764,776 3,241,034 8.58 47,977,775 4,104,418 8.55 Volume SGX Future (Nifty volume) Volume SGX volume as Future % of NSE Volume

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Table-10: Standing of India in World Derivatives Market (in terms of volume)

Products Stock Future Index Future Stock Option Index Option

July 2008 1 2 9 4

August 2008 1 2 15 4

September 2008 2 2 16 4

Source: www.world-exchanges.org (as on November 10, 2008) Salient points for the 2nd quarter 2008-09 The volume (no. of contracts) and open interest in the derivatives market has increased even when the underlying market is witnessing a downward trend. This indicates that there are sufficient long position holders who anticipate value proposition in a falling market. Falling or rising markets on the back of low volumes may be a cause of concern from the point of market integrity. However, as observed from the data, under the present scenario the fall in the market has been accompanied by high volumes.

In Index Option, there is a sharp increase in turnover (97.95%) and volume (117.08%) during July-September 2008-09 over April-June 2008-09. Possible reasons for increase in options trading activity can be attributed to increase in volatility. Market observers believe that conditions across markets and asset classes have become more volatile and uncertain in the recent past. Generally in such conditions, many people believe that options act as "insurance" against adverse price movements while offering the flexibility to benefit from possible favourable price movements at the same time. Another reason which can be attributed to the increase in activity is the new directive as per the Budget 2008-09 which states that STT would now be levied on
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the Option premium instead of the strike price. In Index Future, both turnover (15.17%) and volume (30.53%) have increased during July-September 2008-09 as compared to April-June 2008-09. There is a decrease in turnover (4.92%) in Single Stock Futures during JulySeptember 2008-09 as compared to April-June 2008-09. Except Index Option, the market share of all other products has decreased (both in terms of volume and turnover) in second quarter of 2008-09 as compared to the first quarter of 2008-09. There is a decrease in turnover (21.04%) and volume (17.39%) in Longer Dated derivative contracts in second quarter of 2008-09 as compared to the first quarter of 2008-09. Longer dated derivatives were launched in March 2008, but the volumes have not picked up consequently. For shorter dated derivative contracts, turnover increased by 24.52% whereas volume increased by 4.81% in second quarter of 2008-09 as compared to the first quarter of 2008-09. During 2008-09, Mini Nifty volumes increased by 49.15% and turnover increased by 33.43% during July-September 2008-09 over April-June 2008-09.

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8. Business Growth in Derivatives segment (NSE)


TABLE 11A Index futures Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 FIGURE 11A Number of contracts per year No. of contracts 4116649 156598579 81487424 58537886 21635449 17191668 2126763 1025588

160000000 140000000
2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

120000000
100000000 80000000 60000000 40000000 20000000 0 year

INTERPRETATION: From the data and the bar diagram above, there is high business growth in the derivative segment in India. In the year 2001-02, the number of contracts in Index Future were 1025588 where as a significant increase of 4116679 is observed in the year 2008-09.

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Table 11B No of turnovers Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 Turnover (Rs. Cr.) 925679.96 3820667.27 2539574 1513755 772147 554446 43952 21483

FIGURE 11B Turnover in Rs. Crores

4000000 3500000 3000000 2500000 2000000 1500000 1000000 500000 0 year


2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

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INTERPRETATION: From the data and above bar chart, there is high turn over in the derivative segment in India. In the year 2001-02 the turnover of index future was 21483 where as a huge increase of 92567996 in the year 2008-09 are observed. TABLE 12A STOCK FUTURES Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 51449737 203587952 104955401 80905493 47043066 32368842 10676843 1957856 -

FIGURE 12A Number of contracts per year in stock future

250000000

200000000
150000000 100000000 50000000 0 year

2008-09 2007-08 2006-07

2005-06
2004-05 2003-04 2002-03 2001-02

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INTERPRETATION: From the data and bar diagram above there were no stock futures available but in the year 200102, it predominently increased to 1957856. Then there was a huge increase of 20, 35, and 87,952 in the year 2007-08 but there was a steady decline to 51449737 in the year 2008-09.

TABLE 12B NO OF TURNOVERS Year Turnover (Rs. Crores) 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 1093048.26 7548563.23 3830967 2791697 1484056 1305939 286533 51515 -

FIGURE 12B Turnover in Rs. Crores 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 year

2008-09 2007-08 2006-07 2005-06 2004-05

2003-04
2002-03 2001-02 2000-01

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INTERPRETATION: From the data and bar chart above, there were no stock futures available in the year 2000-01. There was a steady increase of stock future 51515 in the year 2001-02. but in the year there was a huge increae of 7548563.23 in the year 2007-08 with a considerable decline of 1093048.26 in the year 2008-09.

TABLE 13A INDEX OPTIONS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 24008627 55366038 25157438 12935116 3293558 1732414 442241 175900 -

FIGURE 13A Number of contracts per year

60000000 50000000 40000000 30000000 20000000 10000000 0 year


2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

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Interpretation: From the data and bar chart above, the no of contracts of index option was nil in the year 20002001. But there was a predominant increase of 1,75,900 in the year 2001-2002. In the year 20072008 there was a huge increase in the index option contracts to 55366038 and a decline of 24008627 in the year 2008-2009.

TABLE 13B Turnover per year in Rs. Crores

Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

Turnover (Rs. Crores) 71340.02 1362110.88 791906 338469 121943 52816 9246 3765 -

FIGURE 13B Turnover per year in Rs. Crores


1400000 1200000 1000000 800000 600000 400000 200000 0 year
2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

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Interpretation: From the data and bar chart above, there was no turnover in the year 2000-2001 for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in the year 2007-2008 there was a huge increase of 1362110.088 and a sudden decline to 71340.02 observed in 2008-2009.

TABLE 14A STOCK OPTIONS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 2546175 9460631 5283310 5240776 5045112 5583071 3523062 1037529 -

FIGURE 14A Number of contracts traded per year in stock option 10000000 9000000 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 year

2008-09 2007-08

2006-07
2005-06

2004-05
2003-04 2002-03 2001-02

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INTERPRETATION: From the data and bar chart above the no of contracts of stock option in the year 2000-2001 was nil. But there was a huge increase of 1037529 observed in the year 2001-2002. It was 9460631 which was the the highest in the year 2007-2008. But a gradual decline of 2546175 in the year 2008-2009.

TABLE 14B National turnover in Rs. Crores per year Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 Notional turnover (Rs. crores) 58335.03 359136.55 193795 180253 168836 217207 100131 25163 -

FIGURE 14B National turnover in Rs. Crores per year 400000 350000 300000 250000 200000 150000 100000
2008-09 2007-08 2006-07

2005-06
2004-05 2003-04 2002-03 2001-02

50000
0 year

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Interpretation: From the chart and the bar diagram above the stock option turnover in the year 2000-2001 was nil. There was a slow increase of 25163 in the year 2001-2002. But a phenomenal increase of 359136.55 in the year 2007-2008, and a decline of 58355.03 in the year 2008-2009.

TABLE 15A OVERALL TRADING Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 119171008 425013200 216883573 157619271 77017185 56886776 16768909 4196873 90580 Turnover (Rs. cr.) 2648403.30 13090477.75 7356242 4824174 2546982 2130610 439862 101926 2365

FIGURE 15A Average daily turnovers in Rs. Crores

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60000
2000-2001

50000 40000 30000 20000 10000 0 year

2001-2002 2002-2003 2003-2004

2004-2005
2005-2006 2006-2007 2007-2008 2008-2009

Interpretation: From the data and bar chart above, the overall trading contracts in the year 2000-2001 was 90580 and huge increase of 119171008 in the year 2008-2009. From the data and bar chart above the overall trading turnover in the year 2000-2001 was as low as 2365 but a predominant increase of 2648403.30 observed in the year 2008-2009. TABLE 17 AVERAGE DAILY TURNOVERS

Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

Av. daily turnover (Rs. Crores) 45390.21 52153.30 29543 19220 10167 8388 1752 410 11 Turnover (Strike Price Note: Notional = + *

Premium) Quantity Index

Futures,

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Index Options, Stock Options and Stock Futures were introduced in June 2000, June 2001, July 2001 and November 2001 respectively.

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CHAPTER 5

FINDINGS AND CONCLUSIONS

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FINDINGS & CONCLUSION


From the above analysis it can be concluded that: 1. Derivative market is growing very fast in the Indian Economy. The turnover of Derivative Market is increasing year by year in the Indias largest stock exchange NSE. In the case of index future there is a phenomenal increase in the number of contracts. But whereas the turnover is declined considerably. In the case of stock future there was a slow increase observed in the number of contracts whereas a decline was also observed in its turnover. In the case of index option there was a huge increase observed both in the number of contracts and turnover. 2. After analyzing data it is clear that the main factors that are driving the growth of Derivative Market are Market improvement in communication facilities as well as long term saving & investment is also possible through entering into Derivative Contract. So these factors encourage the Derivative Market in India. 3. It encourages entrepreneurship in India. It encourages the investor to take more risk & earn more return. So in this way it helps the Indian Economy by developing entrepreneurship. Derivative Market is more regulated & standardized so in this way it provides a more controlled environment. In nutshell, we can say that the rule of High risk & High return apply in Derivatives. If we are able to take more risk then we can earn more profit under Derivatives. Commodity derivatives have a crucial role to play in the price risk management process for the commodities in which it deals. And it can be extremely beneficial in agriculture-dominated economy, like India, as the commodity market also involves agricultural produce. Derivatives like forwards, futures, options, swaps etc are extensively used in the country. However, the commodity derivatives have been utilized in a very limited scale. Only forwards and futures trading are permitted in certain commodity items. RELIANCE is the most active future contracts on individual securities traded with 90090 contracts and RNRL is the next most active futures contracts with 63522 contracts being traded.

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RECOMMENDATIONS & SUGGESTIONS


RBI should play a greater role in supporting derivatives.

Derivatives market should be developed in order to keep it at par with other derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate individual investors.

After study it is clear that Derivative influence our Indian Economy up to much extent. So, SEBI should take necessary steps for improvement in Derivative Market so that more investors can invest in Derivative market. There is a need of more innovation in Derivative Market because in today scenario even educated people also fear for investing in Derivative Market Because of high risk involved in Derivatives.

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CHAPTER 6

BIBLIOGRAPHY

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Bibliography:
1) 2) 3) 4) 5) Billio, M. (2010). Crises and Hedge Fund Risk. Billio, M. (2010). Measuring Systemic Risk in the Finance and Insurance Sectors. Brown, G. W. (2012). Are Hedge Funds Systemically Important. I., B.-D. (2012). Hedge Funds Stock Trading during the Financial Crisis of 2007-2009. T, A. (1999). Realized Volatility and Correlation.

Websites visited:
www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.google.com www.derivativesindia.com

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