DRIVERS OF GROWTH IN DERIVATIVE MARKET

Injecting liquidity

Growth in
Increased volatility
Derivatives
Of Development of risk management tools
Market
Asset prices

Integration of financial markets across the

World

TRADING SYSTEM OF DERIVATIVES

S&P CNX Nifty Futures

A futures contract is a forward contract, which is traded on an Exchange. NSE
commenced trading in index futures on June 12, 2000. The index futures contracts are
based on the popular market benchmark S&P CNX Nifty index.

Selection criteria for indices
NSE defines the characteristics of the futures contract such as the underlying index,
market lot, and the maturity date of the contract. The futures contracts are available for
trading from introduction to the expiry date.

Contract Specifications
Trading Parameters
Contract Specifications
Security descriptor
The security descriptor for the S&P CNX Nifty futures contracts is

Market type : N
Instrument Type : FUTIDX
Underlying : NIFTY
Expiry date : Date of contract expiry

Instrument type represents the instrument i.e. Futures on Index.

Underlying symbol denotes the underlying index which is S&P CNX Nifty
Expiry date identifies the date of expiry of the contract
Underlying Instrument
The underlying index is S&P CNX NIFTY.

Trading cycle

S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle -
the near month (one), the next month (two) and the far month (three). A new contract is
introduced on the trading day following the expiry of the near month contract. The new
contract will be introduced for three month duration. This way, at any point in time,
there will be 3 contracts available for trading in the market i.e., one near month, one
mid month and one far month Duration respectively.

Expiry day
 S&P CNX Nifty futures contracts expire on the last Thursday of the expiry
month. If the last Thursday is a trading holiday, the contracts expire on the
previous trading day.

Trading Parameters

Contract size:

The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at
the time of introduction. The permitted lot size for futures contracts & options contracts
shall be the same for a given underlying or such lot size as may be stipulated by the
Exchange from time to time.

Price steps:
 The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.

Base Prices:

Base price of S&P CNX Nifty futures contracts on the first day of trading would
be theoretical futures price. The base price of the contracts on subsequent trading days
would be the daily settlement price of the futures contracts.

Price bands:

There are no day minimum/maximum price ranges applicable for S&P CNX
Nifty futures contracts. However, in order to prevent erroneous order entry by trading
members, operating ranges are kept at +/- 10 %. In respect of orders which have come
under price freeze, members would be required to confirm to the Exchange that there is
no inadvertent error in the order entry and that the order is genuine. On such
confirmation the Exchange may approve such order.

Quantity freeze

Order which may come to the exchange as a quantity freeze shall be based on
the notional value of the contract of around Rs. 5 crores. In respect of orders which have
come under quantity freeze, members would be required to confirm to the Exchange
that there is no inadvertent error in the order entry and that the order is genuine. On
such confirmation, the Exchange may approve such order. However, in exceptional
cases, the Exchange may, at its discretion, not allow the orders that have come under
quantity freeze for execution for any reason whatsoever including non-availability of
turnover /exposure limits.

Order type/Order book/Order attribute

· Regular lot order
· Stop loss order
· Immediate or cancel
· Spread order

Trading:

NSE introduced for the first time in India, fully automated screen based trading.
It uses a modern, fully computerized trading system designed to offer investors across
the length and breadth of the country a safe and easy way to invest.

The NSE trading system called 'National Exchange for Automated Trading'
(NEAT) is a fully automated screen based trading system, which adopts the principle of
an order driven market.

Market Timings

Trading on the derivatives segment takes place on all days of the week (except
Saturdays and Sundays and holidays declared by the Exchange in advance). The market
timings of the derivatives segment are:

Normal Market / Exercise Market Open time: 09:55 hours

Normal market close: 15:30 hours
Set up cut of time for Position limit/Collateral value: till 15:30 hrs
Trade modification end time / Exercise Market: 16:15 hours

Price Bands
 There are no day minimum/maximum price ranges applicable in the derivatives
segment. However, in order to prevent erroneous order entry, operating ranges
and day minimum/maximum ranges are kept as below:

1.  For S&P CNX Nifty Futures: at 10% of the base price

2.  For S&P CNX Nifty Options: at 99% of the base price
3.  For Futures on Individual Securities: at 20% of the base price
4.  For Options on Individual Securities: at 99% of the base price

In view of this, orders placed at prices which are beyond the operating ranges
would reach the Exchange as a price freeze. In respect of orders which have come under
price freeze, members would be required to confirm to the Exchange that there is no
inadvertent error in the order entry and that the order is genuine. On such confirmation
the Exchange may approve such order.

Trading Locations

Till the advent of NSE, an investor wanting to transact in a security not traded
on the nearest exchange had to route orders through a series of correspondent brokers to
the appropriate exchange. This resulted in a great deal of uncertainty and high
transaction costs. One of the objectives of NSE was to provide a nationwide trading
facility and to enable investors spread all over the country to have equal access to NSE.

NSE has made it possible for an investor to access the same market and order
book, irrespective of location, at the same price and at the same cost. NSE uses
sophisticated telecommunication technology through which members can trade
remotely from their offices located in any part of the country. NSE trading terminals
(F&O segment) are present in various cities and towns all over India
Trading System

The Futures and Options Trading System provides a fully automated trading
environment for screen-based, floor-less trading on a nationwide basis and an online
monitoring and surveillance mechanism. The system supports an order driven market
and provides complete transparency of trading operations.

Orders, as and when they are received, are first time stamped and then
immediately processed for potential match. If a match is not found, then the orders are
stored in different 'books'. Orders are stored in price-time priority in various books in
the following sequence:

Getting started to trade in derivatives

Registration with the broker:

When you decide to trade in the derivatives market, pre-requisite is to choose a

broker and get yourself registered intermediaries only. Do sign the agreement with your
broker and take your identification number (ID). This ID would be keyed in the system
at the time of broker placing the order on your behalf. This ID is broker specific i.e. if
you choose to deal with different brokers, you need to sign the agreement with each one
of them and resultantly, you would have different ID’s.

In derivatives market, broker is required to give a risk disclosure document to

their client when they enter into an agreement with him/her to trade in the derivatives
market. Do insist upon the receipt of risk disclosure document from your broker. Read
this disclosure document carefully to understand the risks involved in the derivatives
trading before committing any position in the market.

Placing order with the broker:

Place the order in writing to your broker and insist upon the trade/order
confirmation slip from him. The trading system shall automatically generate a unique
order identification number at the time of order entry itself. Every trading member shall
be required to specify buy or sell order as either an open order or a close order.

Opening or closing a position:

Buy or sell order is open order when new position are created. These orders
would be close orders when by virtue of execution of these orders existing positions get
closed. For instance, when you place the first order to buy say two, 1 month futures
contract; it would be treated as open buy. But, when with this long position (outstanding
purchase position) in two, 1 month contracts, you place order to sell two, 1 month
contract; it would be treated as close sell contracts. Therefore, we may say:

Settlement Mechanism:

Futures Contracts on Index or Individual Securities

Daily Mark-to-Market Settlement

The positions in the futures contracts for each member is marked-to-market to

the daily settlement price of the futures contracts at the end of each trade day.
The profits/ losses are computed as the difference between the trade price or the
previous day’s settlement price, as the case may be, and the current day’s settlement
price. The CMs who have suffered a loss are required to pay the mark-to-market loss
amount to NSCCL which is in turning passed on to the members who have made a
profit. This is known as daily Mark-to-market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not traded
during the last half an hour on a day, is currently the price computed as per the formula
detailed below:

F = S * e rt
where:
F = theoretical futures price
S = value of the underlying index
r = rate of interest (MIBOR)
t = time to expiration
Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.
After daily settlement, all the open positions are reset to the daily settlement price.
CMs are responsible to collect and settle the daily mark to market
profits / losses incurred by the TMs and their clients clearing and settling through them.
The pay-in and pay-out of the mark-to-market settlement is on T+1 days (T = Trade
day). The mark to market losses or profits are directly debited or credited to the CMs
clearing bank account.

Final Settlement:
On the expiry of the futures contracts, NSCCL marks all positions of a
CM to the final settlement price and the resulting profit / loss is settled in cash.
The final settlement of the futures contracts is similar to the daily settlement
process except for the method of computation of final settlement price. The final
settlement profit / loss are computed as the difference between trade price and the
previous day’s settlement price,
as the case may be, and the financial settlement price of the relevant futures contract.
Final settlement loss/ profit amount is debited/ credited to the
relevant CMs clearing bank account on T+1 day (T=expiry day).

Open positions in futures contracts cease to exist after their expiration day.
2.1 STATEMENT OF THE PROBLEM

In today’s economic scenario we are observing rapid changes in capital market,

as volume of business is increasing the risk factor and uncertainty is getting more
importance. The modern financial instruments are used by the investors to make hedge
against risk of their financial loss. Derivatives are the modern financial tool used to
minimize the risk & maximize the return.

Indian economy is fast developing. In Indian Stock Market, all types of

investment avenues are trading but some of the investment avenues like derivatives are
not performing well in the stock market. In addition, the investors are not giving much
attention towards derivatives. It is essential to determine the reasons for non-popularity
of derivatives when compared to equity stocks in Indian stock market and the reasons
for not preferring derivatives as an Investment Avenue by the investors.
2.2 REVIEW OF LITERATURE

A number of studies on the effects of future and option have been conducted
across the world. The introduction of equity/index futures markets enables traders to
transact large volume at much lower transaction costs relative to the cash market. The
consequence of this increase in order flow to futures markets is unresolved on both a
theoretical and an empirical front.
Stein (1987) develops a model in which prices are determined by the interaction
between hedgers and informed speculation. In this model, opening a future market has
two effects;

1) The future market improves risk sharing and therefore reduces price volatility, and
2) if the speculators observe a noisy but informative signal, the hedgers react to the
noise in the speculative trades, producing an increase in volatility in contrast, models
developed by Danthine (1978) argue that the future market improve market depth and
reduce volatility because the cost to informed traders of responding to mis-pricing is
reduced. Froot and Perlod (1991)extend Kyle’s(1985)models to show that market depth
is increased by more rapid discrimination of market wide information and the presence
of market makers in the futures market in addition to the cash market. Ross (1989)
assumes that there exists an economy that is devoid of arbitrage and proceeds to provide
a condition under which no arbitrage situation will be sustained.
Edwardas (1988) and Darrat and Rahman (1995) reported that the introduction
of futures has not changed the long term volatility of spot market. Hodgson and
Nicholas (1991) reported similar findings for derivatives.
Schwartz and Francis (1991) reported that the future and spot market are
integrated and arbitrage opportunities trend to be eliminated within one to seven days.
Chan (1992) observed that the future market processes the information faster than the
spot market he also reported that in case of bad news effect the spot market processes
the information faster than the future market. Kamara et al (1992) found that while the
daily returns volatility increased in the post-futures introduction period, the monthly
returns volatility remained with the introduction of the futures. However james (1993)
found that introduction of derivatives reduced the long-term volatility of the spot
market. Jagadeesh and Subramanyam (1993) and Hong and Subramanyam (1994) have
a found evidence to show that the bid ask spread of stock increased in the post futures
period. Hung-gay et al (1994) have found that futures prices do not have a long term
memory and the price changes in the future market do not follow the random walk.
Chatrath et al (1995) found that the stock index options at the stabilization effect on the
underlying securities in the US market. Antoniou and holmes (1995) found that the
derivatives changed the volatility. Butterworth (1998) reported that while features have
less impact on the volatility of the spot market, it had altered the structure of the spot
market volatility.
Teppo et al (1995) and chris et al (2001) reported that futures market provides
predictive information to the cash market.
About Indian market, Shenbangaraman (2003) opines the introduction of futures
and options has had no effect on spot market volatility, at least none that is statistically
significant. The increase in volatility in the Indian market might have been a
consequence of increased volatility in the US markets. Thenmozhi (2002) investigated
the empirical relationship between the NSE 50 futures and the NSE 50 index to
determine if there is any change in the volatility of the underlying index due to the
introduction of NSE 50 index futures and whether movements in the futures price
provide predictive information regarding subsequent movements in the index. The
finding that the volatility of the spot market has decreased with the introduction of
futures trading and the explanatory power of index futures on spot market volatility
support the introduction of derivatives trading and validates the financial sector reforms
in the country.

Raju and Karande (2003) studied price discovery and volatility in the context of
introduction of Nifty futures at NSE. Co-integration and GARCH techniques were used
to study price discovery and volatility respectively. The major findings are that the
futures market responds to deviations from equilibrium; price discovery occurs in both
the futures and spot market. The results also show that volatility in the spot market has
come down after the introduction of stock index futures. Nath (2003) studied the
behavior of stock market volatility after derivatives and arrived at the conclusion that
volatility of the market as measured by benchmark indices like S&P CNX Nifty
and S&P CNX Nifty junior has fallen in the post derivatives period. The finding is in
line with the earlier findings of Thenmozhi (2002), Shenbagaraman (2003), and Raju
and Karande (2003).
The empirical works suggest that the coming of futures and options have further
strengthened the capital market, proving liquidity and better price discovery. Also there
is no proof for destabilizing the market after the introduction of derivatives.
Recently many projects have been done in the area of Derivatives. But many of
them were either exploratory studies on derivatives or emerging trends on derivatives.
No projects on ‘investor’s awareness towards derivatives in Bangalore, with respect to
futures and options’ were found. The thesis, books, magazines and journals the
researcher have referred and all the other informative sources have been mentioned in
the bibliography.