SACHIN YADAV __________________________________________ TYBFM(2010-2011)


It is indeed a matter of great pleasure and pride to be able to present this project on ³DERIVATIVES IN INDIA´ Throughout the writing of this project the influence of my Prof. Vikram Trivedi has been a guiding light. I have been greatly benefited by her guidance, profound knowledge and her continued interest in my work. I shall ever remain indebted & grateful to her, for her deep sense of personal attachment & the ever increasing encouragement which she has given to me. This is special pleasure in acknowledging her under whom I have initiated my work. Her intense accuracy in respect of the subject had provided the impetus for the commencement of the study. My professors and friends have inevitable played a crucial role in helping me while preparing the project. I do not have words to thanks them enough. I can only extend my sense of deep hearted affection to all of them. I am highly obliged to acknowledge principal ³Fr. Solomon Rodrigues´ for giving

me an opportunity to conduct a detail study & analysis of my desirable topic relevant to my full of interest.

SACHIN YADAV __________________________________________ TYBFM(2010-2011)


I Mr. SACHIN YADAV of Third Year B. Com. [ Financial Markets] ST. GONSALO GARCIA COLLEGE hereby declare that I have completed this project on ³DERIVATIVES IN INDIA´ in the Academic Year 2010-2011. The information submitted is true and correct to the best of my knowledge.

Signature of Student

SACHIN YADAV __________________________________________ TYBFM(2010-2011)



I, hereby certify that Mr. SACHIN YADAV student of St. Gonsalo Garcia college of Arts & commerce, Vasai (w), Third Year Bcom [Financial Markets] Vth Semester, has completed her project on ³DERIVATIVES IN INDIA´, During the Academic Year 2010-2011. The information submitted is true and correct to the best of our knowledge.

Signature of Principal [Fr. (Dr.) Solomon Rodrigues]

Signature of coordinator [ Prof. Jose George]

Signature of Project Guide [ Prof. Vikram Trevedi]

Signature of External Examiner

Date: Place

SACHIN YADAV __________________________________________ TYBFM(2010-2011)

1 2.5 DERIVATIVES IN INDIA INDEX Sr. Particulars EXECUTIVE SUMMARY Objectives Of The Study 1 1.1 3.3 2.4 3 3.2 2. no.2 1. 6 7 8-18 9 11 12 15 19-33 20 23 27 32 34-45 35 40 43 46 47 CHAPTER 1 Introduction Definition of Derivatives History of Derivatives Derivatives in India CHAPTER 2 Development of Derivatives Market in India Factors Contributing to the growth of Derivatives Types of Derivatives Futures VS.4 2 2.3 Page no.1 1.2 3. Forward Markets CHAPTER 3 Participants in Derivatives market Role of Derivatives How Banks use Derivatives Conclusion Bibliography SACHIN YADAV __________________________________________ TYBFM(2010-2011) .3 1.

6 DERIVATIVES IN INDIA EXECUTIVE SUMMARY In the following project. It will give you knowledge about the requirement of market sector of India. It also provides you with various departments which help DERIVATIVES IN INDIA to provide better service. Risk Management Department. departments such as Research department. Each concept in this project has been briefly explained and in an understandable and easier way and has been put in simplistic way. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . This project explains the why DERIVATIVES IN INDIA was formed and the development that has taken place in market due to DERIVATIVES MARKET its role and objectives. This project also highlights various important concepts of finance sector of India. Accounts Department. you are going to have chance to review and understand virtually every aspect of DERIVATIVES IN INDIA and its important role and functions.

7 DERIVATIVES IN INDIA OBJECTIVES OF THE STUDY 1. To study recent trends in Derivatives Market SACHIN YADAV __________________________________________ TYBFM(2010-2011) . To know what is Derivatives Trading In India. To study Derivatives Market as Financial Intermediary. 3. 2.


the value of a gold futures contract derives from the value of the underlying asset i. however is risk averse. Risk cannot be avoided or ignored. known as the underlying asset. the world is a riskier place and exposure to risk is growing. theft and so on. The underlying is the identification tag for a derivative contract. gold. The risk averse SACHIN YADAV __________________________________________ TYBFM(2010-2011) .1 INTRODUCTION : Derivatives are one of the most complex instruments. In this era of globalisation. an interest rate. When the price of the underlying changes. floods. Derivatives on the other hand. the value of the derivative also changes. from coffee to cotton and live cattle to debt instruments. For example.. which could be a share. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. a stock market index.e. The prices in the derivatives market are driven by the spot or cash market price of the underlying asset.volatility in interest rates. such as fire.9 DERIVATIVES IN INDIA CHAPTER 1 1. Insurance protects against specific risks. a commodity. take care of market risks . which can be extended to every product existing. It indicates that it has no independent value. Without an underlying asset. commodity prices. A derivative is a contract whose value is derived from the value of another asset. derivatives do not have any meaning. or a currency. Derivatives are very similar to insurance. The word derivative comes from the word µto derive¶. currency rates. Man. They offer a range of mechanisms to improve redistribution of risk. which is gold in this example. and share prices.

Similarly. In financial derivatives. Trading in derivatives differ from that in equities as most of the derivatives are market to the market. The basic difference between commodity and financial derivatives lies in the nature of the underlying instrument. North America. the underlying asset is a commodity. natural gas. orange. The use of derivatives instruments is the part of the growing trend among financial intermediaries like banks to substitute off-balance sheet activity for traditional lines of business. the underlying includes treasuries. Derivatives contracts are used to counter the price risks involved in assets and liabilities. oats. pepper. Presently. and East Asia. many act as intermediaries dealing in derivative transactions. In commodity derivatives. Derivatives do not eliminate risks. quantifying and managing financial risk.10 DERIVATIVES IN INDIA characteristic of human beings has brought about growth in derivatives. gold. today they account for 75 percent of the financial market activity in Europe. silver. and so on. The exposure to derivatives by banks have implications not only from the point of capital adequacy. Soya beans. stock index. bonds. several centuries ago. business rules and settlement process. Derivative products. They divert risks from investors who are risk averse to those who are risk neutral. Derivatives help the risk averse individuals by offering a mechanism for hedging risks. corn. emerged as hedging devices against fluctuations in commodity prices. rice. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. but also from the point of view of establishing trading norms. Derivatives are responsible for not only increasing the range of financial products available but also fostering more precise ways of understanding. most major institutional borrowers and investors use derivatives. and Euro dollar deposits. Financial derivatives came into the limelight in the post-1970 period. it may be wheat. stocks. cotton. crude oil. foreign exchange. Commodity futures and options have had a lively existence for several centuries. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . turmeric.

or index of prices.2 DEFINITION OF DERIVATIVES : Derivative is a product whose value is derived from the value of one or more basic variables. risk instrument or contract for differences or any other form of security. in a contractual manner. whether secured or unsecured.11 DERIVATIVES IN INDIA 1. commodity or any other asset. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . forex. 1956 {SC(R)A}. Derivatives are securities under the Securities Contract (Regulation) Act and hence the trading of derivatives is governed by the regulatory framework under the Securities Contract (Regulation) Act. share. of underlying securities. According to Securities Contracts (Regulation) Act.  A contract which derives its value from the prices. loan. The underlying asset can be equity. or reference rate). index. derivatives is  A security derived from a debt instrument. called bases (underlying asset.

These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. The first formal commodities exchange. 1975. though it did exist before in 1874 under the names of µChicago Produce Exchange¶ (CPE) and µChicago Egg and Butter Board¶ (CEBB). Interest rate futures contracts were traded for the first time on the CBOT on October 20. was formed in 1848 in the US to deal with the problem of µcredit risk¶ and to provide centralised location to negotiate forward contracts. existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. a spin-off of CBOT. the Canadian Dollar. In 1865. a division of CME. was formed in 1919. Stock index futures and options emerged in 1982. Trading in futures began on the CBOT in the 1860¶s. The first type of futures contract was called µto arrive at¶. the Swiss Franc. The first foreign currency futures were traded on May 16. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. the Chicago Board of Trade (CBOT). From µforward¶ trading in commodities emerged the commodity µfutures¶. 1982. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . The first organized commodity exchange came into existence in the early 1700¶s in Japan. Currency futures were followed soon by interest rate futures. the Australian Dollar. the German Mark. forward contracts have existed for centuries for hedging price risk. Thus. stating what is to be delivered for a fixed price at a specified place on a specified date. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24. known as the futures contracts.3 HISTORY OF DERIVATIVES : The history of derivatives is quite colourful and surprisingly a lot longer than most people think. 1972. and the Euro dollar. The first financial futures to emerge were the currency in 1972 in the US. CBOT listed the first µexchange traded¶ derivatives contract. on International Monetary Market (IMM). Forward delivery contracts. The Chicago Mercantile Exchange (CME). The currency futures traded on the IMM are the British Pound. the Japanese Yen.12 DERIVATIVES IN INDIA 1.

and Scholes invented the famous Black-Scholes Option Formula. Tulips. On April 26. The market for futures and options grew at a rapid pace in the eighties and nineties. Agricultural commodities options were traded in the nineteenth century in England and the US. 1984. the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. Their history also dates back to ancient Greece and Rome. The collapse of the Bretton Woods regime of fixed parties and the introduction of SACHIN YADAV __________________________________________ TYBFM(2010-2011) . A group of firms known as Put and Call brokers and Dealer¶s Association was set up in early 1900¶s to provide a mechanism for bringing buyers and sellers together.13 DERIVATIVES IN INDIA The first of the several networks. tulip bulb prices shot up. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. were a symbol of affluence. The first call and put options were invented by an American financier. 1973. Russell Sage. was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7. There was so much speculation that people even mortgaged their homes and businesses. in 1872. Options are as old as futures. Dutch growers and dealers traded in tulip bulb options. It was in 1973 again that black. 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. These options were traded over the counter. the brightly coloured flowers. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. which offered a trading link between two exchanges. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Merton. With the options markets becoming increasingly popular. the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. owing to a high demand.

The most traded stock indices include S&P 500. the Nasdaq 100. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001). SACHIN YADAV __________________________________________ TYBFM(2010-2011) .The CBOE is the largest exchange for trading stock options.14 DERIVATIVES IN INDIA 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. and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. the Dow Jones Industrial Average. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The N225 is also traded on the Chicago Mercantile Exchange.

have combined to provide an environment where the equity spot market is now India¶s most sophisticated financial market. Some of the recent developments initiated by the regulatory authorities are very important in this respect. coupled with the widespread knowledge and orientation towards equity investment and speculation. Mumbai Stock Exchange has started futures trading in cottonseed and cotton under the BOOE and under the East India Cotton Association. Futures trading have been permitted in certain commodity exchanges.S. Necessary infrastructure has been created by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures and the commencement of operations in selected scripts. A committee headed by S. A. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of London Inter Bank Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest Rates and Forex.4 DERIVATIVES IN INDIA : India has started the innovations in financial markets very late. RBI has initiated measures for freeing the interest rate structure.2%.Tarapore was constituted to go into the merits of full convertibility on capital accounts.15 DERIVATIVES IN INDIA 1.5 million at the NIFTY index is around 0. Badla transactions have been banned in all 23 stock exchanges from July 2001. Liberalised exchange rate management system has been introduced in the year 1992 for regulating the flow of foreign exchange. One aspect of the sophistication of the equity market is seen in the levels of market liquidity that are now visible.} EQUITY DERIVATIVES IN INDIA ± In the decade of 1990¶s revolutionary changes took place in the institutional infrastructure in India¶s equity market. which will be observed if the SACHIN YADAV __________________________________________ TYBFM(2010-2011) . This state of liquidity on the equity spot market does well for the market efficiency. The market impact cost of doing program trades of Rs. These new institutional arrangements. NSE has started trading in index options based on the NIFTY and certain Stocks. It has led to wholly new ideas in market design that has come to dominate the market.

hence it seems easy to think that derivatives based on individual securities could be very important. Thus. If market manipulation is used to artificially obtain 10% move in the price of a stock with a 10% weight in the NIFTY.16 DERIVATIVES IN INDIA index futures market when trading commences. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Stock trading is widely prevalent in India. In India the traditional index. BPL and Videocon. Cash settlements. Index fluctuations affect all portfolios. The flows of this index and the importance of the market index in modern finance. the should restricted to the most liquid stocks. A good index is a sound trade of between diversification and liquidity. The index is the counter piece of portfolio analysis in modern financial economies. in so far as the µshort-squeeze¶ is not a problem. index derivatives are inherently less vulnerable to market manipulation. The 50 stocks in the NIFTY are assuredly the most liquid stocks in India. trades on the largest stock exchange (NSE) are netted from Wednesday morning till Tuesday evening. Membership in the NSE-50 index appeared to be a fair test of liquidity.the BSE ± sensitive index was created by a committee of stockbrokers in 1986. which is universally used with index derivatives. The market capitalisation of the NSE-50 index is Rs.6 trillion. This is six times larger than the market capitalisation of the largest stock and 500 times larger than stocks such as Sterlite. It predates a modern understanding of issues in index construction and recognition of the pivotal role of the market index in modern finance.2. which have made numerous manipulative episodes possible. also helps in terms of reducing the vulnerability to market manipulation. India¶s equity spot market is dominated by a new practice called µFutures ± Style settlement¶ or account period settlement. and only the net open position as of Tuesday evening is settled. Many mutual funds have now adopted the NIFTY as the benchmark for their performance evaluation efforts. This is particularly important given the weaknesses of Law Enforcement in India. In its present scene. this yields a 1% in the NIFTY. The future style settlement has proved to be an ideal launching pad for the skills that are required for futures trading. motivated the development of the NSE-50 index in late 1995. If the stock derivatives have to come about. The index is much harder to manipulate.

the calculation of initial price requires greater skill and more powerful computers.} COMMODITY DERIVATIVES TRADING IN INDIA ± In India. Barnala and Bhatinda in Punjab and Muzaffarnagar. When portfolios contain options. the futures market for commodities evolved by the setting up of the ³Bombay Cotton Trade Association Ltd. Chandausi. silver and onions. which was established in 1913. safflower seed. Fazilka. The most notable centres for existence of futures market for wheat were the Chamber of Commerce at Hapur. Commodities like groundnut. futures position can always be created once options exist. Jalandhar.17 DERIVATIVES IN INDIA The choice of Futures vs. and oils and oilcakes of all of them. the Govt. Hence. raw jute and jute goods. sesame seed. commonly imagined. castor seed and cotton etc began to be exchanged. cotton. Other markets were located at Amritsar. With the setting up of the µGujarati Vyapari Mandali´ in 1900. B. Raw jute and jute goods began to be traded in Calcutta with the establishment of the ³Calcutta Hessian Exchange Ltd. The Bullion Futures market began in Bombay in 1990. After the economic reforms in 1991 and the trade liberalization. Hathras.´ in 1919.N. Ludhiana. of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. sunflower seed. The Committee recommended that futures trading be introduced in basmati rice.´. for a futures position is identical to an appropriately chosen long call and short put position. cottonseed. Sikenderabad and Barielly in U. Meerut. Kabra. groundnut. rapeseed/mustard seed.P. the futures trading in oilseed began. Saharanpur. in 1875. The skills required for pricing options are greater than those required in pricing futures. Risk management of the futures clearing is more complex when options are in the picture. Moga. castor oil and its oilcake. Individuals or firms can choose to employ positions where their downside and exposure is capped by using options. rice bran oil. The difference between these instruments is smaller than. copra and soybean. Dhuri. linseed. Options is often debated. K. A separate association by the name "Bombay Cotton Exchange Ltd´ was established following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Gaziabad.

Zinc and Energy Commodities like crude oil.000 crore in the first four months of trading. trading volumes in the commodity market have also seen a steady rise . Though there are no institutions or banks in commodity exchanges. Commodities market is estimated to be around Rs 44. In India.00. the market for commodities is bigger than the market for securities. coal. Cotton. Lead.29. Assuming a future trading multiple is about 4 times the physical market.000 Crores in future. Some of the commodities traded in India include Agricultural Commodities like Rice Wheat. trading volumes in the commodity market have already crossed Rs 3. Jute. Soya.18 DERIVATIVES IN INDIA All over the world commodity trade forms the major backbone of the economy. as yet. Coffee. Spices. Aluminium.000 crore in FY05 from Rs 1. Groundnut. Nickel.000 crore in FY04.50.71. in many countries it is much higher at around 10 times. Commodities form around 50% of the Indian GDP. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Precious Metals like Gold & Silver. Tea. In the current fiscal year. Base Metals like Iron Ore.to Rs 5. Rubber.


however. did not take off.20 DERIVATIVES IN INDIA CHAPTER 2 2. SEBI also set up a group in June 1998 under the Chairmanship of Prof. The committee recommended that derivatives should be declared as µsecurities¶ so that regulatory framework applicable to trading of µsecurities¶ could also govern trading of securities. as there was no regulatory framework to govern trading of derivatives. which was submitted in October 1998.Gupta on November 18. The committee submitted its report on March 17. NSE and BSE. methodology for charging initial margins. SEBI set up a 24±member committee under the Chairmanship of Dr. deposit requirement and real±time monitoring requirements. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001.J. 1996 to develop appropriate regulatory framework for derivatives trading in India.1 DEVELOPMENT OF DERIVATIVES MARKET IN INDIA : The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of µsecurities¶ and the regulatory framework was developed for governing derivatives trading. The government also rescinded in March 2000. 1995. SEBI permitted the derivative segments of two stock exchanges. which withdrew the prohibition on options in securities. The report. which prohibited forward trading in securities. The market for derivatives.C. worked out the operational details of margining system.L. the three decade old notification. broker net worth. to recommend measures for risk containment in derivatives market in India. and their SACHIN YADAV __________________________________________ TYBFM(2010-2011) .Varma. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange.R. thus precluding OTC derivatives. 1998 prescribing necessary pre±conditions for introduction of derivatives trading in India.

‡ On relative terms. It constituted 70 per cent of the total turnover during June 2002. volumes in the index options segment continues to remain poor. options are considered more valuable when the volatility of the underlying (in this case. and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. the index) is high.21 DERIVATIVES IN INDIA clearing house/corporation to commence trading and settlement in approved derivatives contracts. SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE±30 (Sense) index. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12. Single stock futures were launched on November 9. 2001. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options. 2001 and the trading in options on individual securities commenced in July 2001. 2001. as the former closely resembles the erstwhile badla system. The trading in index options commenced on June 4. Typically. A related issue is that brokers do not earn high commissions by recommending index options to their clients. The trading in BSE Sensex options commenced on June 4. To begin with. 2001 and trading in options on individual securities commenced on July 2. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. 2000. Futures contracts on individual stocks were launched in November 2001. This was followed by approval for trading in options based on these two indexes and options on individual securities. This may be due to the low volatility of the spot index. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): ‡ Single-stock futures continue to account for a sizable proportion of the F&O segment. byelaws. because low volatility leads to higher waiting time for round-trips.

32 in June. The fact that the option premiums tail intra-day stock prices is evidence to this. The call-put volumes in index options have decreased from 2. the intra-day stock price variations should not have a one-to-one impact on the option premiums. If calls and puts are not looked as just substitutes for spot trading.86 in January 2002 to 1. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. ‡ Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. Trading in equity options on most stocks for even the next month was non-existent. ‡ Farther month futures contracts are still not actively traded.22 DERIVATIVES IN INDIA ‡ Put volumes in the index options and equity options segment have increased since January 2002.

In a market. etc. A. local currency or foreign currencies. These price changes expose individuals.} PRICE VOLATILITY ± A price is what one pays to acquire or use something of value. The concept of price is clear to almost everybody when we discuss commodities. petrol. globalisation of the markets. The changes in demand and supply influencing factors culminate in market adjustments through price changes. Prices are generally determined by market forces. There is a price to be paid for the purchase of food grain. consumers have µdemand¶ and producers or suppliers have µsupply¶.23 DERIVATIVES IN INDIA 2. producing firms and governments to significant risks. The objects having value maybe commodities. The break down of the BRETTON WOODS agreement brought and end to the stabilising role of fixed exchange rates and the gold SACHIN YADAV __________________________________________ TYBFM(2010-2011) .2 FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES : Factors contributing to the explosive growth of derivatives are price volatility. This has three factors : the speed of price changes. Such changes in the price is known as µprice volatility¶. the price one pays for use of a unit of another persons money is called interest rate. metal. the frequency of price changes and the magnitude of price changes. These factors are constantly interacting in the market causing changes in the price over a short period of time. And the price one pays in one¶s own currency for a unit of another currency is called as an exchange rate. technological developments and advances in the financial theories. and the collective interaction of demand and supply in the market determines the price. oil.

24 DERIVATIVES IN INDIA convertibility of the dollars. Nations that were poor suddenly became a major source of supply of goods. equity shares and bonds. These price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity. The Mexican crisis in the south east-Asian currency crisis of 1990¶s have also brought the price volatility factor on the surface. led to cut profit margins In Indian context. Now globalisation has increased the size of markets and as greatly enhanced competition . in many cases. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south east asian countries. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets.it has benefited consumers who cannot obtain better quality goods at a lower cost. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Thus. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. it is evident that globalisation of industrial and financial activities necessitiates SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Suddenly blue chip companies had turned in to red. what happened in other part of the world was mostly irrelevant. It has also exposed the modern business to significant risks and. foreign exchange. managers had to deal with domestic economic concerns . south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies.} GLOBALISATION OF MARKETS ± Earlier. The fear of china devaluing its currency created instability in Indian exports. B. The advent of telecommunication and data processing bought information very quickly to the markets.

} TECHNOLOGICAL ADVANCES ± A significant growth of derivative instruments has been driven by technological break through. Improvement in communications allow for instantaneous world wide conferencing. Option pricing models SACHIN YADAV __________________________________________ TYBFM(2010-2011) . At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless.25 DERIVATIVES IN INDIA use of derivatives to guard against future losses. Data transmission by satellite. network systems and enhanced method of data entry. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. This factor alone has contributed to the growth of derivatives to a significant extent. Initially forward contracts in its traditional form. derivatives and risk management products become that much more important.} ADVANCES IN FINANCIAL THEORIES ± Advances in financial theories gave birth to derivatives. C. Closely related to advances in computer technology are advances in telecommunications. D. To the extent the technological developments increase volatility. was the only hedging tool available. The effect of this risk can easily destroy a business which is otherwise well managed. Advances in this area include the development of high speed processors. Derivatives can help a firm manage the price risk inherent in a market economy. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk.

The above factors in combination of lot many factors led to growth of derivatives instruments. work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. In late 1970¶s. SACHIN YADAV __________________________________________ TYBFM(2010-2011) .26 DERIVATIVES IN INDIA developed by Black and Scholes in 1973 were used to determine prices of call and put options.

The change in the value of a forward contract is roughly proportional to the change in the value of its underlying asset. as well as currencies and interest rates. Options and swaps. amount and date in the future is known as a forward contract.27 DERIVATIVES IN INDIA 2. Futures. financial or SACHIN YADAV __________________________________________ TYBFM(2010-2011) .e. These contracts create credit exposures. Forward contracts are customised with the terms and conditions tailored to fit the particular business. Forward contracts are the important type of forward-based derivatives. There is a separate forward market for multitude of underlyings. the parties are exposed to the risk of default during the life of the contract. Derivatives Forwards Futures Options Swaps 1. including the traditional agricultural or physical commodities. FORWARDS A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price. They are the simplest derivatives. As the value of the contract is conveyed only at the maturity. Forwards.3 TYPES OF DERIVATIVES : There are mainly four types of derivatives i.

Negotiations often take place with respect to contract size. dealing in commodities or other financial instruments for forward delivery or settlement on standardised terms. FUTURES A future contract is an agreement between two parties to buy or sell an asset at a certain time the future at the certain price. so that the identity of the buyer or the seller is a matter of indifference to the opposite party. a strong infrastructure is required. delivery locations. including financial. Conditions which are thought of necessary for the establishment of futures trading are the presence of speculative capital and financial facilities for payment of margins and contract settlement. delivery dates and credit terms. They are traded on organised exchanges in which a clearing house interposes itself between buyer and seller and guarantees all transactions. The futures market facilitates stock holding and shifting of risk. legal and communication systems. Futures contract protect those who use these commodities in their business.28 DERIVATIVES IN INDIA risk management objectives of the counter parties. bonds. In addition. delivery grade. They act as a mechanism for collection and distribution of information and then perform a forward pricing function. OPTIONS - SACHIN YADAV __________________________________________ TYBFM(2010-2011) . A futures market is established specifically to meet purely speculative demands is possible but is not known. Futures trading are to enter into contracts to buy or sell financial instruments. 2. 3. The futures trading can be performed when there is variation in the price of the actual commodity and there exists economic agents with commitments in the actual market. hybrid securities and currencies are the commodities of the investment business. Equities. Futures contracts are the special types of forward contracts in the sense that are standardized exchange-traded contracts. There must be a possibility to specify a standard grade of the commodity and to measure deviations from this grade.

at a specified price on or before a specified date is known as a µPut option¶. although occasionally preference shares. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. CALL OPTION : A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset. There are two types of options i. during a period or on a specific date in exchange for payment of a premium is known as µoption¶. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . at a specified price on or before a specified date is known as a µCall option¶. The price at which the underlying is traded is called the µstrike price¶. 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.29 DERIVATIVES IN INDIA A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price.. b. bonds and warrants become the subject of options.e. Hence. a. no option will be exercised if the future price does not increase. Put and calls are almost always written on equities. called the strike price. CALL OPTION AND PUT OPTION. Underlying asset refers to any asset that is traded.

Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. The two commonly used swaps are: a. 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. cash flows to be exchanged are determined at the spot rate at a time when swap is done. The parties to the swap contract of currency generally hail from two different countries. based on some notional principle amount is called as a µSWAP¶. 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 floating rate payer takes a long position in the forward contract. 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. They can be regarded as portfolios of forward's contracts.30 DERIVATIVES IN INDIA 4. Under a currency swap. In case of swap. 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. b. only the payment flows are exchanged and not the principle amount. c. It SACHIN YADAV __________________________________________ TYBFM(2010-2011) . The fixed rate payer takes a short position in the forward contract whereas. A contract whereby two parties agree to exchange (swap) payments. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies.

the majority of options traded on options exchanges having a maximum maturity of nine months. much popular are as follows : 5. Longer-dated options are called warrants and are generally traded over-the-counter. which are not. LEAPS Normally option contracts are for a period of 1 to 12 months. 8. However. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . 6. the swaptions market has receiver swaptions and payer swaptions. WARRANTS Options generally have lives of up to one year. Equity Index Options are most popular form of baskets. The other kind of derivatives. Thus a swaption is an option on a forward swap. SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Rather than have calls and puts.31 DERIVATIVES IN INDIA also allows the investors to exchange one type of asset for another type of asset with a preferred income stream. A receiver swaption is an option to receive fixed and pay floating. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities. 7. A payer swaption is an option to pay fixed and receive floating. BASKETS - Baskets options are option on portfolio of underlying asset. exchange may introduce option contracts with a maturity period of 2-3 years.

Long and short positions are usually Forward positions are not as easily Settlement occurs on date agreed upon between the parties to each transaction.32 DERIVATIVES IN INDIA 2. market participant is always the same and there is no need to analyse the credit of other market participants. and speculators. although a small margin deposit might be required of non-dealer customers on certain occasions. no money changes hands all participants. Settlements are made daily through the exchange clearing house.4 F utur es M ar ket Forward Market Margin deposits are to be required of Typically. include financial banks. Gains on open positions may be withdrawn and losses are collected daily. futures the opposite party. dealing with one other and other interested parties dealing through one or more dealers. risk for a therefore. The clearing house of the exchange A participant must examine the credit becomes the opposite side to each risk and establish credit limits for each cleared credit transactions. Participants are primarily institutions institutions. individual investors. Contract terms are standardised with all All contract terms are negotiated buyers and sellers negotiating only with privately by the parties. Non-member participants deal through Participants brokers (exchange members deal typically on a who principal-to-principal basis. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . until delivery. represent them on the exchange floor) Participants corporations. respect to price.

however. Settlements are normally made in cash. Trading is mostly unregulated. relation to the value of the contract. round trip (in and out of the No commission is typically charged if market) commission is charged. A commission is customer and is relatively small in charged to born buyer and seller. if transacted through a broker. The delivery price is the forward price. The delivery price is the spot price. Most transactions result in delivery. It is the transaction is made directly with negotiated between broker and another dealer. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . A single. offset or transferred to the other participants. Trading is regulated.33 DERIVATIVES IN INDIA liquidated easily. with only a small percentage of all contracts resulting actual delivery.


stock index. they take the positions in the futures market without having position in the underlying cash market. 2. shares. They consider various factors like demand and supply. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk. market positions. Hedgers are those individuals or firms who manage their risk with the help of derivative products.35 DERIVATIVES IN INDIA CHAPTER 3 3. interest rates or currency. international events.] HEDGERS ± The process of managing the risk or risk management is called as hedging. Hedging does not mean maximising of return.] SPECULATORS ± Speculators do not have any position on which they enter into futures and options Market i. They take risk in turn from high returns.} TRADING PARTICIPANTS : 1. open interests. They only have a particular view about future price of a commodity. economic fundamentals. to make predictions. Speculators are SACHIN YADAV __________________________________________ TYBFM(2010-2011) . etc..1 PARTICIPANTS IN THE DERIVATIVES MARKET : The participants in the derivatives market are as follows: A.e.

interest rates and currency. equity. but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders. brokers perform an important function of bringing buyers and sellers together. may be any commodity or finance. one need not be a speculator.] BROKERS ± For any purchase and sale.} INTERMEDIARY PARTICIPANTS : 4. The objective is simply to make profits without risk. equipped with powerful calculating and data processing tools. As a member in any futures exchanges. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange.36 DERIVATIVES IN INDIA essential in all markets ± commodities. 3. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets.] ARBITRAGEURS ± Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. All persons hedging their transaction exposures or speculating on price SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Arbitrage occupies a prominent position in the futures world. This transaction can be in the pit of the trading hall or on online computer terminal. B. arbitrageur or hedger. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary. They help in providing the market the much desired volume and liquidity. Arbitrage may not be as easy and costless as presumed.

He cannot default in his obligation to the clearing house. but his other risk is clients default risk. need not be and for that matter cannot be members of futures or options exchange. Members can attract involvement of other by providing efficient services at a reasonable cost. jobbers carry limited risk. A non-member has to deal in futures exchange through member only. They are the members of the exchange who takes the purchase or sale by other members in their books and then square off on the same day or the next day. They quote their bid-ask rate regularly. This provides a member the role of a broker. A buyer or seller of a particular futures or option contract can approach that particular jobbing counter and quotes for executing deals. It is here the jobber or market maker plays his role. His existence as a broker takes the benefits of the futures and options exchange to the entire economy all transactions are done in the name of the member who is also responsible for final settlement and delivery. Their role is more important in the exchange where outcry system of trading is present. this risk premium is also inbuilt in brokerage recharges. This activity of a member is price risk free because he is not taking any position in his account. Generally. Even by incurring loss. they are also known as market makers. the futures exchange can only function as a club. So. The difference between bid and ask is known as bid-ask spread. More and more involvement of non-members in hedging and speculation in futures and options market will increase brokerage business for member and more volume in turn reduces the brokerage.37 DERIVATIVES IN INDIA movement. the spread increases since jobbers price risk increases. In automated screen based trading best buy and sell rates are displayed on SACHIN YADAV __________________________________________ TYBFM(2010-2011) . they square off their position as early as possible. even if client defaults. 5. Since they decide the market price considering the demand and supply of the commodity or asset. In the absence of well functioning broking houses. When volatility in price is more.] MARKET MAKERS AND JOBBERS ± Even in organised futures exchange. every deal cannot get the counter party immediately. In less volatile market. Thus more and more participation of traders other than members gives liquidity and depth to the futures and options market. it is less.

SACHIN YADAV __________________________________________ TYBFM(2010-2011) . It guarantees the performance of the contracts and for this purpose clearing house becomes counter party to each contract. In outcry system. Therefore. Transactions are between members and clearing house. Further. In online trading system. For derivative market to be successful exchange plays a very important role. exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions. there may be separate exchange for financial instruments and commodities or common exchange for both commodities and financial assets. 7. so the role of jobber to some extent. it is an important institution for futures and option market. Clearing house ensures solvency of the members by putting various limits on him.} INSTITUTIONAL FRAMEWORK : 6. exchange provide access to members and make available real time information online and also allow them to execute their orders. Clearing house may be a separate company or it can be a division of exchange. C. This provides confidence of people in futures and option exchange. clearing house devises a good managing system to ensure performance of contract even in volatile market.38 DERIVATIVES IN INDIA screen. In any case.] EXCHANGE ± Exchange provides buyers and sellers of futures and option contract necessary infrastructure to trade. jobbers provide liquidity and volume to any futures and option market.] CLEARING HOUSE ± A clearing house performs clearing of transactions executed in futures and option exchanges.

In the absence of proper custodian or warehouse mechanism.] CUSTODIAN / WARE HOUSE ± Futures and options contracts do not generally result into delivery but there has to be smooth and standard delivery mechanism to ensure proper functioning of market. but it would be there in stock futures or options. For capital market. 10. custodian and warehouse are very relevant. This also reduces a possibility of any fraud or misappropriation of fund by any market intermediary. it SACHIN YADAV __________________________________________ TYBFM(2010-2011) . along with physical market in stocks. This can be smoothly handled if a bank works in association with a clearing house. 9. for foreign exchange and money market. SEBI is playing a lead role. commodity futures and options and interest rates futures. the issue of delivery may not arise.] REGULATORY FRAMEWORK ± A regulator creates confidence in the market besides providing Level playing field to all concerned.39 DERIVATIVES IN INDIA 8. delivery of financial assets and commodities will be a cumbersome task and futures prices will not reflect the equilibrium price for convergence of cash price and futures price on maturity. In stock index futures and options which are cash settled contracts.] BANK FOR FUND MOVEMENTS ± Futures and options contracts are daily settled for which large fund movement from members to clearing house and back is necessary. Bank can make daily accounting entries in the accounts of members and facilitate daily settlement a routine affair. RBI is the regulatory authority so it can take initiative in starting futures and options trade in currency and interest rates.

This will help offset their losses in the spot market. Since people can alter their risk exposure using futures and options. If the spot price falls. Derivatives markets help to reallocate risk among investors. Similarly. A person who wants to reduce risk.40 DERIVATIVES IN INDIA will also regulate the stock index futures to be started very soon in India.2 ROLE OF DERIVATIVES : Derivative markets help investors in many different ways : 1. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . When he does so. Forward Market Commission is working for settling up national National Commodity Exchange. you can always invest in an asset and then change its risk to a level that is more acceptable to you by using derivatives. can transfer some of that risk to a person who wants to take more risk. As an investor. For instance. or by buying a Put option. the short hedgers will gain in the futures market. Consider a risk-averse individual.] RISK MANAGEMENT ± Futures and options contract can be used for altering the risk of investing in spot market. consider an investor who owns an asset. the opposite position in the market may be taken by a speculator who wishes to take more risk. as you will see later. the put option can always be exercised. The approach and outlook of regulator directly affects the strength and volume in the market. He can obviously reduce risk by hedging. if the spot price falls below the exercise price. For commodities. He can protect himself by selling a futures contract. derivatives markets help in the raising of capital. 3. He will always be worried that the price may fall before he can sell the asset.

Large spot transactions can often lead to significant price changes. Since it is easier and cheaper to trade in derivatives. it is easier to take a short position in derivatives markets than it is to sell short in spot markets. Finally. spot. However. Hence these markets help to ensure that prices reflect true values. Futures prices are believed to contain information about future spot prices and help in disseminating such information. futures and options markets are inextricably linked. Consequently. futures markets provide a low cost trading mechanism. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. because herein you can take large positions by depositing relatively small margins. 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.] MARKET EFFICIENCY ± The availability of derivatives makes markets more efficient. 4. Thus information pertaining to supply and demand easily percolates into such markets. they offer greater liquidity. it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. derivatives markets involve lower transaction costs. Secondly.41 DERIVATIVES IN INDIA 2.] PRICE DISCOVERY ± Price discovery refers to the markets ability to determine true equilibrium prices. futures markets tend to be more liquid than spot markets. 3.] OPERATIONAL ADVANTAGES ± As opposed to spot markets. Options markets provide information about the volatility or risk of the underlying asset. SACHIN YADAV __________________________________________ TYBFM(2010-2011) . As we have seen.

SACHIN YADAV __________________________________________ TYBFM(2010-2011) . is commensurate with the risk that he is taking. This is important because facilitation of speculation is critical for ensuring free and fair markets. the amount of capital required to take a comparable position is less in this case. Speculators always take calculated risks.] EASE OF SPECULATION ± Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions.42 DERIVATIVES IN INDIA 5. A speculator will accept a level of risk only if he is convinced that the associated expected return. Also.

One of the consequences of the development of the currency swap market is that banks now often make much more competitive medium term forward foreign exchange prices than they used to. a bank could receive fixed rate US dollars in a currency swap and pay fixed rate EUROS. this activity has no associated foreign exchange risk. They are free to fund themselves in the most competitively priced currency SACHIN YADAV __________________________________________ TYBFM(2010-2011) . It is possible for the banks to cover this exposure in the forward market by selling EUROS forwards and buying US dollars. Most banks quote forward foreign exchange and currency swap prices from the same desk and increases liquidity in the latter has improved liquidity in the former.3 HOW BANKS USE DERIVATIVES : ASSET LIABILITY MANAGEMENT Banks have traditionally taken deposits from their customers and put those deposits to work as loans. If a bank is asked to lend to a customer in a currency other than one of those it has on deposits it creates a currency exposure for the bank. would make the resultant cost of the loan prohibitively expensive for the borrower. need no longer restrict their lending activities to the currencies in which they have natural deposits.43 DERIVATIVES IN INDIA 3. Because the deposits and the loans are dominated in the same currency. Currency swaps provide an economic alternative to this problem for banks. In order to cover the exposure created by a loan to a customer in EUROS funded by a bank¶s deposit in US dollar. The transaction costs associated with this. Suppose a customer wants to borrow EUROS from a US Bank for 5 years and that the US bank has no natural source of EUROS. Banks therefore. in particular the bid / offer spread in the medium term foreign exchange forward market. But it does limit banks to lending to customers which need to borrow in the currencies which the banks have available on deposits.

This means that banks can fund themselves much more effectively in the inter bank market in maturities such as the overnight. reflects that it is much easier for banks to borrow at the short end of the curve than the long end. Suppose a bank has a customer who needs 5 years fixed rate funds. The bank is short floating rate interest at 3 month LIBOR and long fixed rate interest at the rate at which it lends to its customer. spot / next. So in order to hedge its position the banks needs to match its exposure to 3 month LIBOR by receiving on a floating SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Let us say that the bank finances in this loan in the interbank market at 3 month LIBOR. This is called the asset liability mismatch. one month. The bank now has a 3 month liability and a 5 year asset (Figure 1).44 DERIVATIVES IN INDIA and to lend to their customers in the currency of the customer¶s preference. one week. or tomorrow to the next day). With the development of the swaps market it is possible for banks to satisfy their customers demands for fixed rate funding while ensuring that the banks assets and liabilities are matched. three months and six months than they can in maturities such as five years or 20 years. using a currency swap as an asset and liability matching tool The ³Normal yield curve´. tom / next (overnight from tomorrow.

The bank can no longer profit from a fall in interest rates but it cannot lose money on its asset and liability mismatch as a result of an increase in rates. The bank will make or lose money based on its pricing of the credit risk in the transaction and its overall loan exposure rather than on its ability to forecast interest rates. and match its exposure on a fixed rate basis by paying a fixed rate in a interest rate swap.45 DERIVATIVES IN INDIA rate basis in an interest rate swap. This structure has the benefit for the bank that it eliminates the bank¶s exposure to interest rate risk. This is a hedge which is ideally suited to an interest rate swap which the bank receives a floating rare of interest and pays a fixed rare (Figure 2). SACHIN YADAV __________________________________________ TYBFM(2010-2011) . Hence the interest rate swaps provide banks with an opportunity to change their risks from interest rate to credit.

SEBI should conduct seminars regarding the use of derivatives to educate individual investors. There must be more derivative instruments aimed at individual investors. Derivatives market should be developed in order to keep it at par with other derivative markets in the world. Speculation should be discouraged. SACHIN YADAV __________________________________________ TYBFM(2010-2011) .46 DERIVATIVES IN INDIA CONCLUSION RBI should play a greater role in supporting derivatives.

Bhalla  Financial Services and Markets ± Dr.cxotoday. C.com SACHIN YADAV __________________________________________ TYBFM(2010-2011) . S. Klob  Derivatives Market in India ± Susan Thomas  Financial Derivatives ± V. Gardner WEBLIOGRAPHY : Websites:  http//www.indiainfoline. Parameswaran  Understanding futures market ± Robert.com  http//www.indiamart. W. K. K. Guruswamy  Futures and Options ± D.com  http//www.47 DERIVATIVES IN INDIA BIBLIOGRAPHY : BOOKS  Futures markets ± Sunil.

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