SUMMER INTERNSHIP PROJECT REPORT

Submitted by

BINU DINANATH PANDEY

In the partial fulfilment of the requirement for the award of the diploma Of Post Graduate Diploma in Management IN
SARASWATI INSTITUTE OF MANAGEMENT AND RESEARCH CENTRE KHARGHAR

AICTE, NEW DELHI APPROVED
MAY-JUNE 2010

Under the guidance of
Corporate guide Institute guide Mr. Navmit singh chadha Yogesh pahuja ( Branch Head) ( Director)
1

Mr.

DECLARATION

I Mr. Binu Dinanath Pandey do hereby declare that the project report entitled “Indian derivative market” being submitted to Saraswati Institute of Management & Research Centre, kharghar is my own piece of work and it has not been submitted to any other institute or published at any time before.

Binu Dinanath Pandey Roll no. 17 SIMARC

2

ACKNOWLEDGEMENT
This report bears the imprint of many people. Right from the experienced staff of Reliance money, to the staff of Saraswati Institute of management and research centre without whose support and guidance. I would have not got the unique opportunity to successfully complete my esteemed organisation. I take this opportunity to express my deep gratitude to all the employees of reliance money, thane. Also I am indebted for the rich guidance, knowledge and suggestions provided by my guide Mr.Navmit Singh Chadha who took sincere efforts & illustrated the financial concept with their vast knowledge in the field, which helped me in carrying out my internship. I am gratified to my director Mr.Yogesh pahuja and my academician manager ms. Shashi Sharma for their earnest coordination owing to which, I has the leg-up of undertaking the internship at the prominent organisation, Reliance money pvt ltd. Last but not least. I also thank all those people whom I met in the industry during my internship and helped me to accomplish my assignment in the most efficient effective manner.

Binu d Pandey SIMARC College

3

EXECUTIVE SUMMARY
The project work is pursued as a part of PGDM (Finance) curriculum at Saraswati institute of management and research centre, kharghar. It is undertaken as a traineeship at Reliance money ltd.The project is done under expert supervision & guidance of Mr.Yogesh pahuja (Director, SIMARC) and Mr. Navmit Singh chadha (Branch manager, reliance money). The project is about the study derivative market and trading in future and option. At reliance money, initially the trainees were imparted process & product knowledge. They were give sufficient time to know about the equity and also about the future and option trading. They had to work with the franchise and think of ways of improving the sales and distribution channel & implementing them. The main aim was to increase sales & for this different ways were tried and implemented. They were provided with database and had to make cold call from the data. Main objective was to know the need of the customer and how to fulfil that in the best way. The project dealt with various field like: • Trading account. • Mutual fund • Insurance ( life& general) • Gold coin Thus it gave trainees the opportunity to learn about the entire product and with range of products reliance money offered it made task a bit easier as well could fulfil the need of the customer in a better way. Binu Dinanath Pandey (Roll no. 17)
4

SIMARC College

CONTENT Ch.n Title of the chapter o. Page no.

5

Certificate Declaration Acknowledgement Executive summary 1 2 Introduction to the project Company profile - Overview - Structure & SWOT - Competitors of reliance money Introduction – what is derivative History of derivative Characteristics of derivative Function of derivative Advantage and disadvantage of derivative Type of derivative and derivative market Risk associated with derivative Participants of the derivative market Derivative in Indian market - Derivative in Indian market chronology - Trading mechanics in Indian derivative market Myths and Realities of derivative market in Indian derivative market Equity market scenario in India Derivative product in India Development of derivative in india
6

01 02 03 04 07 08 09 10 12 16 18 21 24 25 27 39 40 44 51 52 56 60 63 66 67

3 4 5 6 7 8 9 10 11

12 13 14 15 16

17 18 19 20

Research methodology - Objective - Scope - Method Data analysis and interpretation Summary of findings and suggestion Bibliography Appendix and Abbreviations

70 78 79 80

7

CHAPTER 1
INTRODUCTION TO THE PROJECT Introduction: Derivatives are a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products. In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad". When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy. This project attempts to familiarize with financial derivatives, their use and the need to appreciate and manage risk. It covers the snapshot of the project in Indian derivative and what exactly risk & how involve in derivative market. With help of the project you can get brief idea of derivative in Indian market.

Prepared by: Binu Dinanath Pandey (SIMARC COLLEGE)

8

CHAPTER 2

RELIANCE MONEY OVERVIEW
The reliance –anil dhirubhai ambani group is among India’s top three private sector business houses on all major financial parameter, with a market capitalization of Rs.100, 000cr. The interest of the group range from communication Reliance communication & financial service (Reliance ltd) to generation, transmission and distribution of power (Reliance energy) Infrastructure and entertainment. Reliance capital is one of India’s leading & fastest growing private sector financial service company, and rank among the top 3 private sector financial service & banking companies, in terms of net worth. Reliance capital has interests in asset management & mutual funds, life and general insurance private equity and proprietary investments stock broking & other actives in financial services. RCL is registered as a depository participant with national securities depository service ltd (NSDL) and central depository service ltd (CDSL) under the securities and exchange board of india (Depositories and Participants) regulations,1996. RCL has sponsored the reliance mutual fund within the framework of the securities and exchange board of India (mutual fund) regulations 1996. The investment portfolio of RCL is structured in a way that realizes the highest post tax return on its instruments. Advantages offered by reliance money over other companies: • • • • • • • Cost effective Convenience Security Single window for multiple products. 3 in 1 integrated access Demat account with reliance capital. Other service like research, live news from Reuter and Dow Jones etc.

9

 Product offering by reliance money: 1. Trading portal:      Equity broking Commodity broking Derivative ( future and option) Offshore investment (contract for difference) D-mat accounts 2. Financial product:       Mutual fund Life insurance Ulips plan Term plan Money back plan General insurance   Vehicle /motor insurance Health insurance House insurance

IPO’s NFO’s 3. Value –added services:

 

Retirement planning Financial planning
10

 

Tax saving Child red future planning

4. Credit cards

5. Gold coins retailing

STRUCTURE OF RELIANCE CAPITAL

11

Reliance money is a part of the reliance Anil Dhirubhai Ambani Group and is promoted by Reliance capital, the fastest growing private sector financial services company in India, ranked amongst the top 3 private sector financial companies in terms of net worth. Reliance money is a comprehensive financial solution provider that enables you to carry out trading and investment activities in a secure, cost-effective and convenient manner. Through reliance money, you can invest in a wide range of asset classes from Equity, Equity and commodity Derivatives, Mutual Funds, insurance products, IPO’s to availing services of Money Transfer & Money changing. Reliance Money offers the convenience of on-line and offline transactions through a variety of means, including its Portal, Call & Transact, Transaction Kiosks and at its network of affiliates.

Vision of Reliance Money

To achieve & sustain market leadership, Reliance Money shall aim for complete customer satisfaction, by combining its human and technological resources, to provide world class quality services. In the process Reliance Money shall strive to meet and exceed customer's satisfaction and set industry standards.

Mission statement:

12

“Our mission is to be a leading and preferred service provider to our customers, and we aim to achieve this leadership position by building an innovative, enterprising , and technology driven organization which will set the highest standards of service and business ethics.”

COMPETITOR OF RELIANCE MONEY
Reliance Money serves a vast range of all financial products like advisory services, Mutual funds, Demat Accounts, Insurances, Gold etc, so all the companies who offer these services are the competitors of the Reliance Money. There are many competitors for Reliance Money on this basis and almost all of them offer the services which Reliance Money offers. Few major competitors are:
o

Sharekhan

:

o Sharekhan was created when SSKI Investor Services Pvt. Ltd., a company in the securities and equities segment decided to harness the power of the Internet and offer services to its customers through an online stock trading portal. Sharekhan brings and provides a user-friendly online trading facility.
13

They also have an extensive all-India ground network of franchisees across the country. o The company offers its services through a combination of online and offline channels. The online model comprises a portal, chat facilities, and 'speed trade' terminals. And the offline model uses a combination of an IVR infrastructure and a team of customer agents to receive orders over the telephone.

o

ICICI securities

:

o ICICI Securities, A subsidiary of ICICI Bank, was set up in February 1993 to provide investment-banking services to investors in India. As on date ICICI Bank holds 99.9% of the share capital of ICICI Securities. o ICICI Securities Limited is India’s leading full service investment bank with a o Dominant position in all segments of its operations – o Corporate finance o Fixed income o Equities

Kotak securities : Kotak Securities Limited, a 100% subsidiary of Kotak Mahindra Bank, is the stock broking and distribution arm of the Kotak Mahindra Group. Kotak Mahindra is one of India's leading financial institutions, offering complete financial solutions that encompass every sphere of life. From commercial banking, to stock broking, to mutual funds, to life insurance, to investment banking, the group caters to the financial needs of individuals and corporate. Kotak also offers stock broking through the branch and Internet, Investments in IPO, Mutual funds and Portfolio management service.
o

India Infoline Ltd: : India Infoline Ltd is listed on both the leading stock exchanges in India, viz. the Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE). The India Infoline group, comprising the holding company, India Infoline Ltd
o 14

and its subsidiaries, straddles the entire financial services space with offerings ranging from Equity research, Equities and derivatives trading, Commodities trading, Portfolio Management Services, Mutual Funds, Life Insurance, Fixed deposits and other small savings instruments to loan products and Investment banking. India Infoline also owns and manages the websites. India Infoline Securities Pvt Ltd is a 100% subsidiary of India Infoline Ltd, which is engaged in the businesses of Equities broking and Portfolio Management Services. It offers broking services in the Cash and Derivatives segments of the NSE as well as the Cash segment of the BSE.

INDIABULLS : India bulls are India’s leading Financial Services and Real Estate Company having over 640 branches all over India. India bulls serves the financial needs of more than 4,50,000 customers with its wide range of financial services and products from securities, derivatives trading, depositary services, research & advisory services, consumer secured & unsecured credit, loan against shares and mortgage & housing finance. India bulls Financial Services Ltd is listed on the National Stock Exchange, Bombay Stock Exchange.
o

SWOT ANALYSIS OF RELIANCE MONEY LTD
 STRENGHS: I. II. III. IV. All four accounts trading, demat,forex, commodities are opened just for Rs.750/Trading account is interlinked ( if saving account is in IDBI,AXIS,and HDFC bank) Flexibility and adaptability to the dynamic need of capital market. Trader s can also invest in mutual funds.

15

V.

Reliance money unlike other brokering houses has introduced a new prepaid system of brokerage for new the share trading in which it provides the lowest form of brokerage charge from an investor. It’s convenient You can access reliance money’s service through: The internet Transaction The phone (franchise) Call centre

VI.

VII.

It also provides investment in general insurance and life insurance.

 WEAKNESS: I. Against security: In reliance money, if you have some share in your demat account teen you do not get margin against your securities, where as some companies are providing margin on securities in the range on 60-70%. Less number of branches in India. Do not have access on regional exchange( such as UPSE) Competition from banks Problem of saving a/c No interest on cash margin Do not take cash

II. III. IV. V. VI. VII.

16

 OPPORTUNITIES:

I. II. III. IV.

Already having a good market access through different products. Market share of company is increase rapidly Reliance money ltd is not so longer in the financial securities areas but at present it has a very good response of investor. Since reliance money is coming with its own bank and stock exchange.

 THREATS : I. II. III. IV. New competitors ( Religare are posing a lot of threats to the company) No margin on delivery Other threats are: sub broker, brokers, and suppliers. Basically very small limit of delivery.

17

CHAPTER 3 INTRODUCTION OF DERIVATIVE
According to dictionary derivative means “something which is derived from another source”. Therefore derivative is not primary, and hence not independent. In financial terms, derivative is a product whose value is derived from the value of one or more basic variables. These basic variable are called bases, which may be value of underlying asset, a reference rate etc. The underlying asset can be equity, foreign exchange, commodity or any asset. For example:The value of any asset, say share of any company, at a future depends upon the share’s current price. Here, the sharer is underlying asset, the current price of the share is the bases and the future value of the share is the derivative. Similarly, the future rate of the foreign exchange depends upon its spot rate of exchange. In this case, the future exchange rate is the derivative and the spot exchange rate is the base. Derivatives are contract for future delivery of assets at price agreed at the time of the contract. The quantity and quality of the asset is specified in the contract .the buyer of the asset will make the cash payment at the time of delivery.  Meaning: According to JOHN C. HUL “A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables.” According to ROBERT L. MCDONALD “A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else”. The word “DERIVATIVES” is derived from the word itself derived of an underlying asset. It is a future image or copy of an underlying asset which may be shares, stocks, commodities, stock indices, etc. A derivative is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.

Derivatives are derived from the following products:
18

A. Shares B. Debentures C. Mutual funds D. Gold E. Steel F. Interest rate G. Currencies. Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines "derivative" to include1. or Unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R) A and hence the trading of derivatives is governed by the regulatory framework under the SC(R) A. A security derived from a debt instrument, share, loan whether secured

 FACTORS DRIVING THE GROWTH OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing Economic agents a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

19

CHAPTER 4

HISTORY OF DERIVATIVE

“Derivatives trading begin in 1865 when the Chicago board of trade (CBOT) listed the first “exchange traded” derivatives contract in the USA. These contracts were called “future contract”. In 1999, the Chicago butter & egg board, a spin-off of CBOT, was reorganised to allow future trading, its name was changed to Chicago mercantile exchange (CME). The early twentieth century was a dark period for derivatives trading as bucket shops were rampant. Bucket shops are small operators in options and securities that typically lure customers into transactions and then flee with the money, setting up shop elsewhere. In 1922 the federal government made its first effort to regulate the futures market with the Grain Futures Act. In 1936 options on futures were banned in the United States. All the while options, futures and various derivatives continued to be banned from time to time in other countries. The 1950s marked the era of two significant events in the futures markets. In 1955 the Supreme Court ruled in the case of Corn Products Refining Company that profits from hedging are treated as ordinary income. This ruling stood until it was challenged by the 1988 ruling in the Arkansas Best case. The Best decision denied the deductibility of capital losses against ordinary income and effectively gave hedging a tax disadvantage. Fortunately, this interpretation was overturned in 1993. Another significant event of the 1950s was the ban on onion futures. Onion futures do not seem particularly important, though that is probably because they were banned, and we do not hear much about them. But the significance is that a group of Michigan onion farmers, reportedly enlisting the aid of their congressman, a young Gerald Ford, succeeded in banning a specific commodity from futures trading. To this day, the law in effect says, "you can create futures contracts on anything but onions.” In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created the International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that were not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one based on Ginnie Mae (GNMA) mortgages. While the contract met with initial success, it eventually died. The CBOT resuscitated it several times, changing its structure, but it never became viable.

20

In 1975 the Merc responded with the Treasury bill futures contract. This contract was the first successful pure interest rate futures. It was held up as an example, either good or bad depending on your perspective, of the enormous leverage in futures. For only about $1,000, and now less than that, you controlled $1 million of T -bills. In 1977, the CBOT created the T -bond futures contract, which went on to be the highest volume contract. In 1982 the CME created the Eurodollar contract, which has now surpassed the T -bond contract to become the most actively traded of all futures contracts. In 1982, the Kansas City Board of Trade launched the first stock index futures, a contract on the Value Line Index. The Chicago Mercantile Exchange quickly followed with their highly successful contract on the S&P 500 index. 1973 marked the creation of both the Chicago Board Options Exchange and the publication of perhaps the most famous formula in finance, the option pricing model of Fischer Black and Myron Scholes. These events revolutionized the investment world in ways no one could imagine at that time. The Black-Scholes model, as it came to be known, set up a mathematical framework that formed the basis for an explosive revolution in the use of derivatives. In 1983, the Chicago Board Options Exchange decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard and Poor's and became known as the S&P 100, which remains the most actively traded exchangelisted option. The 1980s marked the beginning of the era of swaps and other over-the-counter derivatives. Although over-the-counter options and forwards had previously existed, the generation of corporate financial managers of that decade was the first to come out of business schools with exposure to derivatives. Soon virtually every large corporation, and even some that were not so large, were using derivatives to hedge, and in some cases, speculate on interest rate, exchange rate and commodity risk. New products were rapidly created to hedge the now-recognized wide varieties of risks. As the problems became more complex, Wall Street turned increasingly to the talents of mathematicians and physicists, offering them new and quite different career paths and unheard-of money. The instruments became more complex and were sometimes even referred to as "exotic."

21

In 1994 the derivatives world was hit with a series of large losses on derivatives trading announced by some well-known and highly experienced firms, such as Procter and Gamble and Metallgesellschaft. One of America's wealthiest localities, Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities. England's venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office. These and other large losses led to a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. While some minor changes occurred in the way in which derivatives were sold, most firms simply instituted tighter controls and continued to use derivatives. To a huge outcry, sometimes against the instruments and sometimes against the firms that sold them. While some minor changes occurred in the way in which derivatives were sold, most firms simply instituted tighter controls and continued to use derivatives. These stories hit the high points in the history of derivatives. Even my aforementioned "Chronology" cannot do full justice to its long and colorful history. The future promises to bring new and exciting developments.

22

Chapter 5 Characteristics of derivative market
Derivatives are agreements (contracts) which confer rights and/or obligations based on some underlying interest. The specific rights and obligations encompassed by a derivative contract may be cash settlement, delivery of, or the transfer of rights to, the underlying interest. The underlying interest of a derivative may include physical assets such as commodities (e.g., gold, wheat), equities or equity indexes, debt instruments, other derivative instruments, or any agreed upon pricing index or arrangement, such as the movement over time of the Consumer Price Index or freight rates. Whether the underlying interest is a financial instrument or a commodity does not necessarily alter the nature of the derivative. The derivative contract is not in itself a transfer of the underlying interest; that transfer occurs as part of a separate transaction unless the contract is extinguished by offset. Since the underlying interest itself is not being transferred in a transaction relating to a derivative, there is no limit to the number of outstanding open positions of a particular derivative instrument. For example, the open interest of a futures contract is theoretically unconstrained, but the financial status of market participants and other market factors serve to keep the open interest below certain resistance levels, whereas generally the quantity of authorized and outstanding shares of a particular issuer constitutes the limit for trading in that issue.  Regulatory issues relative to the underlying interest characteristic of derivatives tend to center on fairness and efficiency, concentration of positions, and the delivery process including allocation of deliveries or exercise in the case of options.

When the underlying interest is traded in a jurisdiction other than the one where the derivative instrument is traded, or identical derivative products are traded in two jurisdictions, there may be concern that increased potential may exist for fraud or manipulation because of the likely inability of a regulator in one jurisdiction to monitor market activity directly and/or to conduct complete investigations of market activities in another jurisdiction. This may create a need for increased cross-jurisdictional communication and cooperation. Legal and regulatory issues relating to the transfer of rights across international boundaries also may be raised.

On organized exchanges derivatives are, by design, standardized or fungible. Such standardization together with the interposition of a clearing house or the exchange itself as a counterparty or guarantor permits multilateral offset and random assignment of delivery notices (although these features are not exclusive to derivatives). In futures, although not necessarily in options, for example, a
23

price movement increases the value of one position while reducing the value of the opposite position by an equal amount. Thus, derivative trading generally is said to be zero sum.

The interposition of a clearing house (or an exchange) and the requirement to post standing or initial margins is intended to eliminate counterparty credit risk. (In some markets, price limits or capital-based position limits are also used to address financial risk.) Margin posted on derivatives generally is analogous to a performance bond rather than a down payment. As such, margin is intended to cover the potential failure due to default to meet settlement variation prior to liquidation of a position. The level of margin also affects the degree of leverage associated with a contract.

Ordinarily, the daily gain or loss on a position is marked-to-market and, in most markets, the difference is collected by the clearing house and may be transferred from the losing to the gaining position holders through the clearing house. For options, in most markets but not all markets, the writer/seller only is required to post margin which is marked-to-market each day but not passed through the market.

Because the clearing house or exchange is interposed as the buyer to the seller and the seller to the buyer, the identity of other market participants is less material. Such clearing arrangements enhance confidence and liquidity in exchange-traded derivatives.

It is important that the exchange and/or clearing house set margin levels which are sufficient so as not to imperil the financial integrity of the market and which do not adversely affect liquidity.

The distribution, to customers, of a generic risk disclosure statement is often required before trading is undertaken. The notification of risk relative to futures and options trading is not unique to derivatives and does not imply a negative judgment by the regulator regarding trading in those instruments.

24

Derivatives facilitate risk shifting and may assist in price discovery for the underlying interest. Prices from derivative markets may have an effect on the price in the market for the underlying interest and vice versa.

Prices in the derivative market may be influenced by a concentration of positions, both in the derivative instrument and the underlying interest. Economic inefficiencies may arise if trading occurs at artificial or distorted prices. When physical delivery of the underlying interest is specified in the derivative contract, issues relating to delivery may arise. These may include the definition of acceptable commodities or instruments, the appropriateness of alternative delivery locations and media, the operation of warehouses, or the timing of delivery.

Due to these factors, regulatory or enforcement mechanisms may be employed to deter manipulation and the undisclosed concentration of positions. Regulatory methods may include large trader reporting, position limits, hedge limit determinations, monitoring, and/or moral suasion. To the extent trading is centralized or is reported to a centralized source, compliance monitoring is facilitated. Enforcement methods involve, at a minimum, the prosecution of fraud and manipulation.

In some jurisdictions, to assure maintenance of a centralized market, certain offexchange transactions are precluded; in those jurisdictions where such transactions are permitted, often they must be reported to a central authority (such as the exchange).

The ultimate value of the rights or obligations conferred by derivatives may be heavily dependent on developments in the underlying market. Derivatives differ from their underlying interest; these differences may have regulatory implications. On the other hand, there is a fundamental relationship between the market for the derivative and the market for the underlying interest. The nature of this relationship will depend on the rights and obligations covered by the derivative instrument and may also have regulatory implications.

25

Particular characteristics of derivatives may raise possible regulatory issues. Alternative regulatory responses may be designed or may have evolved to address such characteristics in different markets.

Hence this is the characteristics of derivative market.

Chapter 6

FUNCTION OF DERIVATIVE MARKET
The derivative market performs a number of economic functions:  Prices in an organised derivatives market reflect the perception of market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivative converge with prices of the underlying at the expiration of the derivative contract. Thus, derivative help in discovery of future as well as current price.

 The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

26

 Derivatives due to their inherent nature are linked to the underlying cash market. With the introduction of the derivatives, the underlying market witnesses higher trading volume because of the participation by more players who would not otherwise participate for lack of arrangement to transfer risk.

 Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organisation derivative market, speculator trade in the underlying cash market.

 An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.

 The derivatives have a history of attracting many bright, creative, well educated people with entrepreneurial attitude. They often energize others to create new businesses new products and new employment opportunities, the benefits of which are immense.

 Derivatives market helps increase savings and investment in the end. Transfer of risk enables market participants to expand their volumes of activity.

 Risk management: it involves structuring of financial contracts to produce gains or losses that counter balance the losses or gains arising from movements in financial prices. Thus risks are reduced and profit is increased of a financial enterprises.

 Price discovery: this represents the ability to achieve and disseminate price information without price information investors; consumers and producers cannot make decision. Derivatives are well suited for providing price information.

 Transactional efficiency: transitional efficiency is the product of liquidity. Inadequate liquidity results in high transaction costs.

27

CHAPTER 7
ADVANTAGE AND DISADVANTAGE OF DERIVATIVE

 Advantages of Derivatives

Constant risks have stimulated market participants to manage it through various risk management tools. Derivative products is a one such risk management tools. With the increase in awareness about the risk management capacity of derivatives, its market developed and later expanded. Derivatives have now become an integral part of the capital markets of developed as well as emerging market economies. Benefits of derivative products can be enumerated as under: 1. Versatility - The major advantage of derivatives is their versatility. An investor can use derivative in a most conservative to most risky manner as his risk profile dictates. 2. High Leverage - Derivative contract enables the investor to take an exposure to the full value of underlying shares for a fraction of its value in the form of margin. 3. High Liquidity - Derivative contracts offer very high liquidity compared to cash market. 4. Price Risk Management: The derivative instrument is the best way to hedge risk that arises from its underlying. Suppose, ‘A’ has bought 100 shares of a real estate company with a bullish view but, unfortunately, the stock starts showing bearish trends after the subprime crisis. To avoid loss, ‘A’ can sell the same quantity of futures of the script for the time period he plans to stay invested in the script. This activity is called hedging. It helps in risk minimization, profit maximization, and reaching a satisfactory risk-return trade-off, with the use of a portfolio. The major beneficiaries of the futures instrument have been mutual funds and other institutional investors. 5. Price Discovery: The new information disseminated in the marketplace is interpreted by the market participants and immediately reflected in spot and futures prices by triggering the trading activity in one or both the markets. This process of price adjustment is often termed as price discovery and is one of the major benefits of trading in futures. Apart from this, futures help in improving efficiency of the markets. 6. Asset Class: Derivatives, especially futures, offer an exclusive asset class for not only large investors like corporate and financial institutions but also for retail investors like high net worth Individuals. Equity futures offer the advantage of portfolio risk diversification for all business entities. This is due to fact that historically, it has been witnessed that there lies an inverse correlation of daily returns in equities as compared to commodities.
28

7. High Financial Leverage: Futures offer a great opportunity to invest even with a small sum of money. It is an instrument that requires only the margin on a contract to be paid in order to commence trading. This is also called leverage buying/selling. 8. Transparency: Futures instruments are highly transparent because the underlying product (equity scripts/index) are generally traded across the country or even traded globally. This reduces the chances of manipulation of prices of those scripts. Secondly, the regulatory authorities act as watchdogs regarding the day-today activities taking place in the securities markets, taking care of the illegal transactions. 9. Predictable Pricing: Futures trading is useful for the genuine investor class because they get an idea of the price at which a stock or index would be available at a future point of time.

Advantages of Derivative Trading – The biggest advantage of derivative trading is that you can buy stocks in future trading by paying only 20% or 30% of the price. That means if you are buying a stock of Rs.10 each and the lot contains 1000 stocks you can pay only Rs.2000 to Rs.3000 to buy the lot. Whereas, the stock price in that cases would have been Rs.10000. So, you are gaining more profit at a time without investing more money. In case of derivative trading you can short sell the stocks. That means you can first sell the lot of stock and then buy them back within the stipulated time to honour the contract. In case of an overvalued stock that are sure to fall in near future, you can gain from short selling. This is an option that you cannot get in equity trading unless you are doing intraday trading. In future trading the brokerage is usually lower than the equity trading. As you are buying the stocks in a lot the brokerage is calculated not on the unit of the stocks but on the unit of the lot. Disadvantages of Derivative Trading The biggest disadvantage of the derivative trading is that you have a time frame to complete the selling of the stock. If the stock price does not rise up to the expected level, even then you have to sell off the stocks to honour the contract. Another negative aspect is that the if the stock price fall then the investor loose huge money in derivative trading as the amount of stock involved in this trading is huge.


Another limitation of derivative trading is that not all the listed stocks are available for derivative trading. There are selected stocks in a stock exchange i.e NSE and BSE in which you can do derivative trading.

CHAPTER 8
29

TYPE OF DERIVATIVE AND DERIVATIVE MARKET

TYPE OF DERIVATIVE

There are the different types of derivative market are as follows: A) FUTURE 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 As in a forward contract, the trader who promises to buy is said to be in ‘long position’ and the one who promises to sell is said to be in ‘short position’ in futures
30

also.

Future same as a forward contract, an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. Futures have evolved from standardization of forward contracts. Futures differ from forward contracts in the following respects: • • • Futures are generally traded on an exchange. A future contract contains standardized articles. The delivery price on a future contract is generally determined on an exchange, and depends on the market demands.

B) OPTION:
The concept of options is not new one. In Fact, options have been in use for centuries. The idea of an option existed in ancient Greece and Rome. The Romans wrote options on the cargo that were transported by their ship. In the 17th century, there was an active option markets in Holland. In fact, options were used in a large measure in the .tulip bulb mania of that century. However, in the absence of mechanism to guarantee the performance of the contract, the refusal of many put option writers to take delivery of the tulip bulb and pay the high prices of the bulb they had originally agreed to, led to bursting of the bulb bubble during the winter of 1637.A number of speculators were wiped out in the process. In India, options on stocks of companies were illegal until 25th January 1995 according to sec. 20 of Securities Contracts (Regulation) Act, 1956. When Securities Laws (amendment) Act, 1956 deleted section 20 thus making the introduction of options as legal act.

An options contract is an agreement between a buyer and a seller. Such a contract confers on the buyer a right but not an obligation to buy or sell a specified quantity of the underlying asset at a fixed price on or up to a fixed day in the future on a
31

payment of a premium to the seller. The premium paid by the buyer to the seller is the prices of an option contract Options on a futures contract have added a new dimension to future trading like futures options provide price protection against adverse price move. Present day options trading on the floor of an exchange began in April 1973. When the Chicago Board of trade created the Chicago Board Options Exchange (CBOE) for the sole purpose of trading Options on a limited number of New York stock exchange listed equities. Options-an agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the agreement according to the terms specified in the agreement. In an options contract, the specified price is called the exercise price or strike price, the specified date is called the expiration date, and the action to perform the buying or selling of the asset according to the option contract is called exercise. TYPES OF OPTIONS: According to buying or selling an asset, options have the following types: • Call option: A call option is one, which gives the option holder the right to buy an underlying asset (commodities, foreign exchange, stock shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the writer of a call option is under an obligation to sell the asset at a specified price, in case the buyer exercises his option to buy. Thus, the obligation to sell arises only when the option exercised.

Put option: A put option is one, which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell.

DOUBLE OPTION: A double option is one, which gives the option holder both the right either to buy or to sell an
32

underlying asset at a predetermined price on or before a specified date in future. According to terms on exercise in the contract, options have the following types: o European options: - can be exercised only on the expiration date. o American options: - can be exercised on or prior to the expiration date. Define K-strike price and T-expiration date, then an option's payoff (value) VT at expiration date is: VT = (ST-K) +, (call option) VT = (K -ST) +, (put option) Other Terminology use in option: 1) Holder: The buyer of the option 2) Premium: The amount paid by the buyer of the option to the seller. 3) Writer: The option seller. 4) Strike price: The predetermined price at which a given futures contract brought or sold. Also called the “exercise price” these levels are set at regular intervals. 5) At-the-money: an option is at-the money when the underlying futures price equals or nearly equals, the strike price. For e.g.: a RELINFRA put or call option is at-themoney if the option strike price is at 100 and the price of the RELINFRA future contract is at or near 100. 6) In-the-money: a call option is in-the-money when the underlying future price is greater than the strike price. For ex: if RELINFRA future price are at 100 and the reliance option strike price is 95 the call is in the money. 7) Out-of-the-money: a call option is out-of-the-money if the strike price is greater than the underlying future price. For ex: if RELINFRA futures are at 100 and the RELINFRA call option strike price is 110 the option is out-of-the-money. Particular In-the-money At-the-money Out-of-the-money C) FORWARD 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
33

Call option Future>Strike Future=Strike Future<Strike

Put option Future<Strike Future=Strike Future>Strike

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 normally 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 size, 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 counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions 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. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

D) SWAPS:

34

Swap is an agreement between two parties to exchange one set of financial obligations with other. It is widely used throughout the world but is recent in India. Swap may be interest swap or currency swaps. Swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the longend of the maturity spectrum. Swaps allow companies to exploit advantages across a matrix of currencies and maturities. Some other type of derivative: Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longerdated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaption: Swaption 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 swaption market has receiver swaption and payer swaption. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating

TYPE OF DERIVATIVE MARKET

35

There the following type of derivative market: Exchange-Traded and Over-the-Counter Derivative Instruments OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “havala” or forwards markets. An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE.4 Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts

I.

EXCHANGE TRADED DERIVATIVE:
36

Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges, similar to the exchanges meant for trading stocks, whereas Over-the-Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. In the Exchange Traded Derivatives Market or Future Market, the exchange acts as the main party and while trading derivatives it is actually the risk which is traded between the two trading parties. Compared to trading derivatives over-the-counter ("OTC"), an organized exchange with an integrated clearing house provides investors with a higher level of transparency and reduced counterparty risk.

A) NATIONAL STOCK EXCHANGE: The National Stock Exchange (NSE), located in Bombay, is India's first debt market. It was set up in 1993 to encourage stock exchange reform through system modernization and competition. It opened for trading in mid-1994. It was recently accorded recognition as a stock exchange by the Department of Company Affairs. The instruments traded are, treasury bills, government security and bonds issued by public sector companies. The Organisation: The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a taxpaying company unlike other stock exchanges in the country. NSE Group: 1. India Index Services & Products Ltd. (IISL) 2. National Securities Clearing Corporation Ltd. (NSCCL) 3. NSE.IT Ltd. 4. National Securities Depository Ltd. (NSDL) 5. DotEx International Limited NSE's markets NSE provides a fully automated screen-based trading system with national reach in the following major market segments:37

• • • • •

Equity OR Capital Markets {NSE's market share is over 65%} Futures & Options OR Derivatives Market {NSE's market share over 99.5%} Wholesale Debt Market (WDM) Mutual Funds (MF) Initial Public Offerings (IPO)

B) BOMBAY STOCK EXCHANGE: A very common name for all traders in the stock market, BSE, stands for Bombay Stock Exchange. The oldest market not only in the country but also in Asia. In the early days, BSE was known as "The Native Share & Stock Brokers Association." It was established in the year 1875 and became the first stock exchange in the country to be recognised by the government. In 1956, BSE obtained a permanent recognition from the Government of India under the Securities Contracts (Regulation) Act, 1956. In the past and even now, it plays a pivotal role in the development of the country's capital market. This is recognised worldwide and its index, SENSEX, is also tracked worldwide. Earlier it was an Association of Persons (AOP), but now it is a demutualised and corporatized entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). BSE Vision The vision of the Bombay Stock Exchange is to "Emerge as the premier Indian stock exchange by establishing global benchmarks." BSE Management Bombay Stock Exchange is managed professionally by Board of Directors. It comprises of eminent professionals, representatives of Trading Members and the Managing Director. The Board is an inclusive one and is shaped to benefit from the market intermediaries participation. The Board exercises complete control and formulates larger policy issues. The day-to-day operations of BSE are managed by the Managing Director and its school of professional as a management team.

38

C) NATIONAL COMMODITY AND DERIVATIVE EXCHANGE LIMITED: National Commodity & Derivatives Exchange Limited (NCDEX) is a professionally managed online multi commodity exchange promoted by ICICI Bank Limited (ICICI Bank), Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). Punjab National Bank (PNB), CRISIL Limited (formerly the Credit Rating Information Services of India Limited), Indian Farmers Fertilizer Cooperative Limited (IFFCO) and Canara Bank by subscribing to the equity shares have joined the initial promoters as shareholders of the Exchange. NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. The institutional promoters of NCDEX are prominent players in their respective fields and bring with them institutional building experience, trust, nationwide reach, technology and risk management skills. NCDEX is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It has commenced its operations on December 15, 2003. NCDEX is a nation-level, technology driven de-mutualised on-line commodity exchange with an independent Board of Directors and professionals not having any vested interest in commodity markets. It is committed 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. NCDEX is regulated by Forward Market Commission 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. NCDEX is located in Mumbai and offers facilities to its members in more than 550 centres throughout India. The reach will gradually be expanded to more centres.

39

II.

OVER THE COUNTER: The Over-The-Counter (OTC) markets are essentially spot markets and are localised for specific commodities. Almost all the trading that takes place in these markets is delivery based. OTC trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is the opposite of exchange trading which occurs on futures exchanges or stock exchanges. An over-the-counter contract is a bi-lateral contract, in which two parties agree on how a particular trade or agreement is to be settled in the future. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement. An over-the-counter market is a financial market where products are traded over-the-counter. The buyers as well as the sellers have their set of brokers who negotiate the prices for them. This can be illustrated with the help of the following example: A farmer, who produces castor, wishing to sell his produce, would go to the local mandi. There he would contact his broker who would in turn contact the brokers representing the buyers. The buyers in this case would be wholesalers or refiners. In event of a deal taking place the goods and the money would be exchanged directly between the buyer and the seller. Thus, it can be seen that this market is restricted to only those people who are directly involved with the commodity. In addition to the spot transactions, forward deals also take place in these markets. However, they too happen on a delivery basis and hence are restricted to the participants in the spot markets.

In the OTC market, trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors, rather than providing the order matchmaking service seen in specialist exchanges. In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing
40

requirements. Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone.

Although NASDAQ operates as a dealer network, NASDAQ stocks are generally not classified as OTC because the NASDAQ is considered a stock exchange. As such, OTC stocks are generally unlisted stocks, which trade on the Over the Counter Bulletin Board or on the pink sheets. Be very wary of some OTC stocks, however; the OTCBB stocks are either penny stocks or are offered by companies with bad credit records.

Hence the explanation of derivative product is given the chapter 15. (Derivative product in India)

*************

41

CHAPTER 9 RISKASSOCIATED WITH DERIVATIVE MARKET
While derivatives can be used to help manage risks involved in investments, they also have risks of their own. However, the risk involved in derivatives trading are neither new nor unique- they are the same kind of risks associated with traditional bond are equity instruments.  Market risk: Derivatives exhibit price sensitivity to change in market condition, such as fluctuation in interest rates or currency exchange rates. The market risk of leveraged derivatives may be considerable, depending on the degree of leverage and the nature of the security.

 Liquidity risk: Most derivatives are customized instrument and could exhibit substantial liquidity risk implying they may not be sold at a reasonable period. Liquidity may decrease or evaporate entirely during unfavourable markets.

 Credit risk; Derivatives not traded on exchange are traded in the over the counter (OTC) Market. OTC instrument are subject to the risk of counter party defaults.

 Hedging risk: Several types of derivatives including futures, option and forward are used as hedges to reduce specific risks. If the anticipated rises do not develop, the hedge may limit the funds total return.
42

***********

CHAPTER10 PARTICIPANTS OF DERIVATIVE MARKET

There the three important participants in the derivative market are: o Hedgers o Speculators o Arbitrageurs

The explanation of the following participant given below

A) HEDGERS:
Hedgers are the traders who wish to eliminate the risk of price change to which they are already exposed. It is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Hedgers are those persons who don’t want to take the risk therefore they hedge their risk while taking position in the contract. In short it is a way of reducing risks when the investor has the underlying security. PURPOSE: “TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK”
43

Hedgers are those who protect themselves from the risk associated with the price of an asset by using derivatives. A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts. In this way he gets an assured fixed price of his produce. In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. Hedgers are often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take an example: A Hedger pays more to the farmer or dealer of a produce if its prices go up. For protection against higher prices of the produce, he hedges the risk exposure by buying enough future contracts of the produce to cover the amount of produce he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if the price of the produce raise enough to offset cash loss on the produce.

B) SPECULATORS:
Speculators are somewhat like a middleman. They are never interested in actual owing the commodity. They will just buy from one end and sell it to the other in anticipation of future price movements. They actually bet on the future movement in the price of an asset. They are the second major group of futures players. These participants include independent floor traders and investors. They handle trades for their personal clients or brokerage firms. Buying a futures contract in anticipation of price increases is known as .going long. Selling a futures contract in anticipation of a price decrease is known as going short. Speculative participation in futures trading has increased with the availability of alternative methods of participation. Speculators have certain advantages over other investments they are as follows: If the traders. Judgment is good; he can make more money in the futures market faster because prices tend, on average, to change more quickly than real estate or stock prices. Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place.

44

SPECULATION IN THE FUTURES MARKET Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:   Naked positions - Position in any future contract. Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market. Example: Here the Speculator believes that stock market will go to appreciate. Current market price of RELCAPITAL = 1500 Strategy: Buy February RELCAPITAL futures contract at 1500 Lot size = 500 shares Contract value = 7, 50,000 (1500*500) Margin = 75000 (10% of 750000) Market action = rise to 1550 Future Gain: Rs. 25000 [(1550-1500)*500] Market action = fall to 1400 Future loss: Rs.-50000 [(1400-1500)*500] *Example according to current market scripts

C) ARBITRAGEURS:
According to dictionary definition, a person who has been officially chosen to make a decision between two people or groups who do not agree is known as Arbitrator. In commodity market Arbitrators are the person who takes the advantage of a discrepancy between prices in two different markets. If he finds future prices of a commodity edging out with the cash price, he will take offsetting positions in both the markets to lock in a profit. Moreover the commodity futures investor is not charged interest on the difference between margin and the full contract value. Arbitrage is the concept of simultaneous buying of securities in one market where the price is low and selling in another market where the price is higher.

Example: Current market price of RELINFRA inBSE= 500 Current market price of RELINFRA in NSE= 510 Lot size = 250 shares Thus the Arbitrageur earns the profit of Rs.2500 (10*250) *Example according to current market scripts

45

********

46

INDIAN DERIVATIVE MARKET
47

CHAPTER11
DERIVATIVES MARKET IN INDIA

Prior to liberalization, in India financial markets, there were only a few financial products and the stringent regulatory products and the stringent regulation environment also eluded any possibility of development of a derivatives market in country. All Indian corporate were mainly relying on term lending institution for meeting their project financing or any other financing requirements and on commercial banks for meeting working capital finance requirement. Commercial banks are on their assets and liabilities. The only derivative product they were aware of is the foreign exchange forward contract. But this scenario changed in the post liberalization period. Conservative Indian business practitioners began to take a different view of various aspects of their operations to remain competitive. Financial risks were given adequate attention and .treasury function. Has assumed a significance role in all major corporate since then. Initially, banks were allowed to pass on gains arising out of cancellation of forward’s contracts to the customers and customers were permitted to cancel and re-book the forward contracts. This remarkable change was followed by the introduction of cross currency forward contacts. But the major milestone in developing forex derivatives market in India was the introduction of cross currency options. The RBI.s objective of introducing cross currency options was to provide a complicated hedging strategy for the corporate in their risk management activities. The concept of derivatives is of course not new to the Indian market. Though derivatives in the financial markets have nothing to talk about home, in the commodity markets they have a long history of over hundred years. In 1875, the first commodity futures exchange was set up in Mumbai under the guidance of Bombay Cotton Traders Association. A clearinghouse for clearing and settlement of these traders was set up in 1918. Over a period of twenty years during 1900-1920, other futures markets were set up in various places. Futures market in raw jute in Kolkata (1912), wheat futures market in Hapur (1913), and bullion futures market in Mumbai (1920). When it comes to financial markets, derivatives in equities claim a long existence. The official history of Bombay Stock Exchange (then known as Native Share and Stock Brokers Association) reveals that the concept of options existed since 1898 as is reflected from a quote given by one of the MPs-.India being the original home of options, a native broker would give a few points to the brokers of the other nations in the manipulation of puts and calls.. However, such an early expertise gained by Indian traders in derivatives trading has come to an end with the Government of India’s ban on forward contract during the
48

1960.s on the ground of their intrinsic undesirability. But ironically, the same were reintroduced by the government in the 1980.s as essential instruments for eliminating wide fluctuations in prices and more so because of the World Bank , UNCTAD report, which strongly urged the Indian government to start futures trading in major cash crops, especially in view of India’s entry to WTO. With the world embracing the derivative trading on large scale, the Indian market obviously cannot remain aloof, especially after liberalization has been set in motion. Now we are in the threshold of introducing trading in derivatives, beginning with the stock index futures to be well set for the introduction of derivative trading. With L.C. Gupta committee having recently submitted its project report on derivative market. Report on the subject, SEBI is engaged in the process of assessing the feasibility and desirability of introducing such trading. The NSE and BSE are two exchanges on which financial derivatives are traded. The combined notional value of the daily volumes on both the bourses stands at around RS. 150000cr. In developed markets trading in the derivatives segment are thrice as large as in the cash markets. In India, the figure is hardly 20% of cash markets. Quite clearly our derivative markets have a long way to go. According to the Executive Director of Association of NSE Member of India (Amni), Vinod Jain, Volumes in derivatives segment are stagnating due to lack of growth in the number of markets participants. Besides these products are still to catch up with the masses who are keeping away from this segment due to lack of understanding of the products and high contract price.

A) COMMODITIES DERIVATIVES MARKETS
In order to give more thrust on agricultural sector, the National Agricultural Policy, 2000 has envisaged and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to extend the coverage of futures markets to minimize the wide fluctuations in commodity market prices and for hedging the risk from price fluctuations. As a result of these recommendations, there are presently, 15 exchanges carrying out futures trading in as many as 30 commodity items. Out to these, two exchanges viz. IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have been upgraded to international exchanged to deal international contracts in peepers and castor oil respectively. Moreover, permission has been given to two more exchange viz. the First Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil and oilcake), and Keshave Commodity Exchange Ltd., Delhi (for potato), where futures trading started very recently. The government has also permitted four exchange viz., EICA, Mumbai. The Central Gujarat Cotton Dealers Association, Vadodara; The South India cotton Association Coimbatore; and the Ahmadabad Cotton Merchants Association, Ahmadabad, for conducting forward (non-transferable specific delivery) contracts in cotton. Lately as part of further liberalization of trade in agriculture and dismantling of ECA, 1955 futures trade in sugar has been permitted and three new exchanges viz., Commodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and
49

E-Sugar India.com, Mumbai have been given approval for conducting sugar futures (Ministry of Food and Consumer Affairs, 1999). In the recent past, the GOI has set up a committee to explore and appraise matters important to the establishment and financing of the proposed national commodity exchange for the nationwide trading of commodity futures contracts. The usage of warehouse receipts as a means for delivery of commodities under the contracts is also being explored. The warehouse receipts system has been operational zed in COFEI (coffee futures exchange of India) with effect from 1998. The Government of India is on the move to establish a system of warehouse receipts in other commodity stock exchanges at various places of the country. Besides these domestic developments, during 1998, Reserve Bank of India permitted the Indian Corporate Sector to access the exchanges subject to certain conditions with a view to enable domestic metal manufacturers to compete with global players. The de-regulation of oil-imports being on the cards, government should create the right atmosphere for oil sector to participate in the international oilderivatives Markets. Despite these developments, there are still many impediments that hold back the farming community from entering the futures market and reap full benefits. A brief description of commodity exchanges is those which trade in particular commodities, neglecting the trade of securities, stock index futures and options etc. In the middle of 19th century in the United States, businessmen began organizing market forums to make the buying and selling of commodities easier. These central marketplaces provided a place for buyers and sellers to meet, set quality and quantity standards, and establish rules of business. Agricultural commodities were mostly traded but as long as there are buyers and sellers, any commodity can be traded. In 1872, a group of Manhattan dairy merchants got together to bring chaotic condition in New York market to a system in terms of storage, pricing, and transfer of agricultural products. In 1933, during the Great Depression, the Commodity Exchange, Inc. was established in New York through the merger of four small exchanges. The National Metal Exchange, the Rubber Exchange of New York, the National Raw Silk Exchange, and the New York Hide Exchange. The major commodity markets are in the United Kingdom and in the USA. In India there are 25 recognized future exchanges, of which there are three national level multicommodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: • • • National Commodity & Derivatives Exchange Limited (NCDEX) Multi Commodity Exchange of India Limited (MCX) National Multi-Commodity Exchange of India Limited (NMCEIL)

All the exchanges have been set up under overall control of Forward Market Commission (FMC) of Government of India.
50

 National Commodity & Derivatives Exchange Limited (NCDEX) National Commodity & Derivatives Exchange Limited (NCDEX) located in Mumbai is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956 and had commenced its operations on December 15, 2003.This is the only commodity exchange in the country promoted by national level institutions. It is promoted by ICICI Bank Limited, Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). It is a professionally managed online multi commodity exchange. NCDEX is regulated by Forward Market Commission and is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations.  Multi Commodity Exchange of India Limited (MCX) Headquartered in Mumbai Multi Commodity Exchange of India Limited (MCX), is an independent and de-mutualised exchange with a permanent recognition from Government of India. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, Union Bank of India, Corporation Bank, Bank of India and Canara Bank. MCX facilitates online trading, clearing and settlement operations for commodity futures markets across the country. MCX started offering trade in November 2003 and has built strategic alliances with Bombay Bullion Association, Bombay Metal Exchange, and Solvent Extractors. Association of India, Pulses Importers Association and Shetkari Sanghatana.  National Multi-Commodity Exchange of India Limited (NMCEIL) National Multi Commodity Exchange of India Limited (NMCEIL) is the first demutualized, Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was granted approval by the Government to organise trading in the edible oil complex. It has operationalised from November 26, 2002. Central Warehousing Corporation Ltd., Gujarat State Agricultural Marketing Board and Neptune Overseas Limited are supporting it. It got its recognition in October 2002. Commodity exchange in India plays an important role where the prices of any commodity are not fixed, in an organised way. Earlier only the buyer of produce and its seller in the market judged upon the prices. Others never had a say. Today, commodity exchanges are purely speculative in nature. Before discovering the price, they reach to the producers, end-users, and even the retail investors, at a grassroots level. It brings a price transparency and risk management in the vital market. A big difference between a typical auction, where a single auctioneer announces the bids and the Exchange is that people are not only competing to buy but also to sell. By Exchange rules and by law, no one can bid under a higher bid, and no one can offer to sell higher than someone else lower offer. That keeps the market as efficient as possible, and keeps the traders on their toes to make sure no one gets the purchase or sale before they do. A brief description of commodity exchanges is those which
51

trade in particular commodities, neglecting the trade of securities, stock index futures and options etc. In the middle of 19th century in the United States, businessmen began organizing market forums to make the buying and selling of commodities easier. These central marketplaces provided a place for buyers and sellers to meet, set quality and quantity standards, and establish rules of business. Agricultural commodities were mostly traded but as long as there are buyers and sellers, any commodity can be traded. In 1872, a group of Manhattan dairy merchants got together to bring chaotic condition in New York market to a system in terms of storage, pricing, and transfer of agricultural products.

B) CURRENCY DERIVATIVES
Foreign exchange derivatives market is one of the oldest derivatives markets in India. Presently, India has got a well-established dollar-rupee forward market with contrast traded for one month, two months and three months expiration. Currency derivatives markets have begun to evolve with the allowing of banks to pass on the gains upon cancellation of a forward to the customer and permitting customer to cancel and rebook forward contracts. Introduction of cross currency options can be considered as another major step towards developing forex derivatives markets in India. Today, Indian corporate is permitted to purchase cross currency options to hedge exposures arising out of trade. Authorized dealers who offer these products have to necessarily cover their exposure in international markets i.e., they shall not carry the risk in their own books. Cross currency options are essentially meant for buying or selling any foreign currency in terms of US dollar. They are therefore, useful only to those traders who invoice their exports and imports in currencies other than US dollar or for corporate who borrow in currencies other than US dollar. As against this, majority of Indian trade is invoiced in the US dollars. Thus, they have almost no relevance in the Indian context. Indian banks are allowed to use the foreign currency interest rate swaps, forward rate agreements/interest rate options/swaps, and forward rate agreements/interest rate option/swaption/caps/floors to hedge interest rate and currency mismatch in their balance sheets. Resident and the non-resident clients are also permitted to use the above products as hedges for liabilities on their balance sheets. Here it is worth remembering that globally, foreign exchange traders are becoming as common as stock traders. But in India, forex dealers still play second fiddle to stock traders and merely meet the needs of the exporter’s deposits. This may be due to their risk averting behaviour and perhaps lack of proper research. Such being the position of the forex market, it is too premature to expect that once, foreign currency-Indian rupee options are introduced, the market will pick up momentum. This is all the more essential in a market where exchange rates though stated to be market determined, are often found influenced by RBI.s intervention in the exchange market. As a result, exchange rate movements hardly obey the principle of interest rate differentials. The incongruence in the domestic money rates as derived from the USD/INR forwards yield curve supports this assertion. For example, the one-year domestic term money
52

is around 6-6.25% whereas that of the one-year implied forward rate is around 5.40%. In such a scenario, it is difficult for a currency trader to take a firm view on the exchange rate movement.

C) STOCK MARKET DERIVATIVES
Today trading on the spot market for equity in India has always been a futures market with weekly/fortnightly settlements. These markets features the risks and difficulties of futures market, But without the gains in price discovery and hedging services that come with separation the spot market from the futures market. India’s primary market is acquainted with two types of derivatives. • • Convertible bonds Warrants As these warrants are listed and traded, it could be said that options market of a limited sort already exist in our market. Besides, a wide range of interesting derivatives markets exists in the informal sector. Contracts such as .bhav-bhav. .teji-mandi. Etc. is traded in these markets. These informal markets enjoy a very limited participation and have their presence outside the conventional institutions of India’s financial system. The first step towards introduction of derivatives trading in India in its current format was the promulgation of the securities laws (Amendment) Ordinance, 1995 that withdrew the prohibition on options in securities. The real push to derivatives market in India was however given by the SEBI. The security market watchdog, in November 1996 by setting up a committee under the chairmanship of Dr L C Gupta to develop .appropriate regulatory framework for derivatives trading in India.. In 2000, SEBI permitted NSE and BSE to commence trading in index futures contracts based on S&P CNX Nifty and BSE 30(sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. Futures contracts on Individual stocks were launched on November 9, 2001. Trading and settlement is done in accordance with the rules of the respective exchanges. But the trading volumes were initially quite modest. This could be due to ----• • • Initially, few members have been permitted by SEBI to trade on derivatives; FII.S, MFS have been allowed to have a very limited participation; Mandatory requirements for brokerage firms to have .SEBI approvedcertification test- passed. Brokers for undertaking derivatives trading. And
53

Lack of clarity on taxation and accounting aspects under derivatives trading.

The current trading behaviour in the derivatives segments reveals that single stock futures continues to account for sizeable proportion. A recent press report indicates that futures in Indian exchanges have reached global volumes. One possible reason for such skewed behaviour of the traders could be that futures closely resemble the erstwhile badla system. Such distortions are not however in the interest of the market. SEBI has permitted trading in options and futures on individual stocks, but not on all the listed stocks. It was very selective, stocks that are said to be highly volatile with a low market capitalization are not allowed for option trading. This act of SEBI is strongly resented by a section of the market. Their argument is that equity options are indispensable to investors who need to protect their investment from volatility. The higher the volatility of a stock the more necessary it is to list options on that stock. They are highly vocal in arguing that SEBI should design an effective monitoring, surveillance and risk management system at the level of the exchanges and clearing house to avert and manage the default risks that are likely to arise owing to high volatility in low market capital stocks instead of simply banning trading in options on them. SEBI needs to examine these arguments. It may have to take a stand to nip in the bud all kinds of manipulations by handling out severe punishments to all such erring companies. Today, mutual funds are permitted to use equity derivatives products for hedging and portfolio rebalancing... However, such usage is not favoured by fund managers as they strongly apprehend that the dividing line between hedging and speculation being thin, they may always get exposed to the questioning by the regulatory authorities.

D) CREDIT DERIVATIVES AND OTHERS A credit derivative is a financial transaction whose pay-off depends on whether or not a credit event occurs. A credit event can be: • • • • • • Bankruptcy Default Upgrade Downgrade Interest rate movement Mortgage defaults
54

Unforeseen pay-offs

A credit derivative, like any other derivative, derives its value from a case is the credit. In the event of the underlying asset failing to perform as expected, credit derivatives, ensures that someone other than the principal lender absorbs the resulting financial loss. Credit derivatives market in India though could be said as non-existent holds huge potential. Some of the important factors/situation such as opening up of the insurance sector to foreign private players, relief to investors, tax benefits to corporate, proxy hedgers etc., could provide the momentum to the credit derivatives market in India, boosting yields and bringing down risk for both the corporate and banks. Secondly, Indian banking system is saddled with huge NPA.s, which it is of course, eagerly trying to get rid of. The mounting pressure on profitability is making banks more credit-averse. In such a situation, if markets can offer .credit-insurance. In the form of derivatives, everyone would jump for it.

DERIVATIVE IN INDIA
The securities and exchange board of India (SEBI) allowed trading in equities-based derivatives on stock exchange in June 2000. Accordingly the National stock exchange of India and Bombay stock exchange of India introduced trading in future on June 9, 2000 & June 12, 2000 respectively. Currently future and options turnover on the NSE is Rs.7000-8000 crore approximately. In India stock index option were introduced from July 2, 2001.

Derivatives in India: chronology:  December 14,1995  November18,1996  May 11,1998  July 7,1999  May 24,2000  May 25,2000  June 9,2000  June12,2000  September 25,2000 The NSE sought sebi’s permission to trade index futures. The LC gupta committee setup to draft a policy framework for index futures. The LC gupta committee submitted a report on the policy framework for index futures. Reserve bank of india gave permission for OTC forward rate agreements and interest rate swaps. SIMEX chose nifty for trading futures and options on Indian index. Sebi allowed the NSE and the BSE to trade in index future. Trading of the BSE sensex future commented on the BSE. Trading of the nifty futures commenced on the NSE. Nifty future trading commented on the
55

 June 2,2001

SGX Individual stock options and derivative

TRADING MECHANICS IN INDIAN DERIVATIVE MARKET

A) SPOT MARKET:
In a spot market transactions are settled “on the spot”. Once a trade is agreed upon, the settlement-i.e. the actual exchange of money for goods takes place with minimum possible delay. There are two real-world implementations of a spot market rolling settlement and real time gross settlement (RTGS). With rolling settlement trade are netted through one day, and settled X working days later, this is called T+X rolling settlement. For example: with T+5 rolling settlement, traders are netted through Monday, and the net open position as of Monday evening is settled on the coming Monday. Similarly, traders are netted through Tuesday, and settled on the coming Tuesday. With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a close approximation and RTGS is a true spot market.

B) FORWARD TRANSACTION:
In a forward contract two parties irrevocably agree to settle a trade at a future date for a stated price and quantity no money changes hands at the time the trade is agreed upon. Suppose a buyer Rajeshwari and seller Ranbir agrees to do a trade in 100 grams of gold on 31dec 2009 at Rs 15000/- tolas. Here Rs. 15000/- tola is the “forward price of 31dec 2012 gold”. The buyer Rajeshwari is said to be long and the seller Ranbir is said to be short. Once the contract has been entered into Rajeshwari obligated to pay Ranbir Rs.150k on dec31, 2012 and take delivery of 100tolas of

56

gold. Similarly ranbir is obligated to be ready to accept Rs.150k on 31, dec and give 100 tolas of gold in exchange.

C) EXCHANGE TRADE V/S OTC DERIVATIVES:
The OTC derivatives markets have the following features compared to exchangetraded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. 3. 4. There are no formal centralized limits on individual positions, leverage, or margining, There are no formal rules for risk and burden-sharing, There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

5.

D) CARRY FORWARD: Badla is a mechanism to avoid the discipline of a spot market; to do trade on the spot market but not actually do settlement. The “carry forward” activies market a well functioning spot market has no possibility of carry forward. Derivative trade take place distinctively from the spot market. The spot price is separately observed from the derivative price. A modern financial system consists of a spot market, which is a genuine spot market and a derivative market is separate from the spot market. E) INTERMEDIATION IN INDIAN DERIVATIVE MARKET: There are two kinds of brokerage firms on the index future market, trading members (TMs) and clearing members. NSCC bears the full of default by a clearing member. Trading members obtain the right to trade through a clearing member; the CM adopts the full credit risk of the TM. If a TM fails, NSCC holds the relevant CM responsible.

F) MARGIN MONEY:
The aim of margin money is to minimize the risk of default by either countryparty. The payment of margin ensures that the risk is limited to the previous day’s price movement on each outstanding position. Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk of the stock/index margins are calculated. In general margin ranges between 10-50% of the contract value.
PURPOSE

57

The purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations. TYPES OF MARGIN INITIAL MARGIN: It is a amount that a trader must deposit before trading any futures. The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper completion of all obligations associated with a trader’s futures position, the initial margin is returned to the trader.

OBJECTIVE The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction. MAINTENANCE MARGIN: It is the minimum margin required to hold a position. Normally the maintenance is lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call to top up the margin account to the initial level before trading commencing on the next level. ADDITIONAL MARGIN: In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown . CROSS MARGINING: This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges. MARK-TO-MARKET MARGIN It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done.

58

TERMINAL OF TRADING
This is the sample terminal of reliance money with help of this terminal broker/dealer can traded online or offline in the market. The above sample shows the option index trading of S&P CNX NIFTY. It shows the different option price i.e at the money, in the money, out of the money, deep in the money and deep out of the money.

59

CHAPTER12 Myths and Realities of derivative in India
In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to

60

introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? What is the underlying truth behind such myths? The myths and the realities behind them are: 1. Derivatives increase speculation and do not serve any economic purpose Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices, or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance. 2. Indian Market is not ready for derivative trading Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives and how Indian market fares:
61

Large market Capitalization - India is one of the largest market-capitalized countries in Asia with a market capitalization of more than Rs.765000 crores. High Liquidity in the underlying - The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country's Market capitalization gets traded. These are clear indicators of high liquidity in the underlying. Trade guarantee - The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. A Strong Depository - National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country. A Good legal guardian - In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

3. Disasters prove that derivatives are very risky and highly leveraged instruments Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines. Some of the reasons behind disasters related to derivatives are: 1. Lack of independent risk management 2. Improper internal control mechanisms 3. Problems in external monitoring done by Exchanges and Regulators 4. Trader taking unauthorized positions 5. Lack of transparency in the entire process

62

.1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up in Mumbai in 1920. History and existence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign exchange markets. Government of India has also been facilitating the setting up and operations of these markets in India by providing approvals and defining appropriate regulatory frameworks for their operations. Approval for new exchanges in last six months by the Government of India also indicates that Government of India does not consider this type of trading to be harmful albeit within proper regulatory framework. This amply proves that the concept of options and futures has been well ingrained in the Indian equities market for a long time and is not alien as it is made out to be. Even today, complex strategies of options are being traded in many exchanges which are called teji-mandi, jota-phatak, and bhav-bhav at different places in India (Vohra and Bagari, 1998) in that sense; the derivatives are not new to India and are also currently prevalent in various markets including equities markets.

63

5. The existing capital market is safer than Derivatives? World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular day (T), you have to settle these trades on the third working day from the date of trading (T+3). Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock exchanges allow the participants to trade during one-week period for settlement in the following week. The trades are netted for the settlement for the entire one-week period. In that sense, the Indian markets are already operating the futures style settlement rather than cash markets prevalent internationally. In this system, additionally, many exchanges also allow the forward trading called badla in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent currently in France in their monthly settlement markets. It allowed one to even further increase the time to settle for almost 3 months under the earlier regulations. This way, a curious mix of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. The more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at the same time allow futures and options to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants. In addition the existing system although futures style does not ask for any margins from the clients. Given the volatility of the equities market in India, this system has become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failed on Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although, the exposure was so high and even the loss was also very big compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for a single minute.

64

CHAPTER13 Equity market scenario in India
The Indian Equity Market is more popularly known as the Indian Stock Market. The Indian equity market has become the third biggest after China and Hong Kong in the Asian region. According to the latest report by ADB, it has a market capitalization of nearly $600 billion. As of March 2009, the market capitalization was around $598.3 billion (Rs 30.13 lakh crore) which is onetenth of the combined valuation of the Asia region. The market was slow since early 2007 and continued till the first quarter of 2009. A stock exchange has been defined by the Securities Contract (Regulation) Act, 1956 as an organization, association or body of individuals established for regulating, and controlling of securities. The Indian equity market depends on three factors • • •

Funding into equity from all over the world Corporate houses performance Monsoons

The stock market in India does business with two types of fund namely private equity fund and venture capital fund. It also deals in transactions which are based on the two major indices - Bombay Stock Exchange (BSE) and National Stock Exchange of India Ltd. (NSE). The market also includes the debt market which is controlled by wholesale dealers, primary dealers and banks. The equity indexes are allied to countries beyond the border as common calamities affect markets. E.g. Indian and Bangladesh stock markets are affected by monsoons. The equity market is also affected through trade integration policy. The country has advanced both in foreign institutional investment (FII) and trade integration since 1995. This is a very attractive field for making profit for medium and long term investors, short-term swing and position traders and very intra day traders. The Indian market has 22 stock exchanges. The larger companies are enlisted with BSE and NSE. The smaller and medium companies are listed with OTCEI (Over The counter Exchange of India). The functions of the Equity Market in India are supervised by SEBI (Securities Exchange Board of India). History of Indian Equity Market The history of the Indian equity market goes back to the 18th century when securities of the East India Company were traded. Till the end of the 19th century, the trading of securities was unorganized and the main trading centers were Calcutta (now Kolkata) and Bombay (now Mumbai).

65

Trade activities prospered with an increase in share price in India with Bombay becoming the main source of cotton supply during the American Civil War (1860-61). In 1865, there was drop in share prices. The stockbroker association established the Native Shares and Stock Brokers Association in 1875 to organize their activities. In 1927, the BSE recognized this association, under the Bombay Securities Contracts Control Act, 1925. The Indian Equity Market was not well organized or developed before independence. After independence, new issues were supervised. The timing, floatation costs, pricing, interest rates were strictly controlled by the Controller of Capital Issue (CII). For four and half decades, companies were demoralized and not motivated from going public due to the rigid rules of the Government. In the 1950s, there was uncontrollable speculation and the market was known as 'Satta Bazaar'. Speculators aimed at companies like Tata Steel, Kohinoor Mills, Century Textiles, Bombay Dyeing and National Rayon. The Securities Contracts (Regulation) Act, 1956 was enacted by the Government of India. Financial institutions and state financial corporation were developed through an established network. In the 60s, the market was bearish due to massive wars and drought. Forward trading transactions and 'Contracts for Clearing' or 'badla' were banned by the Government. With financial institutions such as LIC, GIC, some revival in the markets could be seen. Then in 1964, UTI, the first mutual fund of India was formed. In the 70's, the trading of 'badla' resumed in a different form of 'hand delivery contract'. But the Government of India passed the Dividend Restriction Ordinance on 6th July, 1974. According to the ordinance, the dividend was fixed to 12% of Face Value or 1/3 rd of the profit under Section 369 of The Companies Act, 1956 whichever is lower. This resulted in a drop by 20% in market capitalization at BSE (Bombay Stock Exchange) overnight. The stock market was closed for nearly a fortnight. Numerous multinational companies were pulled out of India as they had to dissolve their majority stocks in India ventures for the Indian public under FERA, 1973. The 80's saw a growth in the Indian Equity Market. With liberalized policies of the government, it became lucrative for investors. The market saw an increase of stock exchanges, there was a surge in market capitalization rate and the paid up capital of the listed companies.

66

The 90s was the most crucial in the stock market's history. Indians became aware of 'liberalization' and 'globalization'. In May 1992, the Capital Issues (Control) Act, 1947 was abolished. SEBI which was the Indian Capital Market's regulator was given the power and overlook new trading policies, entry of private sector mutual funds and private sector banks, free prices, new stock exchanges, foreign institutional investors, and market boom and bust. In 1990, there was a major capital market scam where bankers and brokers were involved. With this, many investors left the market. Later there was a securities scam in 1991-92 which revealed the inefficiencies and inadequacies of the Indian financial system and called for reforms in the Indian Equity Market. Two new stock exchanges, NSE (National Stock Exchange of India) established in 1994 and OTCEI (Over the Counter Exchange of India) established in 1992 gave BSE a nationwide competition. In 1995-96, an amendment was made to the Securities Contracts (Regulation) Act, 1956 for introducing options trading. In April 1995, the National Securities Clearing Corporation (NSCC) and in November 1996, the National Securities Depository Limited (NSDL) were set up for demutualised trading, clearing and settlement. Information Technology scrip’s were the major players in the late 90s with companies like Wipro, Satyam, and Infosys. In the 21st century, there was the Ketan Parekh Scam. From 1st July 2001, 'Badla' was discontinued and there was introduction of rolling settlement in all scrip’s. In February 2000, permission was given for internet trading and from June, 2000, futures trading started.

67

CHAPTER14 DERIVATIVE PRODUCT IN INDIA TYPE OF DERIVATIVE PRODUCTS IN INDIA

 Index Futures A futures contract is a standardized contract to buy or sell a specific security at a future date at an agreed price. An index future is, as the name suggests, a future on the index i.e. the underlying is the index itself. There is no underlying security or a stock, which is to be delivered to fulfil the obligations as index futures are cash settled. As other derivatives, the contract derives its value from the underlying index. The underlying indices in this case will be the various eligible indices and as permitted by the Regulator from time to time.

 Index Options Options contract give its holder the right, but not the obligation, to buy or sell something on or before a specified date at a stated price. Generally index options are European Style. European Style options are those option contracts that can be exercised only on the expiration date. The underlying indices for index options are the various eligible indices and as permitted by the Regulator from time to time.

 Stock Futures A stock futures contract is a standardized contract to buy or sell a specific stock at a future date at an agreed price. A stock future is, as the name suggests, a future on a
68

stock i.e. the underlying is a stock. The contract derives its value from the underlying stock. Single stock futures are cash settled.

 Stock Options Options on Individual Stocks are options contracts where the underlying are individual stocks. Based on eligibility criteria and subject to the approval from the regulator, stocks are selected on which options are introduced. These contracts are cash settled and are American style. American Style options are those option contracts that can be exercised on or before the expiration date.

 Weekly Options Equity Futures & Options were introduced in India having a maximum life of 3 months. These options expire on the last Thursday of the expiring month. There was a need felt in the market for options of shorter maturity. To cater to this need of the market participants BSE launched weekly options on September 13, 2004 on 4 stocks and the BSE Sensex. Weekly options have the same characteristics as that of the Monthly Stock Options (stocks and indices) except that these options settle on Friday of every week. These options are introduced on Monday of every week and have a maturity of 2 weeks, expiring on Friday of the expiring week.

Hence this the different type of derivative product

The National stock Exchange (NSE) has the following derivative products: Products Underlying Instrument Type Trading Cycle Index Futures S&P CNX Nifty Index Options S&P CNX Nifty European Same as index futures
69

Futures on Individual Securities 30 securities stipulated by SEBI Same as index futures

maximum of 3Month trading cycle.

Options on Individual Securities 30 securities stipulated by SEBI American Same as index futures

Expiry Day Contract Size

Price Steps Base PriceFirst day of trading

At any point in time, there will be 3 contracts available : 1) near month, 2) mid month & 3) far month duration Last Thursday of the expiry month Permitted lot size is 200 & multiples Thereof Re.0.05 previous day closing Nifty value

Same as index futures Same as index futures

Same as index futures As stipulated by NSE (not less than Rs.2 lacs) previous day closing value of underlying security

Same as index futures As stipulated by NSE (not less than Rs.2 lacs) Same as Index options

Base PriceSubsequent Price Bands

Daily settlement Price Operating ranges are kept at + 10 %

Re.0.05 Theoretical value of the options contract arrived at based on BlackScholes model daily close price Operating ranges for are kept at 99% of the base price 20,000 units or greater

Daily settlement price Operating ranges are kept at + 20 %

Same as Index options Operating ranges for are kept at 99% of the base price Same as individual futures

Lower of 1% of Market wide position limit stipulated for open positions or Rs.5 crores BSE also offers similar products in the derivatives segment.

Quantity Freeze

20,000 units or Greater

70

CHAPTER15 DEVELOPMENT OF DERIVATIVE IN INDIA
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three– decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE– 30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. 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, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.

71

CHAPTER16 RESEARCH METHODOLOGY

OBJECTIVE • • • • • To understand the theoretical as well as practical knowledge of derivative market in India. To analyze investors perception toward investment in derivative market. Aim to understand the how much risk involve in derivative market To understand the online and offline trading To know how dealer can trade in derivative market

CONCLUSION: Derivatives allow firms and individuals to hedge risks and to take risks efficiently. In India very few people invest in derivative as compared to invest in equity and mutual fund.  SCOPE OF THE STUDY

Introduction of derivatives in the Indian capital market is the beginning of a new era which is truly exciting. Derivation worldwide is recognized risk management products. There products have a long history in India; in the unorganised sector especially in currency and commodity market. The availability of these products on organised exchanges has provided the market participants with broad risk management tools. This study mainly covers the area of hedging and speculation. The main aim of the study is to prove how risks in investing to equity share can be reduced and how to make maximum return to the other investment.

72

Method of data collection
Sources of Data (Primary & Secondary) In this project work primary and secondary data sources of data has been used. I. Primary data : Primary data is collected through observation and through direct communication. Under this, Survey method has been used. For this report primary data was collected by personally with derivative (f&o) investors and potential investors in different areas of Thane. II. Secondary data: It is the data which has already been collected by someone or organisation for some other purpose or research study. The data for study has been collected from various sources. • Books • Internet • Internal sources. Time: 58 day Sample size: The sample size of my project is limited to 60 only. Sample design: Data has been presented with the help of pie chart, graph, bar diagram.

73

LIMITAITONS OF STUDY
1. LIMITED TIME: The time available to conduct the study was only 58 day. It being a wide topic had a limited time. 2. LIMITED RESOURCES: Limited resources are available to collect the information about the derivative trading. 3. VOLATALITY: Share market is so much volatile and it is difficult to forecast anything about it whether you trade through online or offline 4. ASPECTS COVERAGE: Some of the aspects may not be covered in my study

74

CHAPTER 18
DATA ANALYSIS AND INTERPRETATION Sample taken - 60 Q1) Have you invested in derivative market? Option YES NO Total Number of respondents 23 37 60 percentage 38.33333333 61.66666667 100

Interpretation: The study shows that most of the people are not aware about derivative .The following pie diagram reveal that only 38% of people invest in derivative product.

75

Q2) Educational qualification of people those who are invested and not invest in derivative product? (According to sample survey) Option Undergraduate Graduate Post graduate Professional Total Respondents 9 12 16 24 60 Percentage 15% 20% 25% 40% 100%

INTERPRETATION: The following pie diagram shows 40% of the total sample size for the survey is professionals. This taken with the view to analyse whether professional invest in Derivative products

76

Q3) INCOME RANGE: OPTION Below 150k 150k-300k 300k-500k Above 500k Total RESPONDENTS 2 3 8 9 23 PERCENTAGE 8.695652174 13.04347826 34.7826087 39.13043478 100

INTERPRETATION: The following bar graph shows 39% of the people surveyed are having income more than 500k

77

Q4) what percentage of monthly house hold income could be available for investment?

Option 5%-10% 11%-15% 16%-20% 21%-25% more than 25% Total

Respondents 3 6 7 5 2 23

Percentage 13.04347826 26.08695652 30.43478261 21.73913043 8.695652174 100

Interpretation: The following cone diagram shows 30% of the people invest 16%-20%of their income. Most of the respondents invest 11% to 25%of their surplus income in the equity market

78

Q5) Have you invested in Equity (Shares/Mutual funds)? Number of respondents 39 21 60

Option YES NO Total

percentage 65 35 100

INTERPRETATION: The following pie diagram shows 65% of people are investing in equity through shares or mutual funds.

79

Q6) Participation in derivative market as: Option Investor Speculators broker/dealer Hedger Total Respondents 9 4 7 3 23 percentage 39.13043478 17.39130435 30.43478261 13.04347826 100

INTERPRETATION: The following area graph show more people participate as a investor in the market according to survey less no of people in participate as a hedger

80

Q7) Reasons for not investing in derivative product? option lack of knowledge increase speculation Risky & highly leverage counterpart risk Total respondents percentage 26 70.27027027 6 5 0 37 16.21621622 13.51351351 0 100

INTERPRETATION: The following pyramid chart shows most of the people have not invested because of lack of knowledge.

81

Q8) Experience of investment in derivative instruments? option Great result moderate but acceptable Disappointed total respondents 5 14 4 23 Percentage 21.73913043 60.86956522 17.39130435 100

INTERPRETATION: The following bar graph shows most of investors getting moderate but acceptable result. That is around 61%.

82

CHAPTER 19 RECOMMONDATION AND SUGGESTION (SUMMARY)

• • • • • • • • •

Most of the people are not aware about derivative product in india More risk involve in derivative that is second reason people are not invest in derivative product Sebi should conduct demo lecture/ seminars regarding the use of derivatives to educate individual investors. Most of the people in India invest in option index. Because they have fear of other index. Derivative market in India should be developed in order to keep it at par with other derivatives market in the world. RBI should play a greater role in supporting derivatives. Speculation should be discouraged There must be more derivative instruments aimed at individual investors. Most of the people are not aware because the syllabus of derivative market not includes upto graduation level.

83

Chapter 20 BIBILOGRAPHY  Books:

• • •

Options, futures, and other derivatives by john hull. NSE’s certification in financial markets – dealers module Ajay shah of book (Introduction to derivative market)

 Web sites visited:

www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.google.com www.derivativeindia.com
84

www.surveymoney.com www.rediff.con/finance www.yahoo.com/finance www.sbcrb.com www.cboe.com

APPENDIX

SAMPLE SURVEY
Survey questionnaire of investors for perception towards investment in derivative market
85

Dear sir/ madam    This questionnaire is meant for educational purpose only. The information provided by you will be kept secure & confidential. This questionnaire only for those who are traded.

o Questions: Q1) what is your primary investment purpose? a) Retirement planning b) ULIPs c) Future education of children d) other Q2) what kind of risk do you perceive while investing in the stock market? a) Uncertainty of returns b) slump in stock market c) Fear of windup of company d) others Q3) Have you invested in derivative products a) Yes b) No If NO go to questionQ4, otherwise Q5 Q4) why you have not invested in derivative market? a) Lack of knowledge b) Increase speculation c) Risky & highly leveraged d) counter party risk Q5) you participate in derivative market as: a) Investor b) speculator c) Broker/ dealer d) hedger Q6) what is the purpose of investing in derivative market? a) Hedge their fund b) risk control c) Direct investment without buying and holding of assets d) More stable Q7) from where you prefer to take advice before investing in derivative market a) Brokerage house b) research analyst c) Websites d) news networks e) Other

Q8) in which of the following would you like to participate: a) Stock index future b) stock index option c) Future on individual stock d) option on individual stock e) Currency future. Q9) what contract maturity period would interest you for trading in? a) 1 month b) 2 month c) 3 month d) 6 month
86

e) 9 month

f) 12 month

Q10) how often do you invest in derivative market? a) 1-10 times in a year b) 11-50 times in year c) More than 50 times in a year d) Regularly Q11) Are you trading other than F&O? o YES o NO Q12) what was the result of your investment? o Great result o Moderate but acceptable o Disappointed

DEMOGRAPHY  Educational qualification a) Undergraduate b) graduate d) professional

c) Post graduate

87

 Income range? a) Below 150k d) Above 500k

b) 150k-300k

c) 300k-500k

 Normally what percentage of your monthly house held income could be available for investment? a) 5%-10% b) 11%-15% c) 16%-20% d) 21%-25% e) More than 25%

Name....................................................................... Age........................................................................... Contact..................................................................... Gender...................................................................... Occupation................................................................

Thanking you From Binu d Pandey

LIST OF ABBREVIATIONS NCDEX: National Commodity and Derivatives Exchange Limited MCX: Multi Commodity Exchange of India Limited NSDL: National securities depository service ltd CDSL: Central depository service ltd
88

RCL: Reliance capital ltd BSE: Bombay Stock Exchange of India ltd NSE: National Stock Exchange of India ltd CBOE: Chicago Board of Options Exchange OTC: Over the counter LIC: Life Insurance Corporation of India ltd CRISIL: Credit Rating Information Service of India ltd NABARD: National Bank for Agriculture and Rural Development IFFCO: Indian Farmers Fertilizer cooperative ltd NMCEIL: National Multi-Commodity Exchange of India ltd RTGS: Real Time Gross Settlement

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

Sign up to vote on this title
UsefulNot useful