CONTENTS

 ACKNOWLEDGEMENT
 SUMMARY
 INTRODUCTION
MEANING OF STOCK MARKET
TRADING
STOCK MARKET INDEX
DERIVATIVE
NSE, BSE
 OBJECTIVE OF REPORT
 MEANING OF DERIVATIVE
 ROLE OF DERIVATIVE
 CONCLUSION
 BIBLIOGRAPHY


 ACKNOWLEDGEMENT

On this modest endeavour , its our moral duty to acknowledge with a deep sense of gratitude, the
valuable help and encouragement rendered to us by one and all. I would like to thanks all the
staff of IILM- Academy of Higher Learning, Jaipur, without whose valuable guidance, enormous
patience and constant encouragement, this work would not have been possible.

Is incredibly to express emotions on paper and words are a poor recompense for the fevers
recuried . I express my deep sense of gratitude to Mrs Dhwani Misra Assistant Professer
IILM-AHL, Jaipur for his keen interest and valuable guidance from time to time, which has
helped us immensely in developing the seminar to its present form.

I would also like to give thanks to my Family members and to all my friends at IILM-
AHL, who gave their valuable time to me and spread their best help in this seminar work.

(Sandhya Saini)

(MBA Part-I, Semester II)

ABSTRACT

The expression 'stock market' refers to the market that enables the trading of company stocks
(collective shares), other securities, and derivatives. Bonds are still traditionally traded in an
informal, over-the-counter market known as the bond market. Commodities are traded in
commodities markets, and derivatives are traded in a variety of markets (but, like bonds, mostly
'over-the-counter').
The size of the worldwide 'bond market' is estimated at $45 trillion. The size of the 'stock market'
is estimated at about $51 trillion. The world derivatives market has been estimated at about $480
trillion 'face' or nominal value, 30 times the size of the U.S. economy…and 12 times the size of
the entire world economy.
The stocks are listed and traded on stock exchanges which are entities (a corporation or mutual
organization) specialized in the business of bringing buyers and sellers of stocks and securities
together. The stock market in the United States includes the trading of all securities listed on the
NYSE, the NASDAQ, the Amex, as well as on the many regional exchanges, e.g. OTCBB and
Pink Sheets. European examples of stock exchanges include the Paris Bourse (now part of
Euronext), the London Stock Exchange and the Deutsche.
 Introduction

Meaning of stock market

A stock market is a private or public market for the trading of company stock and derivatives of
company stock at an agreed price; both of these are securities listed on a stock exchange as well
as those only traded privately.
Trading
Participants in the stock market range from small individual stock investors to large hedge fund
traders, who can be based anywhere. Their orders usually end up with a professional at a stock
exchange, who executes the order.
Some exchanges are physical locations where transactions are carried out on a trading floor, by a
method known as open outcry. This type of auction is used in stock exchanges and commodity
exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of
exchange is a virtual kind, composed of a network of computers where trades are made
electronically via traders.
Actual trades are based on an auction market paradigm where a potential buyer bids a specific
price for a stock and a potential seller asks a specific price for the stock. (Buying or selling at
market means you will accept any ask price or bid price for the stock, respectively.) When the bid
and ask prices match, a sale takes place on a first come first served basis if there are multiple
bidders or askers at a given price.
Stock market index
The movements of the prices in a market or section of a market are captured in price indices
called stock market indices, of which there are many, e.g., the S&P, the FTSE and the Euronext
indices. Such indices are usually market capitalization (the total market value of floating capital
of the company) weighted, with the weights reflecting the contribution of the stock to the index.
The constituents of the index are reviewed frequently to include/exclude stocks in order to reflect
the changing business environment.
Derivative instruments
Main article: Derivative (finance)
Financial innovation has brought many new financial instruments whose pay-offs or values
depend on the prices of stocks. Some examples are exchange-traded funds (ETFs), stock index
and stock options, equity swaps, single-stock futures, and stock index futures. These last two
may be traded on futures exchanges (which are distinct from stock exchanges—their history
traces back to commodities futures exchanges), or traded over-the-counter. As all of these
products are only derived from stocks, they are sometimes considered to be traded in a
(hypothetical) derivatives market, rather than the (hypothetical) stock market.
The Bombay Stock Exchange

The Bombay Stock Exchange

The Bombay Stock Exchange Limited (Marathi:मंबु ई शेयर बाजार) (formerly, The
Stock Exchange, Mumbai; popularly called The Bombay Stock Exchange, or BSE) is the oldest
stock exchange in Asia. It is located at Dalal Street, Mumbai, India.

The Bombay Stock Exchange was established in 1875. There are around 4,800 Indian companies
listed with the stock exchange[1], and has a significant trading volume. As of August 2007, the
equity market capitalization of the companies listed on the BSE was US $ 1.11 trillion [2]. The
BSE SENSEX (SENSitive indEX), also called the "BSE 30", is a widely used market index in
India and Asia. It is located at Dalal Street, Mumbai, India.

Bombay Stock Exchange was established in 1875. There are around 4,800 Indian companies
listed with the stock exchange[1], and has a significant trading volume. As of August 2007, the
equity market capitalization of the companies listed on the BSE was US $ 1.11 trillion [2]. The
BSE SENSEX (SENSitive indEX), also called the "BSE 30", is a widely used market index in
India and Asia .

National stock Exchange

The National Stock Exchange of India Limited (NSE), is a Mumbai-based
stock exchange. It is the largest stock exchange in India and the third largest in the world in
terms of volume of transactions[1]. NSE is mutually-owned by a set of leading financial
institutions, banks, insurance companies and other financial intermediaries in India but its
ownership and management operate as separate entities[2]. As of 2006, the NSE VSAT terminals,
2799 in total, cover more than 1500 cities across India [3]. In July 2007, the NSE had a total
market capitalization of 42,74,509 crore INR making it the second-largest stock market in South
Asia in terms of market-capitalization[4].

The National Stock Exchange of India was promoted by leading Financial institutions at the
behest of the Government of India, and was incorporated in November 1992 as a tax-paying
company. In April 1993, it was recognized as a stock exchange under the Securities Contracts
(Regulation) Act, 1956. NSE commenced operations in the Wholesale Debt Market (WDM)
segment in June 1994. The Capital Market (Equities) segment of the NSE commenced operations
in November 1994, while operations in the Derivatives segment commenced in June 2000

Hang Seng Index

Hang Seng" redirects here. For the bank with the same name, see Hang Seng Bank. For all other
uses, see Hang Seng (disambiguation).
The Hang Seng Index (abbreviated: HSI, Chinese: 恒 生 指 數 ) is a freefloat-adjusted market
capitalization-weighted stock market index in Hong Kong. It is used to record and monitor daily
changes of the largest companies of the Hong Kong stock market and is the main indicator of the
overall market performance in Hong Kong. These 40 companies represent about 65% of
capitalization of the Hong Kong Stock Exchange.

Stock market crash

A stock market crash is often defined as a sharp dip in share prices of equities listed on the stock
exchanges. In parallel with various economic factors, a reason for stock market crashes is also
due to panic. Often, stock market crashes end up with speculative economic bubbles.
There have been famous stock market crashes that have ended in the loss of billions of dollars
and wealth destruction on a massive scale. An increasing number of people are involved in the
stock market, especially since the social security and retirement plans are being increasingly
privatized and linked to stocks and bonds and other elements of the market. There have been a
number of famous stock market crashes like the Wall Street Crash of 1929, the stock market
crash of 1973–4, the Black Monday of 1987, the Dot-com bubble of 2000. But those stock
market crashes did not begin in 1929, or 1987. They actually started years or months before the
crash really hit hard.
One of the most famous stock market crashes started October 24, 1929 on Black Thursday. The
Dow Jones Industrial lost 50% during this stock market crash. It was the beginning of the Great
Depression. Another famous crash took place on October 19, 1987 – Black Monday. On Black
Monday itself, the Dow Jones fell by 22.6% after completing a 5 year continuous rise in share
prices. This event not only shook the USA, but quickly spread across the world. Thus, by the end
of October, stock exchanges in Australia lost 41.8%, Canada lost 22.5%, Hong Kong lost 45.8%
and Great Britain lost 26.4%. Names “Black Monday” and “Black Tuesday” are also used for
October 28-29,1929, which followed Terrible Thursday – starting day of the stock market crash
in 1929

Function and purpose

The stock market is one of the most important sources for companies to raise money. This
allows businesses to go public, or raise additional capital for expansion. The liquidity that an
exchange provides affords investors the ability to quickly and easily sell securities. This is an
attractive feature of investing in stocks, compared to other less liquid investments such as real
estate.
History has shown that the price of shares and other assets is an important part of the dynamics
of economic activity, and can influence or be an indicator of social mood. Rising share prices,
for instance, tend to be associated with increased business investment and vice versa. Share
prices also affect the wealth of households and their consumption. Therefore, central banks tend
to keep an eye on the control and behavior of the stock market and, in general, on the smooth
operation of financial system functions. Financial stability is the raison d'être of central banks.
Exchanges also act as the clearinghouse for each transaction, meaning that they collect and
deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an
individual buyer or seller that the counterparty could default on the transaction.
The smooth functioning of all these activities facilitates economic growth in that lower costs and
enterprise risks promote the production of goods and services as well as employment. In this way
the financial system contributes to increased prosperity.

Relation of the stock market to the modern financial system

The financial system in most western countries has undergone a remarkable transformation. One
feature of this development is disintermediation. A portion of the funds involved in saving and
financing flows directly to the financial markets instead of being routed via banks' traditional
lending and deposit operations. The general public's heightened interest in investing in the stock
market, either directly or through mutual funds, has been an important component of this
process. Statistics show that in recent decades shares have made up an increasingly large
proportion of households' financial assets in many countries. In the 1970s, in Sweden, deposit
accounts and other very liquid assets with little risk made up almost 60 per cent of households'
financial wealth, compared to less than 20 per cent in the 2000s. The major part of this
adjustment in financial portfolios has gone directly to shares but a good deal now takes the form
of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual
funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving
with a higher risk has been accentuated by new rules for most funds and insurance, permitting a
higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized
countries. In all developed economic systems, such as the European Union, the United States,
Japan and other developed nations, the trend has been the same: saving has moved away from
traditional (government insured) bank deposits to more risky securities of one sort or another.

The stock market, individual investors, and financial risk

Riskier long-term saving requires that an individual possess the ability to manage the associated
increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government
insured) bank deposits or bonds. This is something that could affect not only the individual
investor or household, but also the economy on a large scale. The following deals with some of
the risks of the financial sector in general and the stock market in particular. This is certainly
more important now that so many newcomers have entered the stock market, or have acquired
other 'risky' investments (such as 'investment' property, i.e., real estate and collectables).
With each passing year, the noise level in the stock market rises. Television commentators,
financial writers, analysts, and market strategists are all overtalking each other to get investors'
attention. At the same time, individual investors, immersed in chat rooms and message boards,
are exchanging questionable and often misleading tips. Yet, despite all this available
information, investors find it increasingly difficult to profit. Stock prices skyrocket with little
reason, then plummet just as quickly, and people who have turned to investing for their children's
education and their own retirement become frightened. Sometimes there appears to be no rhyme
or reason to the market, only folly.

This is a quote from the preface to a published biography about the long-term value-oriented
stock investor Warren Buffett.[2] Buffett began his career with $100, and $105,000 from seven
limited partners consisting of Buffett's family and friends. Over the years he has built himself a
multi-billion-dollar fortune. The quote illustrates some of what has been happening in the stock
market during the end of the 20th century and the beginning of the 21st.
The behavior of the stock market

NASDAQ in Times Square, New York City.

From experience we know that investors may temporarily pull financial prices away from their
long term trend level. Over-reactions may occur—so that excessive optimism (euphoria) may
drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical
and empirical arguments have been put forward against the notion that financial markets are
efficient.
According to the efficient market hypothesis (EMH), only changes in fundamental factors, such
as profits or dividends, ought to affect share prices. (But this largely theoretic academic
viewpoint also predicts that little or no trading should take place—contrary to fact—since prices
are already at or near equilibrium, having priced in all public knowledge.) But the efficient-
market hypothesis is sorely tested by such events as the stock market crash in 1987, when the
Dow Jones index plummeted 22.6 percent—the largest-ever one-day fall in the United States.
This event demonstrated that share prices can fall dramatically even though, to this day, it is
impossible to fix a definite cause: a thorough search failed to detect any specific or unexpected
development that might account for the crash. It also seems to be the case more generally that
many price movements are not occasioned by new information; a study of the fifty largest one-
day share price movements in the United States in the post-war period confirms this.[3] Moreover,
while the EMH predicts that all price movement (in the absence of change in fundamental
information) is random (i.e., non-trending), many studies have shown a marked tendency for the
stock market to trend over time periods of weeks or longer.
Various explanations for large price movements have been promulgated. For instance, some
research has shown that changes in estimated risk, and the use of certain strategies, such as stop-
loss limits and Value at Risk limits, theoretically could cause financial markets to overreact.
Other research has shown that psychological factors may result in exaggerated stock price
movements. Psychological research has demonstrated that people are predisposed to 'seeing'
patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing
familiar shapes in clouds or ink blots.) In the present context this means that a succession of
good news items about a company may lead investors to overreact positively (unjustifiably
driving the price up). A period of good returns also boosts the investor's self-confidence,
reducing his (psychological) risk threshold.[4]
Another phenomenon—also from psychology—that works against an objective assessment is
group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from
that of a majority of the group. An example with which one may be familiar is the reluctance to
enter a restaurant that is empty; people generally prefer to have their opinion validated by those
of others in the group.
In one paper the authors draw an analogy with gambling. [5] In normal times the market behaves
like a game of roulette; the probabilities are known and largely independent of the investment
decisions of the different players. In times of market stress, however, the game becomes more
like poker (herding behavior takes over). The players now must give heavy weight to the
psychology of other investors and how they are likely to react psychologically.
The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced
investors rarely get the assistance and support they need. In the period running up to the recent
Nasdaq crash, less than 1 per cent of the analyst's recommendations had been to sell (and even
during the 2000 - 2002 crash, the average did not rise above 5%). The media amplified the
general euphoria, with reports of rapidly rising share prices and the notion that large sums of
money could be quickly earned in the so-called new economy stock market. (And later amplified
the gloom which descended during the 2000 - 2002 crash, so that by summer of 2002,
predictions of a DOW average below 5000 were quite common.)

Irrational behavior
Sometimes the market tends to react irrationally to economic news, even if that news has no real
effect on the technical value of securities itself. Therefore, the stock market can be swayed
tremendously in either direction by press releases, rumors, euphoria and mass panic.
Over the short-term, stocks and other securities can be battered or buoyed by any number of fast
market-changing events, making the stock market difficult to predict.

Derivatives & The Stock Market:

What You NEED to Know
Many people are talking about the Stock Market.  But hardly anyone is talking about
Derivatives.  Strange - because size for size the Stock Market is the size of a mouse and
Derivatives are the size of an elephant.
What are derivatives?
A derivative is basically a bet.  It includes such things as options and futures, but there are all
kinds of derivatives available now - including bets on interest rates and even on the weather!!!
The size of the derivatives market has become important in the last 15 years or so.
In 2007 the total world derivatives market expanded to $516 trillion!!!!
Look at the following chart which shows the growth in derivatives over the last 20 years The
data is from an ISDA market survey and the International Monetary Fund GDP. You can see the
explosive growth. Note that there are SIX times the amount of derivatives as the total world
GDP. Isn't that a bubble? What will happen when it pops?

I presume the left hand side is Millions of $.

DERIVATIVES

Derivatives are financial contracts designed to create pure price exposure

to an underlying commodity, asset, rate, index or event. In general they do not
involve the exchange or transfer of principal or title. Rather their purpose is to
capture, in the form of price changes, some underlying price change or event.
The term derivative refers to how the price of these contracts is derived from the
price of some underlying security or commodity or from some index, interest rate
or exchange rate. Examples of derivatives include futures, forwards, options and
swaps, and these can be combined with each other or traditional securities and
loans in order to create hybrid instruments.

Derivatives play an important and useful role in hedging and managing

risk, but they also pose several dangers to the stability of financial markets and
the overall economy. Derivatives can also be used for unproductive purposes
such as the avoidance of taxation, the outflanking prudential regulation of
financial markets and the manipulation of accounting rules, credit ratings and
financial reports.

As a testament to their usefulness, derivatives have played a role in

commerce and finance for thousands of years. Derivatives contracts have been
found written on clay tablets from Mesopotamia that date to 1750 B.C. Aristotle
mentioned an option on the use of olive oil presses in his Politics some 2,500
years ago. The Japanese traded futures-like contracts on warehouse receipts or
rice in the 1700s. In the U.S., forward and futures contracts have been formally
traded on the Chicago Board of Trade since 1849. Today the size of derivatives
markets is estimated by the Bank of International Settlements to exceed $109
trillion in outstanding contracts and over $400 trillion in trading volume on
derivatives exchanges.

Derivatives are useful for hedging the risks normally associated with
commerce and finance. Farmers can use derivatives the hedge the risk that the
price of their crops fall before they are harvested and brought to market. Banks
can use derivatives to reduce the risk that the short-term interest rates they pay to
their depositors will rise against the fixed interest rate they earn on their loans and
other assets. Pension funds and insurance companies can use derivatives to hedge
against large drops in the value of their portfolios.

As an indication of the dangers they pose, it is worthwhile recalling a

shortened list of recent disasters. Long-Term Capital Management collapsed with
$1.4 trillion in derivatives on their books. Sumitomo Bank in Japan used
derivatives their manipulation of the global copper market for years prior to 1996.
Barings bank, one of the oldest in Europe, was quickly brought to bankruptcy by
over a billion dollars in losses from derivatives trading. Both the Mexican
financial crisis in 1994 and the East Asian financial crisis of 1997 were
exacerbated by the use of derivatives to take large positions on the exchange rate.
Most recently, the collapse of a major commodity derivatives dealer Enron
Corporation has lead to the largest bankruptcy in U.S. history.

The first public interest concerns posed by derivatives comes from the
leverage they provide to both hedgers and speculators. Derivatives transactions
allow investors to take a large price position in the market while committing only
a small amount of capital – thus the use of their capital is leveraged. Derivatives
traded in over-the-counter markets have no margin or collateral requirements, and
the industry standard has shown to be deeply flawed by recent failures.

Leverage makes it cheaper for hedgers to hedge, but it also makes it

cheaper to speculate. Instead of buying $1 million of Treasury bonds or $1
million of stock, an investor can buy futures contracts on $1 million of the bonds
or stocks with only a few thousand dollars of capital committed as margin (the
capital commitment is even smaller in the over-the-counter derivatives markets).
The returns from holding the stocks or bonds will be the same as holding the
futures on the stocks or bonds. This allows an investor to earn a much higher rate
of return on their capital by taking on a much larger amount of risk.

Taking on these greater risks raises the likelihood that an investor, even a
major financial institution, suffers large losses. If they suffer large losses, then
they are threatened with bankruptcy. If they go bankrupt, then the people, banks
and other institutions that invested in them or lent money to them will face losses
and in turn might face bankruptcy themselves. This spreading of the losses and
failures gives rise to systemic risk, and it is an economy wide problem that is
made worse by leverage and leveraging instruments such as derivatives. When
people suffer damages, even though they were not counterparties or did any
business with a failed investor or financial institution, then individual incentives
and rules of caveat emptor are not sufficient to protect the public good. In this
case, prudential regulation is needed – not to protect fools from themselves, but to
protect others from the fools.

Another public interest concern involves transparency. Some derivatives

are traded on formal futures and options exchanges which are closely regulated.
Other derivatives are traded over-the-counter in markets that are almost entirely
unregulated. In these non-transparent markets there is very little information
provided by either the private market participants or collected by government
regulators. Prices and other trading information in these markets is not readily
available as is the case with futures and options exchanges. Instead that
information is hoarded by each of the market participants. While standard
theories of financial markets agree that more transparent markets are more
efficient, it requires a public entity to require information be reported and
disseminated to the market.
 

As a result of this lack of information in over-the-counter markets, it

substantially reduces the ability of the government and other market participants
to anticipate and possibly preempt building market pressures, major market
failures, or manipulation efforts.

Yet another danger involves the use of derivatives to evade, avoid, dodge
or out-flank financial market regulations designed to improve economic stability.
In the cases of this decade’s financial crises in Mexico and East Asian, the
financial institutions in those countries used derivatives to out-flank financial
regulations limiting those institutions exposure to foreign exchange risk.
Derivatives can also be used to avoid taxation and manipulate accounting rules
my restructuring the flow of payments so that earning are reported in one period
instead of another.

In sum, the enormous derivatives markets are both useful and dangerous.
Current method of regulating these markets is not adequate to assure that the
markets are safe and sound and that disruptions from these markets do not spill-
over into the broader economy.
 
Some useful definitions:
 

             Forward contract: The original and most basic form of a

derivative contract, a forward transaction is an agreement to buy or
sell a certain quantity of an asset or commodity in the future at a
specified price, time and place. For example, party A agrees to sell
1 million Euro in six months at $0.9402.

             Futures. A standardized agreement to buy or sell a certain

quantity of an asset or commodity in the future at a specified price,
time and place. They are standardized as to the quantity, the specific
underlying assets or commodities and the time. Only the price and
the number of contracts are negotiated in the trading process. For
example, party A sells 10 contracts that set the price of the S&P500
stock index at 1500 in October – if the price falls below 1500 then
party A will profit by the amount the price is below 15000, and if
the price rises above 1500 then party A loses by the amount the
price exceeds 1500.

             Option. An agreement that grants the options buyer the

right, but not the obligation, to buy or sell an asset or commodity at
a specified “strike” price on or before a certain date. A call option
grants the right to buy at the specified strike price, and so it pays off
if the market price for the underlying item rises above that mark. A
put option grants the right to sell as the strike price and pays off
when the market price falls below the strike price. On the other
hand, an option seller or “options writer” has the obligation to pay
when the options buyer exercises their right. Options are traded on
both exchanges and OTC markets. For example, party A buys a call
that grants them the right to buy 1 million Euros at $0.9400 in
September.

 
              Forward rate agreement (FRA). An agreement to borrow
or lend a certain amount of principal at a specified interest rate and
time.
 
             Swap. An agree to swap the net value of two series of
payments in which one is usually based on a fixed interest rate and
the other is linked to a variable interest rate, an interest rate in
another currency, the total rate of return of a security or index, or a
commodity price.
 
             Structured note. A hybrid instrument that combines a bond
or loan with a derivative. A traditional type of structured note is a
callable bond.

Indian Stock Market - Trade Indian Share Market, Equities / Derivatives at NSE & BSE
Trading the Indian Stock Market has become an art. Some of us try to
gauge the direction and help all by posting some or the other
information. This is one of them. We however do not claim success for
success lies with someone who acts at the right time. We claim no
responsibility to your success/failure. We do pray that you succeed
most of the time if not always.
derivatives
A derivative is a financial instrument, which derives its value from some other financial price.
This "other financial price" is called the underlying. In the case of Nifty futures, Nifty index i
Derivatives OUP 1 2 Price volatility may reflect changes in the underlying demand and supply
conditions and thereby provide useful information about the market. Thus, economists do not
view volatility as necessarily har Derivatives OUP 1 2 Price volatility may reflect changes in the
underlying demand and supply conditions and thereby provide useful information about the
market. Thus, economists do not view volatility as necessarily harmful.
3 Speculators face the risk of losing money from their derivatives trades, as they do with other
securities. There have been some well-publicized cases of large losses from derivatives trading.
In some instances, these losses stemmed from fraudulent behavior that went undetected partly
because companies did not have adequate risk management systems in place. In other cases,
users failed to understand why and how they were taking positions in the derivatives.
buy

ollapse as well as the Orange County episodes have helped strengthen the idea
that derivative trading is nothing but reckless speculation.
But this notion is not true. Used carefully, a derivative transaction helps cover risks which
would arise on the trading of securities on which the derivative is based. A derivative
security, can be defined as a security whose value depends on the values of other
underlying variables. Very often, the variables underlying the derivative securities are the
prices of traded securities. A stock option, for example, is a derivative security whose
value is contingent upon the price of a stock. However, derivative securities can be
contingent upon the price of almost any variable. For this reason, another name accorded
to d

Uses of Derivatives

Derivatives can be used as a convenient substitute for other

investments, leaving risks and rewards unchanged -- For example,
instead of buying each of the stocks in
Standard & Poor’s index of the 500 largest US stocks, a pension fund might buy an S&P
500 futures contract of the same face value and set aside the full value in cash reserves.
This strategy is no more or less risky than buying the stocks themselves, but uses futures
as an efficient medium for investments.
Derivatives can be used to hedge other instruments and thereby reduce risks and
rewards or can help manage the risks inherent in a business -- For example, a
pension fund that owns $ 1 billion of large US stocks, but realises that a temporary
market decline is imminent may sell $ 1 billion of futures contract or buy $ 1 billion of put
options, to protect its portfolio against the risk of a general market decline.
In the context of currency fluctuations, exporters face losses if the rupee appreciates and
importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee
forward market, they supply insurance to each other and reduce the risk.
Derivatives can be used speculatively to increase risk and
reward through leverage-
- For example, an investor with $ 1 million could buy futures contracts with a face value
equal to $ 10 million of stock. This investor is taking a big risk in the hope of a gain,
leveraging the investment approximately 10:1. if the stock market goes up 10 percent,
increasing the value of the stock up to $ 11 million, then the investor has made a $ 1
million profit, doubling his initial $ 1 million investment. If the stock market goes down 10
percent, decreasing the value of the stock to $ 9 million, then all of the investors money is
lost.
Derivatives are also the basis for modern financial
engineering-- For example,
mortgage derivatives may be used to create a repackaged asset which is only part of an
underlying bundle of mortgages financially engineered into a variety of sub-divided forms.
One derivative might pass on only the interest payments of the underlying mortgages
while another may pass on only the principal. These new instruments would be an
additional attraction for the investors with varying needs.
In addition, index based derivatives are very useful in minimising risks. An investor who
buys stocks may like to enjoy peace of mind by capping his downside loss. Put options on
the index are the ideal form of insurance here. Regardless of the composition of a
person’s portfolio, index put options will protect him from exposure to a fall in the index.
To illustrate, suppose a person has a portfolio worth Rs 1 million and suppose the Nifty
(NSE 50 Index) is at 1000. This investor decides that he does not want to suffer a loss
worse than 12 Price volatility may reflect changes in the underlying demand and supply
conditions and thereby provide useful information about the market. Thus, economists do not
view volatility as necessarily harmful.
3 Speculators face the risk of losing money from their derivatives trades, as they do with other
securities. There have been some well-publicized cases of large losses from derivatives trading.
In some instances, these losses stemmed from fraudulent behavior that went undetected partly
because companies did not have adequate risk management systems in place. In other cases,
users failed to understand why and how they were taking positions in the derivatives.
1. Rise of Derivatives
The global economic order that emerged after World War II was a system where many less
developed countries administered prices and centrally allocated resources. Even the developed
economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and
unemployment rates made interest rates more volatile. The Bretton Woods system was
dismantled in
The global economic order that emerged after World War II was a system where many less
developed countries administered prices and centrally allocated resources. Even the developed
economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and
unemployment rates made interest rates more volatile. The Bretton Woods system was
dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India
began opening up their economies and allowing prices to vary with market conditions.
Price fluctuations make it hard for businesses to estimate their future production costs and
revenues.2 Derivative securities provide them a valuable set of tools for managing this risk. This
article describes the evolution of Indian derivatives markets, the popular derivatives instruments,
and the main users of derivatives in India. I conclude by assessing the outlook for Indian
derivatives markets in the near and medium term.
2. Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the value of something
else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an
index of prices. In the Appendix, I describe some simple types of derivatives: forwards, futures,
options and swaps.
Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some
preexisting risk by taking positions in derivatives markets that offset potential losses in the
underlying or spot market. In India, most derivatives users describe themselves as hedgers
(FitchRatings, 2004) and Indian laws generally require that derivatives be used for hedging
purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to
profit from anticipated price movements). In practice, it may be difficult to distinguish whether a
particular trade was for hedging or speculation, and active markets require the participation of
both hedgers and speculators.3
A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot
and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003)
describe India’s long history in arbitrage trading, with line operators and traders arbitraging
prices between exchanges located in different cities, and between two exchanges in the same
city. Their study of Indian equity derivatives markets in 2002 indicates that markets were
inefficient at that time. They argue that lack of knowledge, market frictions and regulatory
impediments have led to low levels of capital employed Derivatives OUP 2

3. 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.5
4. Development of Derivative Markets in India
Derivatives markets have been in existence in India in some form or other for a long time. In the
area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,
by the early 1900s India had one of the world’s largest futures industry. In 1952 the government
banned cash settlement and options trading and derivatives trading shifted to informal forwards
markets. In recent years, government policy has changed, allowing for an increased role for
market-based pricing and less suspicion of derivatives trading. The ban on futures trading of
many commodities was lifted starting in the early 2000s, and national electronic commodity
exchanges were created.
In the equity markets, a system of trading called “badla” involving some elements of forwards
trading had been in existence for decades.6 However, the system led to a number of undesirable
practices and it was prohibited off and on till the Securities and Derivatives OUP 3
7 Volatility is measured as the yearly standard deviation of the daily exchange rate series.
Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock
market between 1993 and 1996 paved the way for the development of exchange-traded equity
derivatives markets in India. In 1993, the government created the NSE in collaboration with
state-owned financial institutions. NSE improved the efficiency and transparency of the stock
markets by offering a fully automated screen-based trading system and real-time price
dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a
proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta
Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-
level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and
advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various
operational details such as the margining systems. In 1999, the Securities Contracts (Regulation)
Act of 1956, or SC(R)A, was amended so that derivatives could be declared “securities.” This
allowed the regulatory framework for trading securities to be extended to derivatives. The Act
considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a
30-year ban on forward trading was also lifted in 1999.
The economic liberalization of the early nineties facilitated the introduction of derivatives based
on interest rates and foreign exchange. A system of market-determined exchange rates was
adopted by India in March 1993. In August 1994, the rupee was made fully convertible on
current account. These reforms allowed increased integration between domestic and international
markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the
exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991.7 The
easing of various restrictions on the free movement of interest rates resulted in the need to
manage interest rate risk.

5. Derivatives Instruments Traded in India

In the exchange-traded market, the biggest success story has been derivatives on equity products.
Index futures were introduced in June 2000, followed by index options in June 2001, and options
and futures on individual securities in July 2001 and November 2001, respectively. As of 2005,
the NSE trades futures and options on 118 individual stocks and Derivatives

6. Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have
assets and liabilities of different maturities and in different currencies, and are exposed to
different risks of default from their borrowers. Thus, they are likely to use derivatives on interest
rates and currencies, and derivatives to manage credit risk. Non-financial institutions are
regulated differently from financial institutions, and this affects their incentives to use
derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the
use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far,
with their contribution to total value of NSE trades being less than 8% in October 2005.
However, market insiders feel that this may be changing, as indicated by the growing share of
index derivatives (which are used more by institutions than by retail investors). In contrast to the
exchange-traded markets, domestic financial institutions and mutual funds have shown great
interest in OTC fixed income instruments. Transactions between banks dominate the market for
interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003).
Corporations are active in the currency forwards and swaps markets, buying these instruments
from banks.

Why do institutions not participate to a greater extent in derivatives markets? Some institutions
such as banks and mutual funds are only allowed to use derivatives to hedge their existing
positions in the spot market, or to rebalance their existing portfolios. Since banks have little
exposure to equity markets due to banking regulations, they have little incentive to trade equity
derivatives.11 Foreign investors must register as foreign institutional investors (FII) to trade
exchange-traded derivatives, and be subject

13 Among exchange-traded derivative markets in Asia, India was ranked second behind S. Korea
for the first quarter of 2005. How about China, with who India is frequently compared in other
respects? China is preparing to develop its derivatives markets rapidly. It has recently entered
into joint ventures with the leading U.S. futures exchanges. It has taken steps to loosen currency
controls, and the Central Bank has allowed domestic and foreign banks to trade yuan forward
and swaps contracts on behalf of clients. However, unlike India, China has not fully
implemented necessary reforms of its stock markets, which is likely to hamper growth of its
derivatives markets.
broker-dealer.12 FIIs have a small but increasing presence in the equity derivatives markets.
They have no incentive to trade interest rate derivatives since they have little investments in the
domestic bond markets (Chitale, 2003). It is possible that unregistered foreign investors and
hedge funds trade indirectly, using a local proprietary trader as a front (Lee, 2004).
Retail investors (including small brokerages trading for themselves) are the major participants in
equity derivatives, accounting for about 60% of turnover in October 2005, according to NSE.
The success of single stock futures in India is unique, as this instrument has generally failed in
most other countries. One reason for this success may be retail investors’ prior familiarity with
“badla” trades which shared some features of derivatives trading. Another reason may be the
small size of the futures contracts, compared to similar contracts in other countries. Retail
investors also dominate the markets for commodity derivatives, due in part to their long-standing
expertise in trading in the “havala” or forwards markets.
 Derivatives
The term "Derivative" indicates that it has no independent value, i.e. its value is
entirely "derived" from the value of the underlying asset. The underlying asset can
be securities, commodities, bullion, currency, live stock or anything else. In other
words, Derivative means a forward, future, option or any other hybrid contract of
pre determined fixed duration, linked for the purpose of contract fulfillment to the
value of a specified real or financial asset or to an index of securities.
With Securities Laws (Second Amendment) Act,1999, Derivatives has been
included in the definition of Securities. The term Derivative has been defined in
Securities Contracts (Regulations) Act, as:-
A Derivative includes: -
o a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;
 o a contract which derives its value from the prices, or index of prices, of
underlying securities;
 Futures Contract
Futures Contract means a legally binding agreement to buy or sell the underlying
security on a future date. Future contracts are the organized/standardized contracts
in terms of quantity, quality (in case of commodities), delivery time and place for
settlement on any date in future. The contract expires on a pre-specified date
which is called the expiry date of the contract. On expiry, futures can be settled by
delivery of the underlying asset or cash. Cash settlement enables the settlement of
obligations arising out of the future/option contract in cash.
 Option contract
Options Contract is a type of Derivatives Contract which gives the buyer/holder
of the contract the right (but not the obligation) to buy/sell the underlying asset at
a predetermined price within or at end of a specified period. The buyer / holder of
the option purchases the right from the seller/writer for a consideration which is
called the premium. The seller/writer of an option is obligated to settle the option
as per the terms of the contract when the buyer/holder exercises his right. The
underlying asset could include securities, an index of prices of securities etc.
Under Securities Contracts (Regulations) Act,1956 options on securities has been
defined as "option in securities" means a contract for the purchase or sale of a
right to buy or sell, or a right to buy and sell, securities in future, and includes a
teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;
An Option to buy is called Call option and option to sell is called Put option.
Further, if an option that is exercisable on or before the expiry date is called
American option and one that is exercisable only on expiry date, is called
European option. The price at which the option is to be exercised is called Strike
price or Exercise price.
Therefore in the case of American options the buyer has the right to exercise the
option at anytime on or before the expiry date. This request for exercise is
submitted to the Exchange, which randomly assigns the exercise request to the
sellers of the options, who are obligated to settle the terms of the contract within a
specified time frame.
As in the case of futures contracts, option contracts can be also be settled by
delivery of the underlying asset or cash. However, unlike futures cash settlement
in option contract entails paying/receiving the difference between the strike
price/exercise price and the price of the underlying asset either at the time of
expiry of the contract or at the time of exercise / assignment of the option
contract.
 Index Futures and Index Option Contracts
Futures contract based on an index i.e. the underlying asset is the index, are
known as Index Futures Contracts. For example, futures contract on NIFTY Index
and BSE-30 Index. These contracts derive their value from the value of the
underlying index.
 Similarly, the options contracts, which are based on some index, are known as
Index options contract. However, unlike Index Futures, the buyer of Index Option
Contracts has only the right but not the obligation to buy / sell the underlying
index on expiry. Index Option Contracts are generally European Style options i.e.
they can be exercised / assigned only on the expiry date.
An index, in turn derives its value from the prices of securities that constitute the
index and is created to represent the sentiments of the market as a whole or of a
particular sector of the economy. Indices that represent the whole market are
broad based indices and those that represent a particular sector are sectoral
indices.
In the beginning futures and options were permitted only on S&P Nifty and BSE
Sensex. Subsequently, sectoral indices were also permitted for derivatives trading
subject to fulfilling the eligibility criteria. Derivative contracts may be permitted
on an index if 80% of the index constituents are individually eligible for
derivatives trading. However, no single ineligible stock in the index shall have a
weightage of more than 5% in the index. The index is required to fulfill the
eligibility criteria even after derivatives trading on the index has begun. If the
index does not fulfill the criteria for 3 consecutive months, then derivative
contracts on such index would be discontinued.
By its very nature, index cannot be delivered on maturity of the Index futures or
Index option contracts therefore, these contracts are essentially cash settled on
Expiry.
 Structure of Derivative Markets in India
Derivative trading in India takes can place either on a separate and independent
Derivative Exchange or on a separate segment of an existing Stock Exchange.
Derivative Exchange/Segment function as a Self-Regulatory Organisation (SRO)
and SEBI acts as the oversight regulator. The clearing & settlement of all trades
on the Derivative Exchange/Segment would have to be through a Clearing
Corporation/House, which is independent in governance and membership from
the Derivative Exchange/Segment.
 The regulatory framework of Derivatives markets in India
With the amendment in the definition of 'securities' under SC(R)A (to include
derivative contracts in the definition of securities), derivatives trading takes place
under the provisions of the Securities Contracts (Regulation) Act, 1956 and the
Securities and Exchange Board of India Act, 1992.
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory
framework for derivative trading in India. SEBI has also framed suggestive bye-
law for Derivative Exchanges/Segments and their Clearing Corporation/House
which lay's down the provisions for trading and settlement of derivative contracts.
The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges
and their Clearing Corporation/House have to be framed in line with the
suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative
Exchange/Segment and its Clearing Corporation/House. The eligibility conditions
have been framed to ensure that Derivative Exchange/Segment & Clearing
Corporation/House provide a transparent trading environment, safety & integrity
 and provide facilities for redressal of investor grievances. Some of the important
eligibility conditions are-
o Derivative trading to take place through an on-line screen based Trading System.
o The Derivatives Exchange/Segment shall have on-line surveillance capability to
monitor positions, prices, and volumes on a real time basis so as to deter market
manipulation.
o The Derivatives Exchange/ Segment should have arrangements for dissemination
of information about trades, quantities and quotes on a real time basis through
atleast two information vending networks, which are easily accessible to investors
across the country.
o The Derivatives Exchange/Segment should have arbitration and investor
grievances redressal mechanism operative from all the four areas / regions of the
country.
o The Derivatives Exchange/Segment should have satisfactory system of
monitoring investor complaints and preventing irregularities in trading.
o The Derivative Segment of the Exchange would have a separate Investor
Protection Fund.
o The Clearing Corporation/House shall perform full novation, i.e., the Clearing
Corporation/House shall interpose itself between both legs of every trade,
becoming the legal counterparty to both or alternatively should provide an
unconditional guarantee for settlement of all trades.
o The Clearing Corporation/House shall have the capacity to monitor the overall
position of Members across both derivatives market and the underlying securities
market for those Members who are participating in both.
o The level of initial margin on Index Futures Contracts shall be related to the risk
of loss on the position. The concept of value-at-risk shall be used in calculating
required level of initial margins. The initial margins should be large enough to
cover the one-day loss that can be encountered on the position on 99% of the
days.
o The Clearing Corporation/House shall establish facilities for electronic funds
transfer (EFT) for swift movement of margin payments.
o In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent
Member or close-out all open positions.
o The Clearing Corporation/House should have capabilities to segregate initial
margins deposited by Clearing Members for trades on their own account and on
account of his client. The Clearing Corporation/House shall hold the clients’
margin money in trust for the client purposes only and should not allow its
diversion for any other purpose.
o The Clearing Corporation/House shall have a separate Trade Guarantee Fund for
the trades executed on Derivative Exchange / Segment.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment of
BSE and the F&O Segment of NSE.
 The various membership categories in the derivatives
market
The various types of membership in the derivatives market are as follows:
o Trading Member (TM) – A TM is a member of the
derivatives exchange and can trade on his own
behalf and on behalf of his clients.
o Clearing Member (CM) –These members are
permitted to settle their own trades as well as the
trades of the other non-clearing members known as
Trading Members who have agreed to settle the
trades through them.
o Self-clearing Member (SCM) – A SCM are those
clearing members who can clear and settle their own
trades only.
o
 Derivative contracts are permitted by
SEBI
Derivative products have been introduced in a phased manner starting with Index
Futures Contracts in June 2000. Index Options and Stock Options were introduced
in June 2001 and July 2001 followed by Stock Futures in November 2001.
Sectoral indices were permitted for derivatives trading in December 2002. Interest
Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced
in June 2003 and exchange traded interest rate futures on a notional bond priced
off a basket of Government Securities were permitted for trading in January 2004.
1. The eligibility criteria for stocks on which derivatives
trading may be permitted
AA stock on which stock option and single stock future contracts are proposed to
be introduced is required to fulfill the following broad eligibility criteria:-
The stock shall be chosen from amongst the top 500
stock in terms of average daily market capitalisation
and average daily traded value in the previous six
month on a rolling basis.
o The stock’s median quarter-sigma order size over
the last six months shall be not less than required to
cause a change in the stock price equal to one-
quarter of a standard deviation.
o The market wide position limit in the stock shall not
be less than Rs.50 crores.
A stock can be included for derivatives trading as soon as it becomes eligible.
However, if the stock does not fulfill the eligibility criteria for 3 consecutive
months after being admitted to derivatives trading, then derivative contracts on
such a stock would be discontinued.
  Minimum contract
size
The Standing Committee on Finance, a Parliamentary Committee, at the time of
recommending amendment to Securities Contract (Regulation) Act, 1956 had
recommended that the minimum contract size of derivative contracts traded in the
Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this
recommendation SEBI has specified that the value of a derivative contract should
not be less than Rs. 2 Lakh at the time of introducing the contract in the market.
In February 2004, the Exchanges were advised to re-align the contracts sizes of
existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges were
authorized to align the contracts sizes as and when required in line with the
methodology prescribed by SEBI.
 The margining system in the derivative markets
Two type of margins have been specified -
Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which
depends on the time in which Mark to Market margin is collected.
Mark to Market Margin (MTM) - collected in cash for all Futures contracts
and adjusted against the available Liquid Networth for option positions. In the case of Futures
Contracts MTM may be considered as Mark to Market Settlement.
Dr. L.C Gupta Committee had recommended that the level of initial margin
required on a position should be related to the risk of loss on the position. The
concept of value-at-risk should be used in calculating required level of initial
margins. The initial margins should be large enough to cover the one day loss that
can be encountered on the position on 99% of the days. The recommendations of
the Dr. L.C Gupta Committee have been a guiding principle for SEBI in
prescribing the margin computation & collection methodology to the Exchanges.
With the introduction of various derivative products in the Indian securities
Markets, the margin computation methodology, especially for initial margin, has
been modified to address the specific risk characteristics of the product. The
margining methodology specified is consistent with the margining system used in
developed financial & commodity derivative markets worldwide. The exchanges
were given the freedom to either develop their own margin computation system or
adapt the systems available internationally to the requirements of SEBI.
A portfolio based margining approach which takes an integrated view of the risk
involved in the portfolio of each individual client comprising of his positions in
all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and
Single Stock Futures, has been prescribed. The initial margin requirements are
required to be based on the worst case loss of a portfolio of an individual client to
cover 99% VaR over a specified time horizon.
is applicable only for option products.
Calendar spreads are offsetting positions in two contracts in the same underlying
across different expiry. In a portfolio based margining approach all calendar-
spread positions automatically get a margin offset. However, risk arising due to
 difference in cost of carry or the ‘basis risk’ needs to be addressed. It is therefore
specified that a calendar spread charge would be added to the worst scenario loss
for arriving at the initial margin. For computing calendar spread charge, the
system first identifies spread positions and then the spread charge which is 0.5%
per month on the far leg of the spread with a minimum of 1% and maximum of
3%. Further, in the last three days of the expiry of the near leg of spread, both the
legs of the calendar spread would be treated as separate individual positions.
In a portfolio of futures and options, the non-linear nature of options make short
option positions most risky. Especially, short deep out of the money options,
which are highly susceptible to, changes in prices of the underlying. Therefore a
short option minimum charge has been specified. The short option minimum
charge is 3% and 7.5 % of the notional value of all short Index option and stock
option contracts respectively. The short option minimum charge is the initial
margin if the sum of the worst –scenario loss and calendar spread charge is lower
than the short option minimum charge.
To calculate volatility estimates the exchange are required to uses the
methodology specified in the Prof J.R Varma Committee Report on Risk
Containment Measures for Index Futures. Further, to calculate the option value
the exchanges can use standard option pricing models - Black-Scholes, Binomial,
Merton, Adesi-Whaley.
The initial margin is required to be computed on a real time basis and has two
components:-
The first is creation of risk arrays taking prices at discreet times taking latest prices and volatility
estimates at the discreet times, which have been specified.
The second is the application of the risk arrays on the actual portfolio positions to compute the
portfolio values and the initial margin on a real time basis.
es contracts at the end of each trading day. The daily settlement price at the end of
each day is the weighted average price of the last half an hour of the futures
contract. The profits / losses arising from the difference between the trading price
and the settlement price are collected / given to all the clearing members.
The exposure limits in Derivative Products
It has been prescribed that the notional value of gross open positions at any point
in time in the case of Index Futures and all Short Index Option Contracts shall not
exceed 33 1/3 (thirty three one by three) times the available liquid networth of a
member, and in the case of Stock Option and Stock Futures Contracts, the
exposure limit shall be higher of 5% or 1.5 sigma of the notional value of gross
open position.
In the case of interest rate futures, the following exposure limit is specified:
The notional value of gross open positions at any point in time in futures contracts on the
notional 10 year bond should not exceed 100 times the available liquid networth of a member.
The notional value of gross open positions at any point in time in futures contracts on the
notional T-Bill should not exceed 1000 times the available liquid networth of a member.
The position limits in Derivative Products
The position limits specified are as under-
 Client / Customer level position limits:
For index based products there is a disclosure requirement for clients whose
position exceeds 15% of the open interest of the market in index products.
For stock specific products the gross open position across all derivative contracts
on a particular underlying of a customer/client should not exceed the higher of –
1% of the free float market capitalisation (in terms of number of shares).
Or
5% of the open interest in the derivative contracts on a particular underlying stock (in terms of
number of contracts).
This position limits are applicable on the combine position in all derivative
contracts on an underlying stock at an exchange. The exchanges are required to
achieve client level position monitoring in stages.
The client level position limit for interest rate futures contracts is specified at
Rs.100 crore or 15% of the open interest, whichever is higher.
Trading Member Level Position Limits:
For Index options the Trading Member position limits are Rs. 250 cr or 15% of
the total open interest in Index Options whichever is higher and for Index futures
the Trading Member position limits are Rs. 250 cr or 15% of the total open
interest in Index Futures whichever is higher.
For stocks specific products, the trading member position limit is 20% of the
market wide limit subject to a ceiling of Rs. 50 crore. In Interest rate futures the
Trading member position limit is Rs. 500 Cr or 15% of open interest whichever is
higher.
It is also specified that once a member reaches the position limit in a particular
underlying then the member shall be permitted to take only offsetting positions
(which result in lowering the open position of the member) in derivative contracts
on that underlying. In the event that the position limit is breached due to the
reduction in the overall open interest in the market, the member are required to
take only offsetting positions (which result in lowering the open position of the
member) in derivative contract in that underlying and fresh positions shall not be
permitted. The position limit at trading member level is required to be computed
on a gross basis across all clients of the Trading member.
Market wide limits:
There are no market wide limits for index products. For stock specific products
the market wide limit of open positions (in terms of the number of underlying
The requirements for a FII and its sub-account to invest in derivatives
A SEBI registered FIIs and its sub-account are required to pay initial margins,
exposure margins and mark to market settlements in the derivatives market as
required by any other investor. Further, the FII and its sub-account are also
subject to position limits for trading in derivative contracts. The FII and sub-
account position limits for the various derivative products are as under:
Measures have been specified by SEBI to protect the rights of investor
in Derivatives Market
 The measures specified by SEBI include:
Investor's money has to be kept separate at all levels and is permitted to be used only against the
liability of the Investor and is not available to the trading member or clearing member or even
any other investor.
The Trading Member is required to provide every investor with a risk disclosure document
which will disclose the risks associated with the derivatives trading so that investors can take a
conscious decision to trade in derivatives.
Investor would get the contract note duly time stamped for receipt of the order and execution of
the order. The order will be executed with the identity of the client and without client ID order
will not be accepted by the system. The investor could also demand the trade confirmation slip
with his ID in support of the contract note. This will protect him from the risk of price favour, if
any, extended by the Member.
In the derivative markets all money paid by the Investor towards margins on all
open positions is kept in trust with the Clearing House/Clearing corporation and
in the event of default of the Trading or Clearing Member the amounts paid by the
client towards margins are segregated and not
esses and technology necessary for derivatives trading.

The Indian Derivatives Odessey

A distinctive feature of the reforms of the 1990s has been the accent on financial sector reforms.
Financial sector reforms in India were brought to the front burner owing to the fixed income and
stock market Scam of 1992; this luckily enabled a policy focus in India upon the financial sector
well in advance of the East Asian debacle of 1997.

The first three inputs in reforms on the securities markets are now well in place: a new electronic
exchange (NSE), reforms to clearing (NSCC) and the depository (NSDL). NSE commenced
equities trading in November 1994, the clearing corporation was started in April 1996 and the
depository was inaugurated in November 1996. Of these steps, the depository was much delayed
and many critics have highlighted the policy failures in these delays. Yet, from November 1994
to November 1996, India's policy makers undeniably achieved a remarkably rapid transformation
of securities markets in the country.

Once the basic structures of a cash market fall into place, the logical next step for market
development is the commencement of exchange--traded financial derivatives. Derivatives give
people the ability to manage and control risk. Today, in India, fluctuations in the stock market or
in the dollar--rupee generate a political constituency which seeks government interventions into
the market to prevent price fluctuations. This discomfort with price risk is a basic source of the
political opposition to liberalisation, which inevitably exposes Indian citizens to greater price
risk. Derivatives are hence a central part of the reforms process; by giving individuals and firms
the power to make choices about what risks they are comfortable with and what risks are best
hedged away, derivatives make individuals and firms more tolerant of price risk and hence
liberalisation.

In addition, from a purely financial sector perspective, derivatives are important insofar as they
are part and parcel of market development. Derivatives trading helps improve market liquidity,
raises skills and knowledge among market players, and is a vital ingredient of market reforms
such as the transition to rolling settlement.
Hence the commencement of derivatives trading at an exchange is of utmost important, from the
perspective of financial sector development and with respect to the larger problem of creating a
constituency for reforms. This step has unfortunately been plagued by delays, and is one where
the policy establishment is not shown in good light. In terms of knowledge and capabilities,
exchange--traded derivatives could have commenced in India in middle 1996. The story ever
since has been one of delays that are reminiscent of pre--reforms India:
June 1996
NSE sent a proposal to SEBI about starting exchange--traded derivatives. Time elapsed:
5 months.
November 1996
SEBI announced a committee headed by L. C. Gupta to formulate policy for exchange--
traded derivatives. This was one of the largest--ever committees of its nature; it had 24
members. Time elapsed: 16 months.
March 1998
L. C. Gupta Committee submits report. Five months have passed by since this, with no
sign of market commencement in sight.
Through this two--year process, the Bombay Stock Exchange played a prominent role by trying
to delay the onset of exchange--traded derivatives while (successfully) working towards rapid
regulatory approvals for a new badla. In a comic twist, in recent weeks, the BSE now says that it
no longer has any intellectual criticisms of exchange--traded derivatives and wishes to start
trading index futures itself.

Earlier, it was thought that a notification from the finance ministry would be all that was needed
to enable futures trading. The budget speech, instead, has spoken of an amendment to SCRA. It
is hard to see why this clarity was not obtained in 1996 itself, in which case the enabling
provisions could have been well in place in advance of SEBI's processes.
In the case of the depository, SEBI had completed its process prior to the legislation being
approved by parliament. Hence, it should be possible for SEBI to similarly give NSE all
clearances so that the market can commence functioning immediately after the SCRA
amendment is passed.
Coincidentally, two changes are bundled into the current amendment to SCRA: the changes
which enable exchange--traded derivatives and provisions concerning plantation schemes. It is
hard to imagine a greater contrast -- between the basic importance of derivatives for financial
sector development and the peripheral role of plantation schemes.
The crucial milestones in the future of institutional development in India's securities markets
may now be summarised as:
 Transition to rolling settlement. SEBI should now have a policy through which stock
market trading should only be allowed to take place using rolling settlement, starting with
the largest stocks in the country and covering all stocks over a period of two years. This
process can commence now.
 Onset of index futures and index options. This process can commence the moment the
SCRA is amended. Under the best scenario, we can expect to see index futures trading in
November 1998 and index options in December 1998.
 Exchange--traded derivatives on interest rates and currencies. The logical next step,
once exchange--traded derivatives exist, is to trade derivatives which enable risk
management on fluctuations of interest rates and the dollar--rupee. This will be an
outcome of the confidence that the RBI has in the quality of NSE's derivatives exchange
and SEBI's policy regime governing exchange--traded derivatives.
In the aftermath of the East Asian crisis, it is common for policy makers to express a desire to
put problems of financial sector development on a high priority. The policy establishment has set
an extremely bad example in the context of derivatives: NSE had invested a great deal of effort
and expense in being ready to trade derivatives by middle 1996 and they have been waiting ever
since. This is reminiscent of industrial licensing -- through this process, policy--makers are
deterring development in other areas.
When an agency or an entity thinks of embarking on market development in the future, they will
look at the example of NSE and put a top priority on politics rather than financial sector
development. This is reminiscent of the time that Indian industrialists used to spend in Delhi in
obtaining permissions, which came at the expense of the time which they should have spent on
technology and product development. Policy makers should be supporting innovation and
modern

7. Conclusions
In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian
market has equalled or exceeded many other regional markets.13 While the growth is being
spearheaded mainly by retail investors, private sector institutions and large corporations, smaller
companies and state-owned institutions are gradually getting into the act. Foreign brokers such as
JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives.
The variety of derivatives instruments available for trading is also expanding.
There remain major areas of concern for Indian derivatives users. Large gaps exist in the range
of derivatives products that are traded actively. In equity derivatives, NSE figures show that
almost 90% of activity is due to stock futures or index futures, whereas trading in options is
limited to a few stocks, partly because they are settled in cash and not the underlying stocks.
Exchange-traded derivatives based on interest rates and currencies are virtually absent.
Liquidity and transparency are important properties of any developed market. Liquid markets
require market makers who are willing to buy and sell, and be patient while doing so. In India,
market making is primarily the province of Indian private and foreign banks, with public sector
banks lagging in this area (FitchRatings, 2004). A lack of market liquidity may be responsible
for inadequate trading in some markets. Transparency is achieved partly through financial
disclosure. Financial statements Derivatives OUP 7
14 See Chitale (2002) for an assessment of reforms needed for the development of credit
derivatives.
currently provide misleading information on institutions’ use of derivatives. Further, there is no
consistent method of accounting for gains and losses from derivatives trading. Thus, a proper
framework to account for derivatives needs to be developed.
Further regulatory reform will help the markets grow faster. For example, Indian commodity
derivatives have great growth potential but government policies have resulted in the underlying
spot/physical market being fragmented (e.g. due to lack of free movement of commodities and
differential taxation within India). Similarly, credit derivatives, the fastest growing segment of
the market globally, are absent in India and require regulatory action if they are to develop.14
As Indian derivatives markets grow more sophisticated, greater investor awareness will become
essential. NSE has programmes to inform and educate brokers, dealers, traders, and market
personnel. In addition, institutions will need to devote more resources to develop the business
processes and technology necessary for derivatives trading. Derivatives OUP 8
per gram). Jewelry manufacturer Goldbuyer agrees to buy gold at Rs. 600 (the forward or
delivery price) three months from now (the delivery date) from gold mining concern
Goldseller. This is an example of a forward contract. No money changes hands between
Goldbuyer and Goldseller at the time the forward contract is created. Rather, Goldbuyer’s payoff
depends on the spot price at the time of delivery. Suppose that the spot price reaches Rs. 610 at
the delivery date. Then Goldbuyer gains Rs. 10 on his forward position (i.e. the difference
between the spot and forward prices) by taking delivery of the gold at Rs. 600.
A futures contract is similar to a forward contract, with some exceptions. Futures contracts are
traded on exchange markets, whereas forward contracts typically trade on OTC (over-the-
counter) markets. Also, futures contracts are settled daily (marked-to-market), whereas forwards
are settled only at expiration.
Returning to the example above, suppose that Goldbuyer believes that there is some chance for
the spot price to fall below Rs. 600, so that he loses on his forward position. To limit his loss,
Goldbuyer could purchase a call option for Rs. 5 (the option price or premium) at a strike or
exercise price of Rs. 600 with an expiration date three months from now.
BIBLIOGRAPHY