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Firstly I am briefing the current Indian market and compairing it with it past. I am also giving brief data about foreign market. Then at the last I am giving my suggestions and recommendations. With over 25 million shareholders, India has the third largest investor base in the world after USA and Japan. Over 7500 companies are listed on the Indian stock exchanges (more than the number of companies listed in developed markets of Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.). The Indian capital market is significant in terms of the degree of development, volume of trading, transparency and its tremendous growth potential. India‟s market capitalization was the highest among the emerging markets. Total market capitalization of The Bombay Stock Exchange (BSE), which, as on July 31, 1997, was US$ 175 billion has grown by 37.5% percent every twelve months and was over US$ 834 billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the oldest in the world, accounts for the largest number of listed companies transacting their shares on a nationwide online trading system. The two major exchanges namely the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the world, calculated by the number of daily transactions done on the exchanges. The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 – An increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only. Turnover in the Spot and Derivatives segment both in NSE & BSE was higher by 45% into 2006 as compared to 2005. With daily average volume of US $ 9.4 billion, the Sensex has posted excellent returns in the recent years.
Currently the market cap of the Sensex as on July 4th, 2011 was Rs 78.4 Lakh Crore with a P/E of more than 20.
Derivatives trading in the stock market have been a subject of enthusiasm of research in the field of finance the most desired instruments that allow market participants to manage risk in the modern securities trading are known as derivatives. The derivatives are defined as the future contracts whose value depends upon the underlying assets. If derivatives are introduced in the stock market, the underlying asset may be anything as component of stock market like, stock prices or market indices, interest rates, etc. The main logic behind derivatives trading is that derivatives reduce the risk by providing an additional channel to invest with lower trading cost and it facilitates the investors to extend their settlement through the future contracts. It provides extra liquidity in the stock market. Derivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like: Commodities including grains, coffee beans, etc. Precious metals like gold and silver. Foreign exchange rate. Bonds of different types, including medium to long-term negotiable debt securities issued by governments, companies, etc. Short-term debt securities such as T-bills. Over-The-Counter (OTC) money market products such as loans or deposits. Equities For example, a dollar forward is a derivative contract, which gives the buyer a right & an obligation to buy dollars at some future date. The
prices of the derivatives are driven by the spot prices of these underlying assets. However, the most important use of derivatives is in transferring market risk, calledHedging, which is a protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management.
There are various derivative products traded. They are; 1. 2. 3. 4. Forwards Futures Options Swaps
“A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified future date. The price may be agreed on in advance or in future.” “A Future contract is a firm contractual agreement between a buyer and seller for a specified as on a fixed date in future. The contract price will vary according to the market place but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being done”. “An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.” A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called "the call option premium or call option price".
A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price”.
Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a „SWAP‟. In case of swap, only the payment flows are exchanged and not the principle amount” I had conducted this research to find out whether investing in the derivative market is beneficial or not? You will be glad to know that derivative market in India is the most booming now days. So the person who is ready to take risk and want to gain more should invest in the derivative market. On the other hand RBI has to play an important role in derivative market. Also SEBI must encourage investment in derivative market so that the investors get the benefit out of it. Sorry to say that today even educated persons are not willing to invest in derivative market because they have the fear of high risk. So, SEBI should take necessary steps for improvement in Derivative Market so that more investors can invest in Derivative market.
banks and their corporate clients in what are termed as over-the-counter markets. Forward contracts. there is no single market place or organized exchanges.INTRODUCTION A Derivative is a financial instrument whose value depends on other. The variables underlying could be prices of traded securities and stock. . Derivatives have become increasingly important in the field of finance. underlying variables. Options and Futures are traded actively on many exchanges. Swap and different types of options are regularly traded outside exchanges by financial intuitions. In other words. prices of gold or copper. more basic.
This study also covers the recent developments in the derivative market taking into account the trading in past years. . Through this study I came to know the trading done in derivatives and their use in the stock markets.NEED OF THE STUDY The study has been done to know the different types of derivatives and also to know the derivative market in India.
In the class of equity derivatives. as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. their complexity and also turnover. by locking-in asset prices. However. derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. since their emergence. futures and options on stock indices have gained more popularity than on individual stocks. these generally do not influence the fluctuations in the underlying asset prices. most notably forwards. it is possible to partially or fully transfer price risks by locking-in asset prices.LITERATURE REVIEW The emergence of the market for derivative products. the financial markets are marked by a very high degree of volatility. the market for financial derivatives has grown tremendously both in terms of variety of instruments available. these products have become very popular and by 1990s. By their very nature. The lower costs associated with index derivatives vis-vis derivative products based on individual securities is another reason for their growing use. who are major users of index-linked derivatives. Derivative products initially emerged. they accounted for about two-thirds of total transactions in derivative products. . In recent years. can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Through the use of derivative products. futures and options. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. especially among institutional investors. As instruments of risk management. However.
. Derivative Trading is fast gaining momentum. I have chosen this topic.As in the present scenario.
OBJECTIVES OF THE STUDY To understand the concept of the Derivatives and Derivative Trading. To know the role of derivatives trading in India. To know different types of Financial Derivatives. To analyse the performance of Derivatives Trading since 2001 with special reference to Futures & Options .
For better understanding various strategies with different situations and actions have been given.SCOPE OF THE PROJECT The project covers the derivatives market and its instruments. This study extends to the trading of derivatives done in the National Stock Markets . It includes the data collected in the recent years and also the market in the derivatives in the recent years.
The data for study has been collected from various sources: Time: 2 months Statistical Tools Used: Simple tools like bar graphs.RESARCH METHODOLOGY Method of data collection:Secondary sources:It is the data which has already been collected by some one or an organization for some other purpose or research study . line diagrams have been used. Books Journals Magazines Internet sources . tabulation.
LIMITAITONS OF STUDY 1. VOLATALITY: Share market is so much volatile and it is difficult to forecast anything about it whether you trade through online or offline. 4. It being a wide topic had a limited time. 3. . LIMITED RESOURCES: Limited resources are available to collect the information about the commodity trading. 2. ASPECTS COVERAGE: Some of the aspects may not be covered in my study. LIMITED TIME: The time available to conduct the study was only 2 months.
What they would then negotiate happened to be futurestype contract. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. From the time it was sown to the time it was ready for harvest.MAIN TOPICS OF STUDY INTRODUCTION TO DERIVATIVE The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. Under such circumstances. a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. Through the use of simple derivative products. he would have to dispose off his harvest at a very low price. it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. In 1848. However. he would probably obtain attractive prices. farmers would face price uncertainty. which would enable both parties to eliminate the price risk. during times of oversupply. On the other hand. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. or CBOT. the Chicago Board Of Trade. A group of traders got together and created the „to-arrive‟ contract that permitted farmers to lock into . In years of scarcity. it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. although favourable prices could be obtained during periods of oversupply. was established to bring farmers and merchants together.
and in 1925 the first futures clearing house came into existence. pepper. exchange rate. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. Besides commodities. interest rate. These were eventually standardized. wheat. silver etc. . cotton. derivatives contracts also exist on a lot of financial underlying like stocks. Today derivatives contracts exist on variety of commodities such as corn.price upfront and deliver the grain later. etc.
was amended to include derivative contracts in securities. Consequently. 1956 (SCRA). we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. or index of prices. A contract which derives its value from the prices. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. commodity or any other asset. Such a transaction is an example of a derivative. The Securities Contracts (Regulation) Act. of underlying securities. The underlying asset can be equity. share. However when derivatives trading in securities was introduced in 2001. The price of this derivative is driven by the spot price of wheat which is the “underlying” in this case. the term “security” in the Securities Contracts (Regulation) Act. . We thus have separate regulatory authorities for securities and commodity derivative markets. In our earlier discussion. regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). 1956 defines “derivative” to includeA security derived from a debt instrument. loan whether secured or unsecured. The Forwards Contracts (Regulation) Act. risk instrument or contract differences or any other form of security. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. forex.DERIVATIVE DEFINED A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. 1952. regulates the forward/futures contracts in commodities all over India.
TYPES OF DERIVATIVES MARKET Types of derivative Market Exchange traded derivatives Over the Counter Derivatives National Stock Exchange Bombay Stock Exchange National Commodity & Derivative Exchange Index Future Stock Option Index Option Stock Future .
Types of Derivatives Derivatives Future Option Forward Swaps .
• On the expiration date. thereby reducing transaction costs and increasing transactions volume. The other party assumes a short position and agrees to sell the asset on the same date for the same price. • The contract price is generally not available in public domain. the contract has to be settled by delivery of the asset. . However forward contracts in certain markets have become very standardized.FORWARD CONTRACTS A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. and hence is unique in terms of contract size. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. BASIC FEATURES OF FORWARD CONTRACT • They are bilateral contracts and hence exposed to counter-party risk. expiration date and the asset type and quality. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. which often results in high prices being charged. This process of standardization reaches its limit in the organized futures market. Other contract details like delivery date. it has to compulsorily go to the same counter-party. as in the case of foreign exchange. • If the party wishes to reverse the contract. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. The forward contracts are normally traded outside the exchanges. Forward contracts are often confused with futures contracts. • Each contract is custom designed. price and quantity are negotiated bilaterally by the parties to the contract.
. To exit the commitment. which differs from an options contract. and the option writer (seller) the obligation. traded on a futures exchange. A futures contract gives the holder the right and the obligation to buy or sell. The future date is called the delivery date or final settlement date. but not the obligation. The exchange acts as counterparty on all contracts. at a pre-set price. normally. Futures contracts are exchange traded derivatives. the holder of a futures position has to sell his long position or buy back his short position. a futures contract is a standardized contract. which gives the buyer the right. The price of the underlying asset on the delivery date is called the settlement price. etc. The settlement price. effectively closing out the futures position and its contract obligations. to buy or sell a certain underlying instrument at a certain date in the future. but not the right.FUTURE CONTRACT In finance. converges towards the futures price on the delivery date. sets margin requirements. The pre-set price is called the futures price.
• The grade of the deliverable. This can be the notional amount of bonds. In case of bonds. units of foreign currency. • The amount and units of the underlying asset per contract. this specifies which bonds can be delivered. usually by specifying: • The underlying. • Other details such as the tick. In case of physical commodities. a fixed number of barrels of oil. • The type of settlement. This can be anything from a barrel of sweet crude oil to a short term interest rate. • The last trading date. the notional amount of the deposit over which the short term interest rate is traded. Standardization: Futures contracts ensure their liquidity by being highly standardized. this specifies not only the quality of the underlying goods but also the manner and location of delivery. • The currency in which the futures contract is quoted. the minimum permissible price fluctuation. etc. . The delivery month. either cash settlement or physical settlement.BASIC FEATURES OF FUTURE CONTRACT 1.
If he cannot pay. if he is on the losing side. It represents the loss on that contract. consider that a futures trader. To minimize this risk. This is calculated by the futures contract. its price constantly fluctuates. If the trader is on the winning side of a deal. usually called variation or maintenance margin. called the "settlement" or mark-to-market price of the contract. It may be 5% or 10% of total contract price. his contract has increased in value that day. Initial margin: is paid by both buyer and seller. This is intended to protect the exchange against loss.e. Margin: Although the value of a contract at time of trading should be zero. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin. At the end of every trading day. when taking a position. a further margin. who always acts as counterparty. . which is not likely to be exceeded on a usual day's trading.2. agreeing on a price at the end of each day. called a "margin". deposits money with the exchange. is required by the exchange. the exchange will debit his account. and the exchange pays this profit into his account. i. as determined by historical price changes. commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. the exchange demands that contract owners post a form of collateral. To understand the original practice. This renders the owner liable to adverse changes in value. and creates a credit risk to the exchange. On the other hand. then the margin is used as the collateral from which the loss is paid. the contract is marked to its present market value.
3. F(t). and can be done in one of two ways. F(t) = S(t) * (1+r) (T-t) . On this day the t+2 futures contract becomes the t forward contract. or selling a contract to liquidate an earlier purchase (covering a long). such as a short term interest rate index such as Euribor. In other words. non-dividend paying asset. or the closing value of a stock market index. it occurs only on a minority of contracts.a cash payment is made based on the underlying reference rate.that is. the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. A futures contract might also opt to settle against an index based on trade in a related spot market. Expiry is the time when the final prices of the future are determined.the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange. the value of the future/forward. buying a contract to cancel out an earlier sale (covering a short). for a simple. will be found by discounting the present value S(t) at time(t) to maturity(T) by the rate of risk-free return r . the rational forward price represents the expected future value of the underlying discounted at the risk free rate. For many equity index and interest rate futures contracts. for no arbitrage to be possible. Thus. In practice. as specified per type of futures contract: • Physical delivery . • Cash settlement . this happens on the Last Thursday of certain trading month. Pricing of future contract In a futures contract. Most are cancelled out by purchasing a covering position . and by the exchange to the buyers of the contract. Settlement: Settlement is the act of consummating the contract.
He then receives the underlying and pays the agreed forward price using the matured investment. dividend yields. In the case where the forward price is higher: 1.] 4. The arbitrageur buys the futures contract and sells the underlying today (on the spot market). he returns it now. 3. The difference between the two amounts is the arbitrage profit. On the delivery date. which has appreciated at the risk free rate. . In the case where the forward price is lower: 1. 3.The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. he cashes in the matured investment. Any deviation from this equality allows for arbitrage as follows. 2. and receives the agreed forward price. the arbitrageur hands over the underlying. he invests the proceeds. [If he was short the underlying. On the delivery date. 4. and convenience yields. 2. dividends. He then repays the lender the borrowed amount plus interest. The difference between the two amounts is the arbitrage profit.This relationship may be modified for storage costs.
as markets are are scattered. assumed by the clearing corp. centralized and all buyers and sellers come to a common platform to discover the price Currency Market in India. However. Exists. as contracts are High.. Commodities. . futures. which becomes the counter party to all the trades or unconditionally guarantees their settlement Low. as market Efficient.FEATURES FORWARD CONTRACT Traded directly between two parties (not traded on the exchanges) Differ from trade to trade FUTURE CONTRACT Operational Mechanism Contract Specifications Counter party Risk Traded on the exchanges Liquidation Profile Price Discovery Examples Contracts are standardized contracts Exists. as contracts are tailor made contracts standardized catering to the needs of the Exchange traded contracts needs of the parties Not efficient. Index Futures and Individual stock Futures in India.
stating what is to be delivered for a fixed price at a specified place on a specified date. forward contracts have existed for centuries for hedging price risk. From „forward‟ trading in commodities emerged the commodity „futures‟. The first formal commodities exchange. Forward delivery contracts. In 1865. the Chicago Board of Trade (CBOT). though it did exist before in 1874 under the names of „Chicago Produce Exchange‟ (CPE)and „Chicago Egg and Butter Board‟ (CEBB). The Chicago Mercantile Exchange (CME).HISTORY OF DERIVATIVES: The history of derivatives is quite colorful and surprisingly a lot longer than most people think. known as the futures contracts. The first type of futures contract was called „to arrive at‟. Thus. was formed in 1848 in the US to deal with the problem of „credit risk‟ and to provide centralised location to negotiate forward contracts. was formed in 1919. existed in ancient Greece and Rome. . Trading in futures began on the CBOT in the 1860‟s. a spin-off of CBOT. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. The first organized commodity exchange came into existence in the early 1700‟s in Japan. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. CBOT listed the first „exchange traded‟ derivatives contract.
Dutch growers and dealers traded in tulip bulb options. tulip bulb prices shot up.The first of the several networks. a division of CME. Currency futures were followed soon by interest rate futures. the German Mark. which offered a trading link between two exchanges. were a symbol of affluence. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24. There was so much speculation that people even mortgaged their homes and businesses. owing to a high demand.The first financial futures to emerge were the currency in 1972 in the US. . The first foreign currency futures were traded on May 16. Interest rate futures contracts were traded for the first time on the CBOT on October 20. Their history also dates back to ancient Greece and Rome. the brightly coloured flowers. the Australian Dollar. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. on International Monetary Market (IMM). the Canadian Dollar. 1984. The currency futures traded on the IMM are the British Pound. the Swiss Franc. Tulips. Options are very popular with speculators in the tulip craze of seventeenth century Holland. the Japanese Yen. 1975. and the Euro dollar. Stock index futures and options emerged in 1982. was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7. 1982. 1972. Options are as old as futures.
The market for futures and options grew at a rapid pace in the eighties and nineties. On April 26. in 1872. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. These options were traded over the counter. . and Scholes invented the famous BlackScholes Option Formula. Russell Sage. the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. Agricultural commodities options were traded in the nineteenth century in England and the US. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. It was in 1973 again that black.The CBOE is the largest exchange for trading stock options. With the options markets becoming increasingly popular. 1973. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001). A group of firms known as Put and Call brokers and Dealer‟s Association was set up in early 1900‟s to provide a mechanism for bringing buyers and sellers together.The first call and put options were invented by an American financier. Merton.
The US indices and the Nikkei 225 trade almost round the clock. the Dow Jones Industrial Average. . and the Nikkei 225. The N225 is also traded on the Chicago Mercantile Exchange.The most traded stock indices include S&P 500. the Nasdaq 100.
In July 1999. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India‟s (RBI) efforts in creating currency forward market.INDIAN DERIVATIVES MARKET Starting from a controlled economy. India has moved towards a world where prices fluctuate every day. derivatives trading commenced in India .
Gupta Committee submitted report RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. Nifty futures trading commenced at SGX. SEBI gave permission to NSE and BSE to do index futures trading Trading of BSE Sensex futures commenced at BSE. Individual Stock Options & Derivatives 24 May 2000 25 May 2000 9 June 2000 12 June 2000 25 September 2000 2 June 2001 .Table Chronology of instruments 1991 Liberalisation process initiated 14 December 1995 18 November 1996 11 May 1998 7 July 1999 NSE asked SEBI for permission to trade index futures. Trading of Nifty futures commenced at NSE.Gupta Committee to draft a policy framework for index futures L. SIMEX chose Nifty for trading futures and options on an Indian index. . SEBI setup L.C.C.
cross currency options etc. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives. While this is true for many countries. when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. there are still apprehensions about the introduction of derivatives. derivatives markets have become the most important markets in the world. There was a huge gap between the investors‟ aspirations of the markets and the available means of trading. which are well regulated with all the safety mechanisms in place. the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. Today. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970. derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world. Until the advent of NSE.Need for derivatives in India today In less than three decades of their coming into vogue. . Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of India‟s efforts in allowing forward contracts. Today. which have developed into a very large market. derivatives markets have become the most important markets in the world. Myths and realities about derivatives In less than three decades of their coming into vogue. derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. The opening of Indian economy has precipitated the process of integration of India‟s financial markets with the international financial markets.
What are these myths behind derivatives? Derivatives increase speculation and do not serve any economic purpose . The need for derivatives as hedging tool was felt first in the commodities market. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates . effective method for users to hedge and manage their exposures to interest rates. commodity Prices or exchange rates. Agricultural futures and options helped farmers and processors hedge against commodity price risk. both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding . Indian Market is not ready for derivative trading. Is the existing capital market safer than Derivatives? Derivatives increase speculation and do not serve any economic purpose Numerous studies of derivatives activity have led to a broad consensus. Disasters prove that derivatives are very risky and highly leveraged instruments. Derivatives are a low-cost. After the fallout of Bretton wood agreement. the financial markets in the world started undergoing radical changes.
derivatives have strengthened these important linkages between global markets increasing market liquidity and efficiency and facilitating the flow of trade and finance . As the complexity of instruments increased many folds. This situation led to development derivatives as effective risk management tools for the market participants. on-line trading in the capital markets. the accompanying risk factors grew in gigantic proportions. Looking at the equity market. lowering the cost of capital formation and stimulating economic growth. 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. etc. derivatives improve the allocation of credit and the sharing of risk in the global economy. By providing investors and issuers with a wider array of tools for managing risks and raising capital. Now that world markets for trade and finance have become more integrated. increased trading in variety of derivatives instruments. for example. 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 the currencies.
These are clear indicators of high liquidity in the underlying The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). Which means on an average every month 14% of the country‟s Market capitalisation gets traded. Here.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.765000 crores. and how Indian market fares PRE-REQUISITES INDIAN SCENARIO Large market Capitalisation High Liquidity in the underlyin Trade guarantee A Strong Depository India is one of the largest marketcapitalised countries in Asia with a market capitalisation of more than Rs. which are needed for the introduction of derivatives. NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country . we look into the pre-requisites. The daily average traded volume in Indian capital market today is around 7500 crores.
and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices .A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong. independent.
For example. an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$.3d shows how advantages of new system (implemented from June 20001) v/s the old system i. Basically. one can buy a 1 month future of Reliance at Rs 350 and make profits • Hedgers: People who buy or sell to minimize their losses. then the importer can minimize his losses by buying a currency future at Rs 49/$ • Arbitrageurs: People who buy or sell to make money on price differentials in different markets.8 Comparison of New System with Existing System Many people and brokers in India think that the new system of Futures & Options and banning of Badla is disadvantageous and introduced early. We will examine this in detail when we look at futures in a separate chapter. If there is any change in the interest. For example. 3. a futures price is simply the current price plus the interest cost. before June 2001 New System Vs Existing System for Market Players . if you will the stock price of Reliance is expected to go upto Rs. It increases the no of options investors for investment. The figure 3. it presents an arbitrage opportunity. every investor assumes one or more of the above roles and derivatives are a very good option for him.400 in 1 month.What kind of people will use derivatives? Derivatives will find use for the following set of people: • Speculators: People who buy or sell in the market to make profits.3a –3. For example. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI.e. but I feel that this new system is very useful especially to retail investors.
Advantages • Greater Leverage as to pay only the premium.Speculator Existing New Approach & Prize peril prize Approach Peril 1) Deliver based rading. 2) Buy Index Futures hold till expiry 1) Both profit & loss to extent of price change 1)Buy &Sell stocks on delivery basis 2) Buy Call &Put by paying premium 1)Maximum loss possible to premium paid . margin trading& carry forward transactions. . • Greater variety of strike price options at a given time.
2) If Future Contract more or less than Fair price 1) B Group more promising as still 1) Make money whichever way the Market moves.Arbitragers Existing New Approach & Prize peril prize Approach Peril 1) Buying Stocks in one and selling in another exchange. Fair Price = Cash Price + Cost of Carry . in weekly settlement 2) Cash &Carry arbitrage continues 1) Risk free game. forward transactions.
If market goes up. reward dependant on market prices Advantages • Availability of Leverage . earn premium + profit with increase price 1) Additional cost is only premium.Hedger Existing New Approach & Prize peril prize Approach Peril 1) Difficult to offload holding 1) No Leverage available risk 1)Fix price today to buy latter by paying premium. buy ATM Put Option. during adverse market conditions as circuit filters limit to curtail losses. 3)Sell deep OTM call option with underlying shares. 2)For Long. long position benefit else exercise the option.
. 1) Plain Buy/Sell implies unlimited profit/loss.Small Investors Existing New Approach & Prize peril prize Approach Peril 1) If Bullish buy stocks else sell it. 1) Buy Call/Put options based on market outlook 2) Hedge position if holding underlying stock 1) Downside remains protected & upside unlimited Advantages Losses Protected.
Indian law considers them illegal. those who provide OTC derivative products. the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. which fall outside the more formal clearing house structures. There has been some progress in addressing these risks and perceptions. The concept of price is clear to .9 FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES: Factors contributing to the explosive growth of derivatives are price volatility. In view of the inherent risks associated with OTC derivatives. the progress has been limited in implementing reforms in risk management. occur which significantly alter the perceptions of current and potential future credit exposures. hedge their risks through the use of exchange traded derivatives. However. (ii) information asymmetries. Moreover. technological developments and advances in the financial theories. including counter-party.} PRICE VOLATILITY – A price is what one pays to acquire or use something of value. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events. liquidity and operational risks.The following features of OTC derivatives markets can give rise to instability in institutions. globalisation of the markets. Instability arises when shocks. and their dependence on exchange traded derivatives. and the international financial system: (i) the dynamic nature of gross credit exposures. markets. (iv) the high concentration of OTC derivative activities in major institutions. and OTC derivatives markets continue to pose a threat to international financial stability. (iii) the effects of OTC derivative activities on available aggregate credit. A. When asset prices change rapidly. local currency or foreign currencies. The objects having value maybe commodities. such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts. and (v) the central role of OTC derivatives markets in the global financial system. 3.
Now globalisation has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. the frequency of price changes and the magnitude of price changes. oil. in many cases. The Mexican crisis in the south east-Asian currency crisis of 1990‟s has also brought the price volatility factor on the surface. The changes in demand and supply influencing factors culminate in market adjustments through price changes. Nations that were poor suddenly became a major source of supply of goods. There is a price to be paid for the purchase of food grain. equity shares and bonds. metal. what happened in other part of the world was mostly irrelevant. This has three factors: the speed of price changes. the price one pays for use of a unit of another persons money is called interest rate. In a market. producing firms and governments to significant risks.almost everybody when we discuss commodities. and the collective interaction of demand and supply in the market determines the price. These price changes expose individuals. consumers have „demand‟ and producers or suppliers have „supply‟. And the price one pays in one‟s own currency for a unit of another currency is called as an exchange rate. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. The break down of the BRETTON WOODS agreement brought and end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. It has also exposed the modern business to significant risks and. These price volatility risks pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets. etc. The advent of telecommunication and data processing bought information very quickly to the markets.} GLOBALISATION OF MARKETS – Earlier. managers had to deal with domestic economic concerns. Prices are generally determined by market forces. led to cut profit margins . Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Such changes in the price are known as „price volatility‟. B. These factors are constantly interacting in the market causing changes in the price over a short period of time. petrol. foreign exchange.
At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12. C. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. The effect of this risk can easily destroy a business which is otherwise well managed. Futures contracts on individual stocks were launched in November 2001. Suddenly blue chip companies had turned in to red. Data transmission by satellite. This factor alone has contributed to the growth of derivatives to a significant extent. 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.} TECHNOLOGICAL ADVANCES – A significant growth of derivative instruments has been driven by technological break through. Single stock futures were launched on November 9. byelaws. network systems and enhanced method of data entry. and regulations of the respective exchanges and their clearing house/corporation duly approved . The fear of china devaluing its currency created instability in Indian exports. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Improvement in communications allow for instantaneous world wide conferencing. Export of certain goods from India declined because of this crisis. Advances in this area include the development of high speed processors. Thus. The trading in index options commenced on June 4. 2001 and trading in options on individual securities commenced on July 2. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the The trading in BSE Sensex options commenced on June 4. south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. 2000. it is evident that globalisation of industrial and financial activities necessitates use of derivatives to guard against future losses. 2001.In Indian context. 2001. Closely related to advances in computer technology are advances in telecommunications. 2001 and the trading in options on individual securities commenced in July 2001.
A related issue is that brokers do not earn high commissions by recommending index options to their clients. the index) is high. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): • Single-stock futures continue to account for a sizable proportion of the F&O segment. The fact that the option premiums tail intra-day stock prices is evidence to this.by SEBI and notified in the official gazette. • On relative terms. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. • Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.32 in June. It constituted 70 per cent of the total turnover during June 2002. volumes in the index options segment continue to remain poor. options are considered more valuable when the volatility of the underlying (in this case.86 in January 2002 to 1. This may be due to the low volatility of the spot index. Trading in equity options on most stocks for even the next month was non-existent. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options. the intra-day stock price variations should not have a one-to-one impact on the option premiums. as the former closely resembles the erstwhile badla system. The fall in callput volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. • Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. . Typically. • Farther month futures contracts are still not actively traded. If calls and puts are not looked as just substitutes for spot trading. because low volatility leads to higher waiting time for roundtrips.
where I understand the share of futures market ranges between 2 – 3 per cent . But often corporate assume these risks due to interest rate differentials and views on currencies. 429 crores in October 2008 to Rs 45. Significant milestones in the development of derivatives market have been (i) permission to banks to undertake cross currency derivative transactions subject to certain conditions (1996) (ii) allowing corporates to undertake long term foreign currency swaps that contributed to the development of the term currency swap market (1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of currency futures (2008). However. Normally such risks should be taken by corporates who have natural hedge or have potential foreign exchange earnings. I would like to emphasise that currency swaps allowed companies with ECBs to swap their foreign currency liabilities into rupees. In the derivative market foreign exchange swaps account for the largest share of the total turnover of derivatives in India followed by forwards and options. This period has also witnessed several relaxations in regulations relating to forex markets and also greater liberalisation in capital account regulations leading to greater integration with the global economy. 803 crores in December 2008. the value of the trades has gone up steadily from Rs 17. The turnover in the currency futures market is in line with the international scenario. since banks could not carry open positions the risk was allowed to be transferred to any other resident corporate.• The spot foreign exchange market remains the most important segment but the derivative segment has also grown.181 crores during the same period. • Cash settled exchange traded currency futures have made foreign currency a separate asset class that can be traded without any underlying need or exposure a n d on a leveraged basis on the recognized stock exchanges with credit risks being assumed by the central counterparty Since the commencement of trading of currency futures in all the three exchanges. The average daily turnover in all the exchanges has also increased from Rs871 crores to Rs 2.
7 19.21 9.9 21.5 6.3 31.5 19.9 30.6:1 50.1ForexMarketActivity April‟05Mar‟06 April‟06Mar‟07 April‟07Mar‟08 April‟08Mar‟09 Total turnover (USD billion Inter-bank to Merchant ratio Spot/Total Turnover (%) Forward/Total Turnover (%) Swap/Total Turnover (%) Source: RBI 4.404 2.7 .621 2.9 17.5 32.Table 4.1 12.7:1 51.304 2.571 2.66:1 54.0 30.37:1 49.
HDFC Bank. Bank of Baroda. Cooperatives. Mumbai commenced operations in October/ December 2003 respectively. State Bank of Hyderabad.5. Mumbai. SBI Life Insurance Co.mutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading. a state-of-the-art . Three such Exchanges. Regional Trading Canters. Ahmedabad. Importers. Traders. National Commodity & Derivatives Exchange (NCDEX). and Multi Commodity Exchange (MCX). National Multi-Commodity Exchange of India Ltd. Key shareholders of MCX are Financial Technologies (India) Ltd. amongst others MCX being nation-wide commodity exchange. is an independent and demutualised multi commodity Exchange. “National Status” implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. State Bank of Saurashtra. Mumbai have become operational. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors. MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. viz. offering multiple commodities for trading with wide reach and penetration and robust infrastructure. State Bank of Indore. MCX and NCDEX. MCX MCX (Multi Commodity Exchange of India Ltd. MCX.. MCX. Exporters.) an independent and de. Ltd. State Bank of India. Bank of India. Canera Bank. Corporate. (NMCE). Ahmedabad commenced futures trading in November 2002. Industry Associations.. clearing and settlement operations for commodity futures markets across the country. having a permanent recognition from the Government of India. While the NMCE. Corporation Bank Headquartered in Mumbai.. National Exchanges In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Union Bank of India.
an imperative in the commodity trading business.nationwide. (NMCE) was promoted by Central Warehousing Corporation (CWC). Gujarat Agro-Industries Corporation Limited (GAICL). provided by CMC.. These deliveries are executed through a sound and reliable Warehouse Receipt System. The unique strength of NMCE is its settlements via a Delivery Backed System. NMCENational Multi Commodity Exchange of India Ltd. National Institute of Agricultural Marketing (NIAM). NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. NMCE follows best international risk management practices. Gujarat State Agricultural Marketing Board (GSAMB). The contracts are marked to market on daily basis. special intra-day clearing and settlement is held. NMCE was the first commodity exchange to provide trading facility through internet. finance was still a vital missing link. warehousing. and Neptune Overseas Limited (NOL). research and training were adequately addressed in structuring the Exchange. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. facilitates online trading. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). private and public sector marketing of agricultural commodities. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. Derivative Trading Settlement System (DTSS). leading to guaranteed clearing and settlement. NCDEX . through Virtual Private Network (VPN). cooperatives. National Agricultural Cooperative Marketing Federation of India (NAFED). In the event of high volatility in the prices. viz. Even today. NMCE facilitates electronic derivatives trading through robust and tested trading platform. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. digital Exchange. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. clearing and settlement operations for a commodities futures trading. While various integral aspects of commodity economy.
It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. Yellow Red Maize & Yellow soyabean meal . Cotton Seed Oilcake. Yellow Peas. Refined Soy Oil. Soy Bean. Coffee. Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Sesame Seeds. which impinge on its working. Guar Seeds.Mustard Seed . It is a public limited company registered under the Companies Act. Maharashtra in Mumbai on April 23.National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. Besides. Mild Steel Ingot. Rice. Gold. NCDEX currently facilitates trading of thirty six commodities . Tur. NCDEX is subjected to various laws of the land like the Companies Act. professionalism and transparency. Chana. Cotton. It has an independent Board of Directors and professionals not having any vested interest in commodity markets.Raw Jute. Castor Seed. Pepper. Turmeric. It has been launched to provide a worldclass commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices. Chilli. Forward Commission (Regulation) Act and various other legislations. Sugar. Rapeseed . RBD Palmolein. Contracts Act. Expeller Mustard Oil. 48 Rubber. Wheat. 1956 with the Registrar of Companies. Jeera. Silk. Mulberry Green Cocoons. Silver. Gur. Guar gum. The reach will gradually be expanded to more centres. Urad (Black Matpe).2003. Crude Palm Oil. Jute sacking bags.Cashew. Stamp Act.
To know the role of derivatives trading in India.OBJECTIVES OF THE STUDY To understand the concept of the Derivatives and Derivative Trading. To analyse the performance of Derivatives Trading since 2001with special reference to Futures & Options To know the investors perception towards investment in derivative market RESARCH METHODOLOGY Method of data collection:Secondary sources:- It is the data which has already been collected by some one or an organization for some other purpose or research study . The sample will consist of people who are employed or work as free lancers dealing in derivative market to know their . The questionnaire will be filled by around 50 people who will be mainly from Delhi/NCR region.The data for study has been collected from various sources: Books Journals Magazines Internet sources Second Phase is Collection of Primary Data and Analysis: After collecting the Secondary data the next phase will be collection of primary data using Questionnaires. To know different types of Financial Derivatives.
The sources of information are both primary and secondary. These respondents comprise of the persons dealing in derivative market. Those persons who do not trade in derivative market have not been interviewed. RESEARCH DESIGN Nonprobability The non –probability respondents have been researched by selecting the persons who do the trading in derivative market. The secondary data has been taken by referring to various magazines. Sampling Unit The respondents who were asked to fill out the questionnaire in the National Capital Region are the sampling units. The objective of the exploratory research is to gain insights and ideas. in front of the companies. Exploratory and descriptive research The research is primarily both exploratory and descriptive in nature. a rough draft was prepared a pilot study was done to check the accuracy of the Questionnaire and certain changes were done to prepare the final questionnaire to make it more judgmental. telephonic interviews and through other sources also Sample Size . internal sources and internet to get the figures required for the research purposes.perception towards investment in derivative market. newspapers. The people have been interviewed in the open market. The objective of the descriptive research study is typically concerned with determining the frequency with which something occurs. A well structured questionnaire was prepared for the primary research and personal interviews were conducted to collect the responses of the target population SAMPLING METHODOLOGY Sampling Technique Initially. The data collected will be then entered into MS Excel for analysis of the data collected from the questionnaire.
tabulation. Sampling Area The area of the research was National Capital Region (NCR). Time: 2 months Statistical Tools Used: Simple tools like bar graphs. line diagrams have been used.The sample size was restricted to only 50 respondents. .
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