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EXECUTIVE SUMMARY

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. Indias 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, 2009 was Rs 48.4 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, called Hedging, 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. Forwards 2. Futures 3. Options 4. 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.

CAPITAL MARKET

The Capital Market Consists of Primary and Secondary Markets. The primary Market deals with the issue of new instruments by the corporate Sector Such as Equity Share, Preference Shares, and debt instruments. Central and state governments, various public sector industrial units (PSUs), statutory and other authorities such as state electricity boards and port trusts also issue bonds /debt instruments We are living in exciting times ,witnessing a process of ever-increasing globalization and innovation in the financial markets .This is Bringing with it sophistication and thus a need to better understand financial risk and develop tools to manage them. The financial Markets and institution have undergone significant changes keeping pace with the changing needs of Market participants. Along side the rise of Private finance, The financial Markets are seeing an enhanced role of national Governments through sovereign Wealth Funds. Venture Capital funds and hedge funds have added new dimension to the market dynamics. In the securities markets, organizational innovation has been witnessed with corporation and demutualization of all the stock exchanges; institutional innovations in the form of emergence of regulators, self regulatory organizations and clearing corporations and more recently, market innovations through a short selling and securities lending and borrowing scheme, direct market Access, addressing of the legal, regulatory , tax and market Design issues in the development of the corporate bond Market in the Country, Provision of a legal Framework for Trading of Securitized debt, quicker procedures for registration and operation by FIIs ,making PAN as the sole identification number for all transaction in securities Market sand new derivatives products such as currency futures.

PRIMARY MARKET
The primary market in which public issue of securities is made through a prospectus is a retail market and there is no physical location. Offer for subscription to securities is made to investing community. The secondary market or stock exchange is a market for trading and settlement of securities that have already been issued. The investors holding securities sell securities through registered brokers/sub-brokers of the stock exchange. Investors who are desirous of buying securities purchase securities through registered broker/sub-broker of the stock exchange. It may have a physical location like a stock exchange or a trading floor.Since.1995, trading in securities is screen-based and internet-based trading has also made an appearance in India.

SECONDARY MARKET
The secondary market consists of 22 stock exchanges. The secondary market provides a trading place for the securities already issued, to be bought and sold. It also provides liquidity to the initial buyers in the primary market to re-offer the securities to any interested buyer at any price, if mutually accepted. An active secondary market actually promotes the growth of the primary market and capital formation because investors in the primary market are assured of a continuous market and they can liquidate their investments.

THE INDIAN CAPITAL MARKET


The function of the financial market is to facilitate the transfer of funds from surplus sectors (lenders) to deficit sectors (borrowers). Normally, households have investible funds or savings, which they lend to borrowers in the corporate and public sectors whose requirement of fund far exceeds their savings. A financial market consists of investors or buyers of securities, borrowers or sellers of securities, intermediaries and regulatory bodies. Financial market does not refer to a physical location. Formal trading rules, relationships and communication networks for originating and trading financial securities link the participants in the market.

INTRODUCTION
A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly important in the field of finance, Options and Futures are traded actively on many exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as over-thecounter markets in other words, there is no single market place or organized exchanges.

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. 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.

LITERATURE REVIEW
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by lockingin asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-vis derivative products based on individual securities is another reason for their growing use. As in the present scenario, Derivative Trading is fast gaining momentum, I have chosen this topic.

OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading. To know different types of Financial Derivatives To know the role of derivatives trading in India. To analyse the performance of Derivatives Trading since 2001with special reference to Futures & Options

SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better understanding various strategies with different situations and actions have been given. It includes the data collected in the recent years and also the market in the derivatives in the recent years. This study extends to the trading of derivatives done in the National Stock Markets.

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

MAIN TOPICS OF STUDY


1. 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. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, 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. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the toarrive contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence. Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

2. 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. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, 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. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term security in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.

3. TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

Over The Counter Derivatives

National Stock Exchange

Bombay Stock Exchange

National Commodity & Derivative Exchange

Index Future

Index option

Stock option

Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Figure.2 Types of Derivatives (i)

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to

the

contract.

The

forward

contracts are n o r m a l l y

traded outside the

exchanges.

BASIC FEATURES OF FORWARD CONTRACT


They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged. However forward contracts in certain standardized, transaction as in the case of costs and increasing markets have foreign exchange, volume. become thereby very reducing

transactions

This process of

standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially t h e same economic fun ction s of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.

(ii)

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the

commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT


1. Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month. The last trading date. Other details such as the tick, the minimum permissible price fluctuation.

2. Margin: Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, 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. Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. 3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. 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. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. PRICING OF FUTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, nondividend paying asset, the value of the future/forward, discounting the present value . at time to maturity , will be found by

by the rate of risk-free return

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher: 1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower: 1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds. 2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. 3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.

TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURE Operational Mechanism FORWARD CONTRACT FUTURE CONTRACT

Traded directly between Traded on the exchanges. two parties (not traded on the exchanges).

Contract Specifications Counter-party risk

Differ from trade to trade.

Contracts contracts.

are

standardized

Exists.

Exists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally settlement. guarantees their

Liquidation Profile

Low, tailor

as

contracts

are

High, as contracts are standardized

made

contracts exchange traded contracts.

catering to the needs of the needs of the parties.

Price discovery

Not efficient, as markets Efficient, as markets are centralized are scattered. and all buyers and sellers come to a common platform to discover the price. Commodities, futures, Index Futures and Individual stock Futures in India.

Examples

Currency market in India.

OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price. There are two types of options i.e., CALL OPTION & PUT OPTION. CALL OPTION: A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. PUT OPTION: A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

SWAPS Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. 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. The two commonly used swaps are: INTEREST RATE SWAPS: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract. CURRENCY SWAPS: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. FINANCIAL SWAP: Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

5. OTHER KINDS OF DERIVATIVES


The other kind of derivatives, which are not, much popular are as follows:

BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.

LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.

WARRANTS Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

11. HISTORY OF DERIVATIVES:


The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralised location to negotiate forward contracts. From forward trading in commodities emerged the commodity futures. The first type of futures contract was called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. 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. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealers Association was set up in early 1900s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nineties. 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 CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts

(with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

INDIAN DERIVATIVES MARKET


Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of

Indias (RBI) efforts in creating currency forward market. 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. In July 1999, derivatives trading commenced in India Table 2. Chronology of instruments 1991 Liberalisation process initiated 14 December 1995 NSE asked SEBI for permission to trade index futures. 18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy 11 May 1998 7 July 1999 24 May 2000 25 May 2000 framework for index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index

futures trading. 9 June 2000 Trading of BSE Sensex futures commenced at BSE. 12 June 2000 Trading of Nifty futures commenced at NSE. 25 September Nifty futures trading commenced at SGX. 2000 2 June 2001 Individual Stock Options & Derivatives

(1) Need for derivatives in India today In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, 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, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of Indias financial markets with the international financial markets. Introduction of

risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of Indias efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market. (2) Myths and realities about derivatives In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? Derivatives increase speculation and do not serve any economic purpose Indian Market is not ready for derivative trading Disasters prove that derivatives are very risky and highly leveraged instruments. Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding Is the existing capital market safer than Derivatives? (i) Derivatives increase speculation and do not serve any economic purpose: Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by

remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance (ii) Indian Market is not ready for derivative trading Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives, and how Indian market fares: TABLE 3. PRE-REQUISITES INDIAN SCENARIO Large market India is one of the largest market-capitalised Capitalisation countries in Asia with a market capitalisation of more than Rs.765000 crores. High Liquidity underlying in the The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the countrys Market capitalisation gets traded. These are clear

indicators of high liquidity in the underlying. Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing. National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country. In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

A Strong Depository

A Good legal guardian

(3) 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, but I feel that this new system is very useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI. The figure 3.3a 3.3d shows how advantages of new system (implemented from June 20001) v/s the old system i.e. before June 2001 New System Vs Existing System for Market Players

Figure 3.3a

Speculators
Existing Approach
1) Deliver based

SYSTEM Peril &Prize


1) Both profit &

New Peril &Prize


1)Maximum

Approach

1)Buy &Sell stocks

Trading, margin trading & carry forward transactions. 2) Buy Index Futures hold till expiry.

loss to extent of price change.

on delivery basis 2) Buy Call &Put by paying premium

loss possible to premium paid

Advantages
Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.

Figure 3.3b

Arbitrageurs
Existing Approach SYSTEM Peril &Prize Approach New Peril &Prize

1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free one and selling in whichever way promising as still game. another exchange. the Market moves. in weekly settlement forward transactions. 2) Cash &Carry 2) If Future Contract arbitrage continues more or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers
Existing Approach SYSTEM Peril &Prize Approach New Peril &Prize

1) Difficult to 1) No Leverage offload holding available risk during adverse reward dependant market conditions on market prices as circuit filters limit to curtail losses.

1)Fix price today to buy 1) Additional latter by paying premium. cost is only 2)For Long, buy ATM Put premium. Option. If market goes up, long position benefit else exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages
Availability of Leverage Figure 3.3d

Small Investors
Existing Approach
1) If Bullish buy stocks else sell it.

SYSTEM Peril &Prize


1) Plain Buy/Sell implies unlimited profit/loss.

New Peril &Prize


1) Downside remains protected & upside unlimited.

Approach
1) Buy Call/Put options based on market outlook 2) Hedge position if holding underlying stock

Advantages
Losses Protected. Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchangetraded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC

derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter-party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal.

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES: Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the markets, technological developments and advances in the financial theories. A.} PRICE VOLATILITY A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to

be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in ones own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have demand and producers or suppliers have supply, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as price volatility. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. 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. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. 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, foreign exchange, equity shares and bonds. B.} GLOBALISATION OF MARKETS

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. 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. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well

managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important. D.} ADVANCES IN FINANCIAL THEORIES Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970s, work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. The above factors in combination of lot many factors led to growth of derivatives instruments

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30 (Sense) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. 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. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with singlestock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continue to remain

poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. 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

2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity

options on most stocks for even the next month was non-existent. 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. The fact that the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intraday stock price variations should not have a one-to-one impact on the option premiums. The spot foreign exchange market remains the most important segment swaps account for the largest share of the total turnover of have been (i) permission to banks to

but the derivative segment h a s also grown. In the derivative market foreign exchange derivatives in India followed by forwards and options. Significant milestones in the development of derivatives market 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). I would like to emphasise that currency swaps allowed companies with ECBs to swap their foreign currency liabilities into rupees. However, since banks could not carry open positions the risk was allowed to be transferred to any other resident corporate. Normally such risks should be taken by corporates who have natural hedge or have potential foreign exchange earnings. currencies. But often corporate assume these risks due to interest rate differentials and views on

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. 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 value of the trades has gone up steadily from Rs 17, 429 crores in October 2008 to Rs 45, 803 crores in December 2008. The average daily turnover in all the exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same period. The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between 2 3 per cent. BENEFITS OF DERIVATIVES Derivative markets help investors in many different ways: 1.] RISK MANAGEMENT Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. 2.] PRICE DISCOVERY Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct

allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset. 3.] OPERATIONAL ADVANTAGES As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.

4.]

MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.

5.]

EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

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. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. 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. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively. MCX MCX (Multi Commodity Exchange of India Ltd.) an independent and demutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank Bank, Corporation Bank Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure. of India, Bank of Baroda, Canera

MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of-the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading. NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz., warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN). NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of

warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement. NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency. Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal.

. The Present Status of futures trading: Presently futures trading is permitted in all the commodities. Trading is taking place in about 78 commodities through 25 Exchanges/Associations as given in the table below:Registered commodity exchanges in India No. 1. 2. 3. 4. 5. 6. 7. 8. Exchange India Pepper COMMODITY Trade Pepper (both domestic and international contracts) Gur, Mustard seed

&

Spice

Association, Kochi (IPSTA) Vijai Beopar Chambers Ltd.,

Muzaffarnagar Rajdhani Oils & Oilseeds Exchange Gur, Mustard seed its oil & Ltd., Delhi Bhatinda Om & Oil Exchange Ltd., Bhatinda The Chamber of Commerce, Hapur The Meerut Agro oilcake Gur Gur, Potatoes and Mustard

seed Commodities Gur

Exchange Ltd., Meerut The Bombay Commodity Exchange Oilseed Complex, Castor Ltd., Mumbai Rajkot Seeds, Oil & oil international contracts Bullion Castor seed, Groundnut, its oil & cake, cottonseed, its oil & cake, cotton (kapas)

Merchants Association, Rajkot

9. 10. 11. 12. 13.

The

Ahmedabad

and RBD palmolein. Commodity Castorseed, cottonseed, its

Exchange, Ahmedabad oil and oilcake The East India Jute & Hessian Hessian & Sacking Exchange Ltd., Calcutta The East India Cotton Association Cotton Ltd., Mumbai The Spices & Oilseeds Exchange Turmeric Ltd., Sangli. National Board of Trade, Indore Soya seed, Soyaoil and Soya meals, Rapeseed/Mustardseed its

14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

oil and oilcake and RBD Palmolien The First Commodities Exchange of Copra/coconut, its oil & India Ltd., Kochi oilcake Central India Commercial Exchange Gur and Mustard seed Ltd., Gwalior E-sugar India Ltd., Mumbai Sugar National Multi-Commodity Several Commodities Exchange of India Ltd., Ahmedabad Coffee Futures Exchange India Ltd., Coffee Bangalore Surendranagar Cotton Oil & Cotton, Cottonseed, Kapas Sugar (trading yet to

Oilseeds, Surendranagar E-Commodities Ltd., New Delhi

commence) National Commodity & Derivatives, Several Commodities Exchange Ltd., Mumbai Multi Commodity Exchange Ltd., Several Commodities Mumbai Bikaner commodity Exchange Ltd., Mustard seeds its oil & oilcake, Gram. Guar seed. Bikaner Guar Gum Haryana Commodities Ltd., Hissar Mustard seed complex Bullion Association Ltd., Jaipur Mustard seed Complex

24. 25.

STATUS REPORT OF THE DEVELOPMENTS IN THE DERIVATIVE MARKET 1. The Board at its meeting on November 29, 2002 had desired that a quarterly report be submitted to the Board on the developments in the derivative market. Accordingly, this memorandum presents a status report for the quarter JulySeptember 2008-09 on the developments in the derivative market. 2. Equity Derivatives Segment A. Observations on the quarterly data for July-September, 2008-09 During July-September 2008-09, the turnover at BSE was Rs.1,510 crore, which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.

Business Growth in Derivatives segment (NSE)


Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 No. of contracts 4116649 156598579 81487424 58537886 21635449 17191668 2126763 1025588 Index futures

FIGURE 11A Number of contracts per year

INTERPRETATION: From the data and the bar diagram above, there is high business growth in the derivative segment in India. In the year 2001-02, the number of contracts in Index Future were 1025588 where as a significant increase of 4116679 is observed in the year 2008-09.

Table 11B No of turnovers Year 2008-09 2007-08 2006-07 2005-06 Turnover (Rs. Cr.) 925679.96 3820667.27 2539574 1513755

2004-05 2003-04 2002-03 2001-02

772147 554446 43952 21483

FIGURE 11B Turnover in Rs. Crores

INTERPRETATION: From the data and above bar chart, there is high turn over in the derivative segment in India. In the year 2001-02 the turnover of index future was 21483 where as a huge increase of 92567996 in the year 2008-09 are observed.

TABLE 12A STOCK FUTURES Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 51449737 203587952 104955401 80905493 47043066 32368842 10676843 1957856 -

FIGURE 12A Number of contracts per year in stock future INTERPRETATION: From the data and bar diagram above there were no stock futures available but in the year 2001-02, it predominently increased to 1957856. Then there was a huge increase of 20, 35, and 87,952 in the year 2007-08 but there was a steady decline to 51449737 in the year 2008-09.

TABLE 12B NO OF TURNOVERS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 FIGURE 12B Turnover in Rs. Crores INTERPRETATION: Turnover (Rs. Crores) 1093048.26 7548563.23 3830967 2791697 1484056 1305939 286533 51515 -

From the data and bar chart above, there were no stock futures available in the year 2000-01. There was a steady increase of stock future 51515 in the year 2001-02. but in the year there was a huge increae of 7548563.23 in the year 2007-08 with a considerable decline of 1093048.26 in the year 2008-09. TABLE 13A INDEX OPTIONS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 24008627 55366038 25157438 12935116 3293558 1732414 442241 175900 -

FIGURE 13A Number of contracts per year Interpretation: From the data and bar chart above, the no of contracts of index option was nil in the year 2000-2001. But there was a predominant increase of 1,75,900 in the year 20012002. In the year 2007-2008 there was a huge increase in the index option contracts to 55366038 and a decline of 24008627 in the year 2008-2009.

TABLE 13B Turnover per year in Rs. Crores

Year 2008-09 2007-08 2006-07 2005-06

Turnover (Rs. Crores) 71340.02 1362110.88 791906 338469

2004-05 2003-04 2002-03 2001-02 2000-01

121943 52816 9246 3765 -

FIGURE 13B Turnover per year in Rs. Crores Interpretation: From the data and bar chart above, there was no turnover in the year 2000-2001 for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in the year 2007-2008 there was a huge increase of 1362110.088 and a sudden decline to 71340.02 observed in 2008-2009.

TABLE 14A STOCK OPTIONS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 2546175 9460631 5283310 5240776 5045112 5583071 3523062 1037529 -

FIGURE 14A Number of contracts traded per year in stock option INTERPRETATION: From the data and bar chart above the no of contracts of stock option in the year 2000-2001 was nil. But there was a huge increase of 1037529 observed in the year

2001-2002. It was 9460631 which was the the highest in the year 2007-2008. But a gradual decline of 2546175 in the year 2008-2009.

TABLE 14B National turnover in Rs. Crores per year Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 Notional crores) 58335.03 359136.55 193795 180253 168836 217207 100131 25163 turnover (Rs.

FIGURE 14B National turnover in Rs. Crores per year Interpretation: From the chart and the bar diagram above the stock option turnover in the year 2000-2001 was nil. There was a slow increase of 25163 in the year 2001-2002. But a phenomenal increase of 359136.55 in the year 2007-2008, and a decline of 58355.03 in the year 2008-2009.

TABLE 15A OVERALL TRADING Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 No. of contracts 119171008 425013200 216883573 157619271 77017185 56886776 Turnover (Rs. cr.) 2648403.30 13090477.75 7356242 4824174 2546982 2130610

2002-03 2001-02 2000-01

16768909 4196873 90580

439862 101926 2365

FIGURE 15A Average daily turnovers in Rs. Crores

Interpretation: From the data and bar chart above, the overall trading contracts in the year 20002001 was 90580 and huge increase of 119171008 in the year 2008-2009. From the data and bar chart above the overall trading turnover in the year 20002001 was as low as 2365 but a predominant increase of 2648403.30 observed in the year 2008-2009. TABLE 17 AVERAGE DAILY TURNOVERS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 Note: Notional Turnover = (Strike Price + Premium) * Quantity Index Futures, Index Options, Stock Options and Stock Futures were introduced in June 2000, June 2001, July 2001 and November 2001 respectively. Av. daily turnover (Rs. Crores) 45390.21 52153.30 29543 19220 10167 8388 1752 410 11

OPTIONS INTRODUCTION TO OPTIONS


An option is a contract written by a seller that conveys to the buyer the right but not the obligation to buy (in the case of a call option) or to sell (in the case of a put option) a particular asset, at a particular price (Strike price / Exercise price) in future. In return for granting the option, the seller collects a payment (the premium) from the buyer. Exchange traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.

OPTION TERMINOLOGY
Index options: These options have the index as the underlying. In India, they have a European style settlement. E.g. Nifty options, Mini Nifty options etc. Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer / seller of an option: The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time up to the expiration date. European options: European options are options that can be exercised only on the expiration date itself. 4 In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max[0, K St],i.e. the greater of 0 or (K St). K is the strike price and St is the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration.

OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited. However the profits are potentially unlimited. For a writer (seller), the payoff is exactly the opposite. His profits are limited to the option premium, however his losses are potentially unlimited. These nonlinear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs.

Payoff profile of buyer of Asset: Long Asset


In this basic position, an investor buys the underlying asset, Nifty shares for instance, for Rs. 4820, and sells it at a future date at an unknown price, St. Once it is purchased, the investor is said to be "long" the asset. Figure shows the payoff for a long position on Nifty. The figure shows the profits/losses from a long position on Nifty the investor bought ABC Ltd. at Rs. 4820. If the share price goes up, he profits. If the share price falls he loses.

Payoff profile for seller of Asset: Short Asset


In this basic position, an investor shorts the underlying asset, ABC Ltd. shares for instance, for Rs. 4820, and buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be "short" the asset. Figure shows the payoff for a short position on ABC Ltd. The figure shows the profits/losses from a short position on ABC Ltd. The investor sold ABC Ltd. at Rs. 4820. If the share price falls, he profits. If the share price rises, he loses.

Payoff profile for buyer of call options: Long call


A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 4800 bought at a premium of 86.60. The figure shows the profits/losses for the buyer of a three-month Nifty 4800 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 4800, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price.

Payoff profile for writer (seller) of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. The figure shows the profits/losses for the seller of a three-month Nifty 4800 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 4800, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. . The figure shows the profits/losses for the buyer of a three-month Nifty 4800 put option. As can be seen, as the spot Nifty falls, the put option is in-themoney. If upon expiration, Nifty closes below the strike of 4800, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 4800, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Payoff profile for writer (seller) of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. The figure shows the profits/losses for the seller of a three-month Nifty 4800 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 4800, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the upfront option premium of Rs.61.70 charged by him.

Stratagies
LONG CALL STRATEGY

Strategy :Buy call Option


Call Option Current Nifty Strike Price (Rs.) 4691.10 4800

Buying a call is the most basic of all options strategies. It Example: Mr. XYZ Pays Premium (Rs.) 36.35 constitutes the first options trade Point (Rs.) Break Even 4836.35 for someone already familiar Mr. XYZ is bullish on Nifty on 24th (Strike Price+ Premium) with buying / selling stocks and June, when the Nifty is at 4691.10. would now want to trade He buys a call option with a strike options. Buying a call is an easy price of Rs. 4800 at a premium of Rs. strategy to understand. When 36.35, expiring on 31st July. If the you buy it means you are Nifty goes above 4836.35, Mr. XYZ bullish. Buying a will make a net profit (after deducting Call means you are very bullish the premium) on exercising the and expect the underlying option. In case the Nifty stays at or stock / index to rise in future. falls below 4800, he can forego the option (it will expire worthless) with When to Use: Investor is very a maximum loss of the premium. Bullish on the stock / index. Risk: Limited to the Premium. (Maximum loss if market expires at or below the option strike price). Reward: Unlimited Breakeven: Strike Price + Premium

The payoff Schedule On expiry Nifty closes at 4100.00 4300.00 4500.00 4836.35 4900.00 5100.00 5300.00 Net Payoff from Call Option (Rs.)

36.35 36.35 36.35 0 63.65 263.65 463.65

Limited Unlimited The payoff chart (Long Loss Profit Call)

SHORT CALL STRATEGY


When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock / index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is exposed to unlimited risk. A Call option means an Option to buy. Buying a Call option means an investor expects the underlying price of a stock / index to rise in future. Selling a Call option is just the opposite of buying a Call option. Here the seller of the option feels the underlying price of a stock / index is set to fall in the future.

Example:

Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of Rs. 4800 at a premium of Rs. 154, when the current Nifty is at 4894. If the Nifty stays at 4800 or below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ can retain the entire When to use: Investor is very premium of Rs. 154. aggressive and he is very bearish about the stock / index. Risk: Unlimited Reward: Limited to the amount of premium Break-even Point: Strike Price + Premium

Strategy : Sell Call Option Current Nifty index Call Option Mr. XYZ receives Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) (Strike Price +Premium) 4894 4800 154 4954

The payoff schedule On expiry Nifty closes at 4600 4700 4800 4900 4954 5000 5100 5200 Net Payoff from the Call Options(Rs.) 154 154 154 54 0 -46 -146 -246

The Payoff Chart Unlimited Loss (Short Call) Limited Profit

LONG PUT STRATEGY


Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the stock / index. When an investor is bearish, he can buy a Put option. A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk.

A long Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put options. When to use: Investor is bearish about the stock /index. Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expires at or above the option Strike price). Reward: Unlimited Break-even Point: Stock Price - Premium

Example: Mr. XYZ is bearish on Nifty on 24th June, when the Nifty is at 4894. He buys a Put option with a strike price Rs.4800 at a premium of Rs.52, expiring on 31st July. If the Nifty goes below 4748, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 4800, he can forego the option (it will expire worthless) with a maximum loss of the premium.

Strategy : Buy Put Option Current Nifty index Put Option Mr. XYZ Pays Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) (Strike Price - Premium) The payoff schedule On expiry Nifty closes at 4400 4500 4600 4748 4800 4900 5000 5100 Net Payoff from Put option (Rs.) 248 148 48 0 -52 -52 -52 -52 4894 4800 52 4748

The payoff Limited lossChart Unlimited Profit Long Put

SHORT PUT STRATEGY


Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock. An investor Sells Put when he is Bullish about the stock expects the stock price to rise or stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of the Put). You have sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller by the amount of the premium.

When to Use: Investor is very Bullish on the stock / index. The main idea is to make a short term income. Risk: Put Strike Price Put Premium. Reward: Limited to the amount of Premium received. Breakeven: Put Strike Price - Premium

Example: Mr. XYZ is bullish on Nifty when it is at 4891.10. He sells a Put option with a strike price of Rs. 4800 at a premium of Rs. 170.50 expiring on 31st July. If the Nifty index stays Above 4800, he will gain the amount of premium as the Put buyer wont exercise his option. In case the Nifty falls below 4800, Put buyer will exercise the option and the Mr. will start losing money. If the Nifty falls below 4629.50, which is the breakeven point, Mr. XYZ will lose the premium and more depending on the extent of the fall in Nifty

Strategy : Sell Put Option Current Nifty index Put Option Mr. XYZ receives Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) (Strike Price Premium) 4891.10 4800.00 170.50 4629.50

The payoff schedule On expiry Nifty Closes at Net Payoff from the Put Option (Rs.) -529.50 -429.50 -229.50 -29.50 0 170.50 170.50 170.50

4100.00 4200.00 4400.00 4600.00 4629.50 4800.00 5000.00 5200.00

The payoff Chart Unlimited Loss Short Put Limited profit

LONG STRADDLE
A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index. If the price of the stock / index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. When to Use: The investor thinks that the underlying stock / index will Experience significant volatility in the near term. Risk: Limited to the initial premium paid. Reward: Unlimited Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Example: Suppose Nifty is at 4750 on 27th April. An investor, Mr. A enters a long straddle by buying a May Rs 4800 Nifty Put for Rs. 85 and a May Rs. 4800 Nifty Call for Rs. 122. The net debit taken to enter the trade is Rs 207, which is also his maximum possible loss.

Strategy : Buy Put + Buy Call Nifty index Call and Put Mr. A pays Current Value Strike Price (Rs.) Total Premium (Call + Put) (Rs.) Break Even Point (Rs.) (Rs.) 4750 4800 207 5007(U) 4593(L)

The payoff schedule On expiry Nifty closes at 4100 4200 4300 4400 4500 4534 4593 4600 4700 4800 4900 5000 5007 5066 5100 5400 5300 5400 Net Payoff from Put purchased (Rs.) 615 515 415 315 215 181 122 115 15 -85 -85 -85 -85 -85 -85 -85 -85 -85 Net Payoff from Call purchased (Rs.) -122 -122 -122 -122 -122 -122 -122 -122 -122 -122 -22 78 85 144 178 278 378 478 Net Payoff (Rs.)

493 393 293 193 93 59 0 -7 -107 -207 -107 -7 0 59 93 193 293 393

Buy Call put

Long Straddle

SHORT STRADDLE
A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index does not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. Strategy : Sell Put + Sell Call When to Use: The investor thinks Example: that the underlying stock / index will Value Nifty index Current 4750 experience very little volatility in the Suppose Nifty is at 4450 on 27th near term.Call and Put April. Strike Price (Rs.) An investor, Mr. A, enters into 4800 a short straddle by selling a May Rs Risk: Unlimited 4500 Nifty Put for Rs. 85 and a May Mr. A Total Premium 207 Rs. 4500 Nifty Call for Rs. 122. The receives (Call Reward: Limited to the premium + Put) (Rs.) net credit received is Rs. 207, which Received is also his maximum possible profit. Break Even Point 5007 (Rs.)* Breakeven: (Rs.)* Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received 4593

The payoff schedule On expiry Nifty closes at 4100 4200 4300 4400 4500 4534 4593 4600 4700 4800 4900 5000 5007 5066 5100 5200 5300 Net Payoff from Put Sold (Rs.) Net Payoff from Call Sold (Rs.) Net Payoff (Rs.) -493 -393 -293 -193 -93 -59 0 7 107 207 107 7 0 -59 -93 -193 -293

-615 -515 -415 -315 -215 -181 -122 -115 -15 85 85 85 85 85 85 85 85

122 122 122 122 122 122 122 122 122 122 22 -78 -85 -144 -178 -278 -378

Sell Call

Sell Put

Short Straddle

LONG STRANGLE
A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle,

When to Use: The investor thinks Example: that the underlying stock / index will Experience very high levels of Suppose Nifty is at 4500 in May. An volatility in the near term. investor, Mr. A, executes a Long Strangle by buying a Rs. 4300 Nifty Risk: Limited to the initial premium Put for a premium of Rs. 23 and a Rs Paid 4700 Nifty Call for Rs 43. The net debit taken to enter the trade is Rs. Reward: Unlimited 66, which is also his maxi mum possible loss. Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Strategy : Buy OTM Put + Buy OTM Call Nifty index Buy Call Option Mr. A pays Current Value Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) Buy Put Option Mr. A pays Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) 4800 5000 43 5066 4600 23 4534

The payoff schedule On expiry Nifty closes at 4100 4200 4300 4400 4500 4534 4600 4700 4800 4900 5000 5066 5100 5200 5300 5400 Net Payoff from Put Sold (Rs.) 477 377 277 177 77 43 -23 -23 -23 -23 -23 -23 -23 -23 -23 -23 Net Payoff from Call Sold (Rs.) -43 -43 -43 -43 -43 -43 -43 -43 -43 -43 -43 23 57 157 257 357 Net Payoff (Rs.) 434 334 234 134 34 0 -66 -66 -66 -66 -66 0 34 134 234 334

Buy OTM Call Put

Long Strangle

SHORT STRANGLE
A Short Strangle is a slight modification to the Short Straddle. It tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-of-the-money (OTM) put and a slightly out-of-themoney (OTM) call of the same underlying stock and expiration date.

When to Use: This options trading strategy is taken when the options investor thinks that the underlying stock will experience little volatility in the near term. Risk: Unlimited Reward: Limited premium Received to the

Example: Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs. 4700 Nifty Call for Rs 43. The net credit is Rs. 66, which is also his maximum possible gain.

Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

Strategy : Sell OTM Put + Sell OTM Call Nifty index Sell Call Option Mr. A receives Current Value Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) Sell Put Option Mr. A receives Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) 4800 5000 43 5066 4600 23 4534

The payoff schedule On expiry Nifty closes at 4100 4200 4300 4400 4500 4534 4600 4700 4800 4900 5000 5066 5100 5200 5300 Net Payoff from Put Sold (Rs.) -477 -377 -277 -177 -77 -43 23 23 23 23 23 23 23 23 23 Net Payoff from Call Sold (Rs.) 43 43 43 43 43 43 43 43 43 43 43 -23 -57 -157 -257 Net Payoff (Rs.) -434 -334 -234 -134 -34 0 66 66 66 66 66 0 -34 -134 -234

Sell OTM Put Call

Short Strangle

BULL CALL SPREAD STRATEGY BUY CALL OPTION, SELL CALL OPTION
A bull call spread is constructed by buying an in-themoney (ITM) call option, and selling another out-of-the-money (OTM) call option. Often the call with the lower strike price will be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must have the same underlying security and expiration month. The net effect of the strategy is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. When to Use: Investor is Moderately bullish. Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs where the underlying falls to the level of the lower strike or below. Example:

Buys a Nifty Call with a Strike price Rs. 4800 at a premium of Rs. 170.45 and he sells a Nifty Call option with a strike price Rs. 5200 at a premium of Rs. 35.40. The net debit here is Rs. 135.05 which is also his Reward: Limited to the difference maximum loss. between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike or above Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid

Strategy : Buy a Call with a lower strike (ITM) + Sell a Call with a higher strike (OTM) Nifty index Buy ITM Call Option Mr. XYZ Pays Sell OTM Call Option Mr. XYZ Receives Current Value Strike Price (Rs.) 4891.10 4800

Premium (Rs.) Strike Price (Rs.)

170.45 5200

Premium (Rs.) Net Premium Paid (Rs.) Break Even Point (Rs.)

35.40 135.05 4935.05

The payoff schedule On expiry Nifty closes at 4200 4300 4400 4500 4600 4700 4800 5000 5035 5100 5200 5300 5400 5500 5600 Net Payoff from Put Sold (Rs.) Net Payoff from Call Sold (Rs.) Net Payoff (Rs.)

-170.45 -170.45 -170.45 -170.45 -170.45 -170.45 -170.45 -70.45 -35.40 29.55 129.55 229.55 329.55 429.55 529.55

35.40 35.40 35.40 35.40 35.40 35.40 35.40 35.40 35.40 35.40 35.40 -64.60 -164.60 -264.60 -364.60

-135.05 -135.05 -135.05 -135.05 -135.05 -135.05 -135.05 -35.05 0 64.95 164.95 164.95 164.95 164.95 164.95

Sell lower Strike Buy OTM Call Call

Call Purchase

Bull Call Spread

BULL PUT SPREAD STRATEGY SELL PUT OPTION, BUY PUT OPTION
A bull put spread can be profitable when the stock / index is either range bound or rising. The concept is to protect the downside of a Put sold by buying a lower strike Put, which acts as an insurance for the Put sold. The lower strike Put purchased is further OTM than the higher strike Put sold ensuring that the investor receives a net credit, because the Put purchased (further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income. When to Use: When the investor is moderately bullish. Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower strike or below Example:

Mr. XYZ sells a Nifty Put option with a strike price of Rs. 4800 at a premium of Rs. 21.45 and buys a further OTM Nifty Put option with a strike price Rs. 4600 at a premium of Reward: Limited to the net premium Rs. 3.00 when the current Nifty is at credit. Maximum profit occurs where 4191.10, with both options expiring underlying rises to the level of the on 31st July. higher strike or above. Breakeven: Strike Price of Short Put - Net Premium Received

Strategy : Sell a Put +Buy a Put Nifty index Buy ITM Call Option Mr. XYZ Pays Sell OTM Call Option Mr. XYZ Receives Current Value Strike Price (Rs.) Premium (Rs.) Strike Price (Rs.) Premium (Rs.) Net Premium Paid (Rs.) Break Even Point (Rs.) 4991.10 4800 21.45 4600 3.00 18.45 4781.55

The payoff schedule On expiry Nifty closes at 4300.0 0 4400.0 0 4500.0 0 4600.0 0 4700.0 0 4781.5 5 4800.0 0 4900.0 0 5000.0 0 5100.0 0 5200.0 0 5300.0 0 5400.0 0 5500.0 0 5600.0 0 Net Payoff from Put Sold (Rs.) Net Payoff from Call Sold (Rs.) Net Payoff (Rs.)

267.00 197.00 97.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00 -3.00

-478.55 -378.55 -278.55 -178.55 -78.55 3.00 21.45 21.45 21.45 21.45 21.45 21.45 21.45 21.45 21.45

-181.55 -181.55 -181.55 -181.55 -81.55 0.00 18.45 18.45 18.45 18.45 18.45 18.45 18.45 18.45 18.45

Sell lower Strike Buy OTM Put Put

Bull Put spread

BEAR CALL SPREAD STRATEGY SELL ITM CALL, BUY OTM CALL
The Bear Call Spread strategy can be adopted when the investor feels that the stock / index is either range bound or falling. The concept is to protect the downside of a Call Sold by buying a Call of a higher strike price to insure the Call sold. In this strategy the investor receives a net credit because the Call he buys is of a higher strike price than the Call sold. The strategy requires the investor to buy out-of-the-money (OTM) call options while simultaneously selling in-the-money (ITM) call options on the same underlying stock index. When to use: When the investor is mildly bearish on market. Example: Risk: Limited to the difference Mr. XYZ is bearish on Nifty. He between the two strikes minus the sells an ITM call option with strike net price of Rs. 4800 at a premium of Premium. Rs. 154 and buys an OTM call option with strike price Rs. 5000 at a Reward: Limited to the net premium premium of Rs. 49. received for the position i.e., premium received for the short call minus the premium paid for the long call. Break Even Point: Lower Strike + Net credit

The payoff schedule On Net Payoff from Net Payoff from Net Payoff expiry Put Sold (Rs.) Call Sold (Rs.) (Rs.) Nifty closes at 4300.0 154 -49 105 0 Strategy : Sell a Call with a lower strike (ITM) 4400.0 154 -49 105 0 + Buy a Call with a higher strike (OTM) 4500.0 154 -49 105 0 4600.0 Nifty index 154 105 Current -49 Value 4894 0 4700.0 154 -49 105 Buy ITM Call Strike Price (Rs.) 4800 0 Option 4800.0 154 -49 105 0 Mr. XYZ Pays Premium (Rs.) 154 4905.0 54 -49 5 0 Sell OTM Call Strike Price (Rs.) 5000 5000.0 Option 49 -49 0 0 Premium (Rs.) 49 5100.0 Mr. XYZ -46 51 -95 Receives 0 5200.0 -146 151 -95 Net Premium Paid 105 0 (Rs.) 5300.0 -246 251 -95 0 Break Even Point 4905 5400.0 -346 351 -95 (Rs.) 0 5500.0 -446 451 -95 0

Buy OTM Call Sell lower strike Call

Bear Call Spread

BEAR PUT SPREAD STRATEGY BUY PUT, SELL PUT


This strategy requires the investor to buy an in-the-money (higher) put option and sell an out-of-the-money (lower) put option on the same stock with the same expiration date. This strategy creates a net debit for the investor. The net effect of the strategy is to bring down the cost and raise the breakeven on buying a Put (Long Put). The strategy needs a Bearish outlook since the investor will make money only when the stock k price / index fall. The bought Puts will have the effect of capping the investors downside. While the Puts sold will reduce the investors costs, risk and raise breakeven point (from Put exercise point of view). When to use: When you are moderately bearish on market Example: direction Nifty is presently at 4694. Mr. Risk: Limited to the net amount XYZ expects Nifty to fall. He buys paid for the spread. i.e. the one Nifty ITM Put with a strike premium paid for long position price Rs. 4800 at a premium of Rs. less premium received for short 132 and sells one Nifty OTM Put position. with strike price Rs. 4600 at a premium Rs. 52. Reward: Limited to the difference between the two strike prices minus the net premium paid for the position. Break Even Point: Strike Price of Long Put Net Premium Paid

Strategy : Buy a Put with a higher strike (ITM) + Sell a Put with a lower strike (OTM) Nifty index Buy ITM Put Option Mr. XYZ Pays Sell OTM Put Option Mr. XYZ Receives Current Value Strike Price (Rs.) Premium (Rs.) Strike Price (Rs.) Premium (Rs.) Net Premium Paid (Rs.) Break Even Point (Rs.) 4694 4800 132 4600 52 80 4720

The payoff schedule On expiry Nifty closes at 4200.0 0 4300.0 0 4400.0 0 4500.0 0 4600.0 0 4720.0 0 4700.0 0 4800.0 0 4900.0 0 5000.0 0 5100.0 0 Net Payoff from Put Sold (Rs.) Net Payoff from Call Sold (Rs.) Net Payoff (Rs.)

469 369 269 169 68 -52 -32 -132 -132 -132 -132

-348 -248 -148 -48 52 52 52 52 52 52 52

120 120 120 120 120 0 20 -80 -80 -80 -80

Buy Sell lower strike Put

Bear Put spread

FINDINGS & CONCLUSION

From the above analysis it can be concluded that: 1. Derivative market is growing very fast in the Indian Economy. The turnover of Derivative Market is increasing year by year in the Indias largest stock exchange NSE. In the case of index future there is a phenomenal increase in the number of contracts. But whereas the turnover is declined considerably. In the case of stock future there was a slow increase observed in the number of contracts whereas a decline was also observed in its turnover. In the case of index option there was a huge increase observed both in the number of contracts and turnover. 2. After analyzing data it is clear that the main factors that are driving the growth of Derivative Market are Market improvement in communication facilities as well as long term saving & investment is also possible through entering into Derivative Contract. So these factors encourage the Derivative Market in India. 3. It encourages entrepreneurship in India. It encourages the investor to take more risk & earn more return. So in this way it helps the Indian Economy by developing entrepreneurship. Derivative Market is more regulated & standardized so in this way it provides a more controlled environment. In nutshell, we can say that the rule of High risk & High return apply in Derivatives. If we are able to take more risk then we can earn more profit under Derivatives. Commodity derivatives have a crucial role to play in the price risk management process for the commodities in which it deals. And it can be extremely beneficial in agriculturedominated economy, like India, as the commodity market also involves agricultural produce. Derivatives like forwards, futures, options, swaps etc are extensively used in the country. However, the commodity derivatives have been utilized in a very limited scale. Only forwards and futures trading are permitted in certain commodity items. RELIANCE is the most active future contracts on individual securities traded with 90090 contracts and RNRL is the next most active futures contracts with 63522 contracts being traded.

Extra conclusions

1.Find that derivative market has been a phenomenal growth. A large variety of derivative contract have been at exchanges across the world. Some of the factors of driving growth of financial derivatives are: 2.Increased the volatily in asset price in financial market 3.Increased integration of national financial market with international market. 4.Market improved in communication of facilities & sharp decline in their costs. 5.Development of more sophisticated risk management tools, providing economic agent a wider choice of risk management strategies. 6. Innovation in derivative market, which optimally combine the risk & returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction cost as well as transaction cost as compared to individual financial assets.

RECOMMENDATIONS & SUGGESTIONS

RBI should play a greater role in supporting derivatives. Derivatives market should be developed in order to keep it at par with other derivative markets in the world. Speculation should be discouraged. There must be more derivative instruments aimed at individual investors. SEBI should conduct seminars regarding the use of derivatives to educate individual investors.

After study it is clear that Derivative influence our Indian Economy up to much extent. So, SEBI should take necessary steps for improvement in Derivative Market so that more investors can invest in Derivative market. There is a need of more innovation in Derivative Market because in today scenario even educated people also fear for investing in Derivative Market Because of high risk involved in Derivatives.

ABBREVATIONS
A AMEX- America Stock Exchange B BSE- Bombay Stock Exchange BSI- British Standard Institute C CBOE - Chicago Board options Exchange CBOT - Chicago Board of Trade CEBB - Chicago Egg and Butter Board CME - Chicago Mercantile Exchange CNX- Crisil Nse 50 Index CPE - Chicago Produce Exchange CWC- Central Warehousing Corporation D DTSS- Derivative Trading Settlement System F FIIs- Foreign Institutional Investors F & O Future and Options FMC- Forward Markets Commission FRAs- Forward Rate Agreements G

GAICL-Gujarat Agro Industries Corporation Limited GSAMB- Gujarat State Agricultural Marketing Board I IMM - International Monetary Market IPSTA- India Pepper & Spice Trade Association M MCX Multi Commodity Exchange

N NAFED-National Agricultural Co-Operative Marketing Federation Of India NCDEX National Commodities and Derivatives Exchange NIAM- National Institute Of Agricultural Marketing NMSE- National Multi Commodity Exchange NOL- Neptune Overseas Limited NSCCL- National Securities Clearing Corporation NSDL- National Securities Depositories Limited NSE - National Stock Exchange O OTC- Over The Counter P PHLX - Philadelphia Stock Exchange PNB- Punjab National Bank R RBI- Reserve Bank Of India S SC(R) A - Securities Contracts (Regulation) Act, 1956 SEBI- Securities Exchange Board Of India SGX- Singapore Stock Exchange SIMEX - Singapore International Monetary Exchange V VPN- Virtual Private Network

BIBLIOGRAPHY
Books referred: Options Futures, and other Derivatives by John C Hull Derivatives FAQ by Ajay Shah NSEs Certification in Financial Markets: - Derivatives Core module

Websites visited: www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.google.com www.derivativesindia.com