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PROJECT REPORT

ON

DERIVATIVE
PREPARE BY
GAJERA MEHUL

GUIDED BY

DEPARTMENT OF ECONOMICS VEER NARMAD SOUTH GUJRAT UNIVERSITY


1

2012
ACKNOWLEDGEMENT A work is never a work of an individual. I owe a sense of gratitude to the intelligence and co-operation of those people who had been so easy to let me understand what I needed from time to time for completion of this exclusive project.

I wish to extend my sincere gratitude to, Mr. Hitesh patel, Consultant, Angel Broking (Pvt) Ltd., for providing me with all the facilities to carry on this research work efficiently.

Last but not the least, I would like to forward my gratitude to my friends who always endured me and stood with me and without whom I could not have completed the project.

GAJERA MEHUL

TO WHOM IT MAY CONCERN

This is to certify That Mr. Gajera Mehul student of master of business economics (veer Narmad south Gujarat university Mbe), Surat successfully completed their summer training from 1/1/2012 to 15/2/2012 with our company.

During their training they were found to be diligent hardworking, co-operative besides being very punctual in attending the training. They are well disciplined during the project; we wish them all the best for their future career.

TABLE OF CONTENTS

SR NO
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

CONTENT

PAGE NO

EXECUTIVE SUMMARY COMPANY PROFILE INTRODUCTION NEEDS OF STUDY LITERATURE REVIEW OBJECTIVE OF THE STUDY SCOPE OF THE STUDY RESEARCH METHODOLOGY LIMITATION OF THE STUDY MAIN TOPICS OF THE STUDY HISTORY OF DERIVATIVES INDIAN DERIVATIVES MARKET FACTOR AFFECTING TO DERIVATIVES MARKET BENIFITS OF DERIVATIVES NATIONAL EXCHANGES SWOT ANALYSIS CONCLUSION BIBLIOGRAPHY

05 08 11 12 13 14 15 16 17 18 30 32 39 42 44 49 59 60

1. EXECUTIVE SUMMARY
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 . Precious metals Foreign exchange rate. Bonds 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; Forwards

Futures Options Swaps 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.

2. COMPANY PROFILE
ANGEL BROKING PVT. LTD., a Ahmedabad based broking house and a dynamic organization. SVS has been awarded the Membership of NSE, BSE (for Cash and Derivatives Segment), NCDEX, MCX (for Commodity Trading), MCX SX (for Currency Trading) and CDSL as for Depository Services.

In a short span of time Angel broking has emerged as the trusted and respected player in the Financial Market. Its promoter Mr. Pravin modi is regarded as a trader with Midas touch. SVS has developed proprietary trading method and strategy that is unique and is real money spinner. Many of investors have been benefited and earned handsomely from his guidance. As a unique advantage to the clients, SVS offers:

its proprietary research and trading strategy extraordinary domain expertise the state of the art technology that provides customized solutions to all the clients and talented manpower that are always ready to help the clients.

Today, we can say it with confidence that when it is a matter of trading and investments, people rely on SVS. Along with maintaining high growth in the financial services segments, the SVS Securities enjoys high reputation in a diversified field like Textiles, Hotels and Real Estates.

SVS Capital Club Bond with SVS SECURITIES Pvt.Ltd


We intend - To become a benchmark product and service provider for Equity & Derivative Markets in India - To Identify Industry's trading needs, problems and provide solution related to it Each of our leaders brings in diversified experience from various fields of the above segments. Our infrastructure and processes coupled with our sincerity and passion is what makes us confident of achieving our goals and making our vision a reality.

The glimpse of the reward program.


A) Incomes: Introductory income Multi Level Income (from vertical growth) Network Development Income (For Horizontal growth) B) Business Development Incentives. To support your Communication Expenses To Support your Travelling Expenses C) Regular Monthly Income In form of investment in Equity Mutual Fund. To develop the habit of savings and Long Term Investments. D) Leadership Incentives

To support you for developing more leaders under you. To reward you for achieving each higher level of Leadership E) Life Stage Bonuses To reward the Consistency in performance Reward plan offers a range of incentives and the bonuses which are as follows: 1) The foremost benefit is to you, when you use any financial service or product offered by SVS. Here you get the best deal at attractive rates. 2) You get income when you generate sales of various financial products. 3) The introductory income: When you introduce any person who joins as a member, you get an attractive introduction Commission. Upon introducing the first member, you can reap benefit of efforts of all your down liners till five levels below you as mentioned in the table. (All the members under you till 5 levels deep are known as your group)

2. 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-the-counter markets in other words, there is no single market place or organized exchanges.

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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.

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

LIMITAITONS OF STUDY
LACK OF TIME: The time available to conduct the study was only 1.5 months. It being a wide topic had a limited time. LACK OF RESOURCES: Limited resources are available to collect the information about the commodity trading. MARKET VOLATALITY: Share market is so much volatile and it is difficult to forecast any thing about it whether you trade through online or offline

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RESARCH METHODOLOGY
Method of data collection:Secondary sources:It is the data which has already been collected by some one or an organization for some other purpose or research study .The data for study has been collected from various sources: Time: 45 DAYS NCFM Derivative Module Internet sources

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INTRODUCTION

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 lockingin 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 to-arrive 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.

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DEFINATION

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.

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.

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.

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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

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TYPES OF DERIVATIVES

(1) 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.

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(2) 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.

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TERMS OF FUTURE CONTRACT


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. Other details such as the tick, the minimum permissible price fluctuation.

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.

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Initial Margin: Margin 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: 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, 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.

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DIFFERENCE BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE Operational Mechanism

FORWARD CONTRACT

FUTURE CONTRACT

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

Contract Specifications Counter-party risk

Differ from trade to trade.

Contracts are standardized contracts.

Exists.

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

guarantees their settlement.

Liquidation Profile

Low, as contracts are tailor High, as

contracts

are standardized

made contracts catering to the exchange traded contracts. needs of the needs of the parties.

Price discovery

Not efficient, as markets are Efficient, as markets are centralized and scattered. all buyers and sellers come to a common platform to discover the price.

Examples

Currency market in India.

Commodities, futures, Index Futures and Individual stock Futures in India.

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(3) 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.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying assetstock 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 assetstock 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.

(4) 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:

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

(6)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.

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(7)SWAP
Swap 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.

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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.

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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.

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PLAYERS IN DERIVATIVE MARKET

Speculators

Existing

SYSTEM

New

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

Peril &Prize
1) Both profit & loss to extent of price change.

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

Peril &Prize
1)Maximum loss possible to premium paid

1)Buy &Sell stocks

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

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Arbitrageurs

Existing

SYSTEM

New

Approach
one and selling in another exchange. forward transactions. 2) If Future Contract

Peril &Prize
whichever way the Market moves.

Approach
1) B Group more promising as still in weekly settlement 2) Cash &Carry arbitrage continues

Peril &Prize
1) Risk free game.

1) Buying Stocks in 1) Make money

more or less than Fair price

Fair Price = Cash Price + Cost of Carry.

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Hedgers

Existing

SYSTEM

New

Approach
1) Difficult to offload holding during adverse market conditions as circuit filters limit to curtail losses.

Peril &Prize
1) No Leverage available risk reward dependant on market prices

Approach
1)Fix price today to buy latter by paying premium. 2)For Long, buy ATM Put Option. If market goes up, long position benefit else exercise the option. 3)Sell deep OTM call option

Peril &Prize
1) Additional cost is only premium.

with underlying shares, earn premium + profit with increase prcie

Advantages
Availability of Leverage

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Small Investors

Existing

SYSTEM

New

Approach
1) If Bullish buy stocks else sell it.

Peril &Prize
1) Plain Buy/Sell implies unlimited profit/loss.

Approach
1) Buy Call/Put options

Peril &Prize
1) Downside remains protected & upside unlimited.

based on market outlook 2) Hedge position if holding underlying stock

Advantages
Losses Protected.

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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 exchange-traded 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

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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.

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13. 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

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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

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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

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14. 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.

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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.

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National Stock Exchange of India (NSE)

History of the National Stock Exchange of India : Capital market reforms in India and the launch of the Securities and Exchange Board of India (SEBI) accelerated the incorporation of the second Indian stock exchange called the National Stock Exchange (NSE) in 1992. After a few years of operations, the NSE has become the largest stock exchange in India. Three segments of the NSE trading platform were established one after another. The Wholesale Debt Market (WDM) commenced operations in June 1994 and the Capital Market (CM) segment was opened at the end of 1994. Finally, the Futures and Options segment began operating in 2000. Today the NSE takes the 14th position in the top 40 futures exchanges in the world. In 1996, the National Stock Exchange of India launched S&P CNX Nifty and CNX Junior Indices that make up 100 most liquid stocks in India. CNX Nifty is a diversified index of 50 stocks from 25 different economy sectors. The Indices are owned and managed by India Index Services and Products Ltd (IISL) that has a consulting and licensing agreement with Standard & Poor's. In 1998, the National Stock Exchange of India launched its web-site and was the first exchange in India that started trading stock on the Internet in 2000. The NSE has also proved its leadership in the Indian financial market by gaining many awards such as 'Best IT Usage Award' by Computer Society in India (in 1996 and 1997) and CHIP Web Award by CHIP magazine (1999).

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THE DERIVATIVE MARKET

APRIL-JUNE 2011 Market Depth PRODUCT Depth No. of Turnover (Rs. 000)

JULY-SEPTEMBER2011 No. of Turnover (Rs. 000)

Contracts(La kh)

Contracts(Lakh)

VOLUME & TURNOVER Index Future Index Option Single Future Stock Option Total Market Share ( %) Index Future 1,077.5 Index Option Single Future Stock Option Proprietary FII 69.1 27.88 12.35 Stock 1,039.3 41.12 2.19 31.07 8.76 35.26 2.11 31.33 2.08 1,130.9 35.20 21.49 31.94 30.68 32.48 34.09 Stock 514.5 25.5 1,195.8 1,093.1 58.3 2,658.4 599.0 35.9 1,698.7 1,039.3 69.1 3,317.0 415.7 240.1 935.6 571.3 542.6 521.2 1,077.5 1,130.9

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Data for Shorter Dated and Longer Dated derivative contracts

Time

Period 3 Months CONTRACT No of contracts (lakh) 1,694.64 Turnover (Rs. 000 cr.) MORE THAN 3 MONTH No of contracts (lakh) 3.99 Turnover (Rs. 000 cr.)

(Quarter)

July-September 3,307.11 9.87 2011 Apr-Jun 2011 1,194.97 2,655.88 4.83 12.5

Data for Mini Nifty derivative contracts

Time (Quarter)

Period No of contract IN cr

Turnover (Rs. 000 cr.)

July-September 2011 Apr-Jun 2011

43.8 29.4

36.9 7.7

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Minimum, Maximum and Average Daily Volatility of the F&O segment at

NSE for S&P CNX Nifty since April 2011

Average

Maximum

Minimum

volatility April-11 May-11 Month June-11 July-11 August-11 September-11 (%) 2.47 1.71 1.80 2.85 2.27 2.28

Volatility (%) 2.98 1.99 2.28 3.08 2.61 2.51

Volatility

(%) 2.05 1.56 1.61 2.38 2.10 2.09

18. Business Growth in Derivatives segment (NSE)


A Index futures Year 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 No. of contracts 4116649 156598579 81487424 58537886 21635449 17191668 2126763 1025588

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FIGURE Number of contracts per year

No. of contracts
180000000 160000000 140000000 120000000 100000000 80000000 60000000 40000000 20000000 0 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04

INTERPRETATION: From the data and the bar diagram above, there is high business growth in the derivative segment in India. In the year 2003-04, the number of contracts in Index Future were 1025588 where as a significant increase of 4116679 is observed in the year 2010-11. No of turnovers Year 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 Turnover (Rs. Cr.) 925679.96 3820667.27 2539574 1513755 772147 554446 43952 21483

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FIGURE Turnover in Rs. Crores


250000000

200000000

150000000

100000000

50000000

0 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04

INTERPRETATION: From the data and above bar chart, there is high turn over in the derivative segment in India. In the year 2003-04 the turnover of index future was 21483 where as a huge increase of 92567996 in the year 2010-11 are observed.

A STOCK FUTURE Year 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 No. of contracts 51449737 203587952 104955401 80905493 47043066 32368842 10676843 1957856

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FIGURE Number of contracts per year in stock future


250000000

200000000

150000000

100000000

50000000

0 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04

INTERPRETATION: From the data and bar diagram above there were no stock futures available but in the year 2003-04, it predominantly increased to 1957856. Then there was a huge increase of 203587952 in the year 2009-10 but there was a steady decline to 51449737 in the year 2010-11.

INDEX OPTIONS Year 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 No. of contracts 24008627 55366038 25157438 12935116 3293558 1732414 442241 175900

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FIGURE Number of contracts per year


60000000 50000000 40000000 30000000 20000000 10000000 0 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04

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 2003-2004. In the year 2008-2009 there was a huge increase in the index option contracts to 55366038 and a decline of 24008627 in the year 2010-2011.

STOCK OPTIONS Year 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 No. of contracts 2546175 9460631 5283310 5240776 5045112 5583071 3523062 1037529

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FIGURE Number of contracts traded per year in stock option


10000000 9000000 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04

INTERPRETATION: From the data and bar chart above the no of contracts of stock option in the year 20002001 was nil. But there was a huge increase of 1037529 observed in the year 2003-2004. It was 9460631 which was the highest in the year 2008-2009. But a gradual decline of 2546175 in the year 20010-2011.

OVERALL TRADING Year 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 No. of contracts 119171008 425013200 216883573 157619271 77017185 56886776 16768909 4196873 90580 Turnover (Rs. cr.) 2648403.30 13090477.75 7356242 4824174 2546982 2130610 439862 101926 2365

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FIGURE Average daily turnovers in Rs. Crores

Interpretation:
450000000 400000000 350000000 300000000 250000000 200000000 150000000 100000000 50000000 0 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03

From the data and bar chart above, the overall trading contracts in the year 2002-2003 was 90580 and huge increase of 119171008 in the year 2010-2011. AVERAGE DAILY TURNOVERS Year Av. daily turnover (Rs. Crores) 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 45390.21 52153.30 29543 19220 10167 8388 1752 410 11

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.

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17. 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.

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18. 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 Financial Markets & Services by Gordon & Natarajan

Reports: Report of the RBI-SEBI standard technical committee on exchange traded Currency Futures Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

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

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