DERIVATIVE MARKET- INDIA’’

G H A Z I A B A D

INSTITUTE OF TECHNOLOGY AND SCIENCE,MOHAN NAGAR, GHAZIABAD

SUMMER INTERNSHIP PROJECT REPORT ON TITLE

“DERIVATIVE MARKET- INDIA’’

BY

MUKTA DHEEREnrollment No : PG2K8 181

E mail id [email protected]

IL&FS INVESTSMART SECURITIES LIMITED(A group company of HSBC)

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http://www.investsmartindia.com/

I INDIA’S FINANCIAL MULTIPLEX I

A REPORT

ON

“DERIVATIVE MARKET”

_____________________________________________________________A report submitted in complete fulfillment of the requirements of PGDM program

of INSTITUTE OF TECHNOLOGY AND SCIENCE GHAZIABAD

SUBMITTED TO:

PROF. PRIYAFACULTY

I.T.S GHAZIABAD

RAHUL KUMAR AGARWAL ASM

IL&FS INVESTSMART SECURITIES LIMITEDE MAIL [email protected]

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ACKNOWLEDGEMENT

The beatitude, bliss and euphoria that accompany the successful completion of any task

would not be complete without the expression of appreciation of simple virtues to the

people who made it possible.

The final project report is submitted to institute of technology and science, Ghaziabad

for partial fulfilment of diploma, post graduate diploma in management (PGDM).

This project is an attempt to study “DERIVATIVE MARKET-INDIA”

At IL&FS INVESTSMART SECURITIES LTD.(HSBC Group).

I would like to thanks to the Management of IL&FS INVESTSMART

SECURITIES LTD. (HSBC Group) for giving me the opportunity to do my two-month

project training in their esteemed organization. I am highly obliged to Mr. RAHUL

KUMAR AGARWAL (AREA SALES MANAGER) for granting me to undertake my

training at RDC RAJ NAGAR branch.

I express my thanks to all Sales Managers and other relationship managers under

whose guidance and direction, I gave a good shape to my training. Their constant review

and excellent suggestions throughout the project are highly commendable. My heartfelt

thanks go to all the executives who helped me to gain knowledge about the actual

working and the processes involved in various departments. I would also like to

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sincerely thank my faculty guide PROF. PRIYA whose guidance has helped me to

Understand and complete my project in a timely and proper manner

MUKTA DHEER

DECLARATION

I do hereby declare that the project report is submitted as partial fulfilment of the

requirement of PGDM Program of INSTITUTE OF TECHNOLOGY AND SCIENCE,

GHAZIABAD.

The Project has been done under the guidance of Mr. RAHUL KUMAR AGARAWAL,

in Raj nagar branch ,Ghaziabad and PROF. PRIYA Faculty guide, INSTITUTE OF

TECHNOLOGY AND SCIENCE, Ghaziabad

No part of this report has not been published or submitted elsewhere for the fulfilment of

any degree or diploma for any institute or university.

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MUKTA DHEER

EXECUTIVE SUMMARY

New ideas and innovations have always been the hallmark of progress made by mankind.

At every stage of development, there have been two core factors that drives man to ideas

and innovation. These are increasing returns and reducing risk, in all facets of life.

The financial markets are no different. The endeavour has always been to maximize

returns and minimize risk. A lot of innovation goes into developing financial products

centred on these two factors. It has spawned a whole new area called financial

engineering.

Derivatives are among the forefront of the innovations in the financial markets and aim to

increase returns and reduce risk. They provide an outlet for investors to protect

themselves from the vagaries of the financial markets. These instruments have been very

popular with investors all over the world.

Indian financial markets have been on the ascension and catching up with global

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standards in financial markets. The advent of screen based trading, dematerialization,

rolling settlement have put our markets on par with international markets.

As a logical step to the above progress, derivative trading was introduced in the country

in June 2000. Starting with index futures, we have made rapid strides and have four types

of derivative products- Index future, index option, stock future and stock options. Today,

there are 30 stocks on which one can have futures and options, apart from the index

futures and options.

This market presents a tremendous opportunity for individual investors .The markets

have performed smoothly over the last two years and has stabilized. The time is ripe for

investors to make full use of the advantage offered by this market.

We have tried to present in a lucid and simple manner, the derivatives market, so that the

individual investor is educated and equipped to become a dominant player in the market

CONTENTS

PAGE NO.

INTRODUCTION TO PROJECT 7 COMPANY PROFILE 8

DERIVATIVES a) Derivative defined 13 b) Types of market 15 c) History of derivatives 25 d) Indian derivative market 27 e) Need for derivatives in India today 28 f) Myths and realities about derivatives 28

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g) Comparison of new system with existing system 31 h) Factor contributing to the growth of derivatives 36 i) Benefits of derivatives 39 DEVELOPMENT OF DERIVATIVE MARKET IN INDIA 41 NATIONAL EXCHANGES 45

RESEARCH OBJECTIVE 48 RESEARCH METHODOLOGY 48 ANALYSIS & INTERPRETATION 51

RECOMMENDATION & LIMITATION 62

BIBLIOGRAPHY 63

ANNEXURE a) Questionnaire 64b) Abbreviations 68

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

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as over-the-counter markets – in other words, there is no single market place

organized exchanges. Interpretation

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.

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.

2. COMPANY PROFILE

IL&FS Investsmart securities Limited (IISL) is one of India’s leading financial

services organizations providing individuals and corporate with customized financial

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management solutions. IL&FS investsmart limited( IIL) through its subsidiaries in India

and Singapore provide a wide range of investment products to its retail and institutional

client including equity broking investment banking, insurance broking and distribution,

mutual fund distribution and related financial services.

IIL’s 2000 employees provide a complete range of investment solution to over

138000 customers in India through its 88 branches and 190 franchised outlets from 133

cities. Company is having a market capitalization of approximately US $260 million.

Investsmart is listed on the national stock exchange (NSE) and the Bombay stock

exchange (BSE) and its global depository share are listed on the LUXEMBURG STOCK

EXCHANGE

At IISL, we believe in "Realizing your goals together". You will find in us - a trusted

investment partner to help you work towards achieving your financial goals. Our

institutional expertise, combined with a thorough understanding of the financial markets

results in appropriate investment solutions for you.

Our strong team of all your investment needs through a office near you. All you need

to do is drop in at the nearest branch or call us and we’ll be happy to do the rest!

Investsmart recognized as “National Relationship Managers, Customer Service

Executives, Advisory Managers and Research Analysts, offers efficient execution backed

by in-depth research, knowledge and expertise to customers across the country. With a

pan-India presence of over 300 offices, IISL is geared to meet “Best Performing

Financial Advisor-Retail” for two tear in a row (2006-07 and 2007-08) by CNBC

TV18.

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Vision

To become a long term preferred long term financial to a wide base of customer whilst

optimizing Stake holder value.

Mission

To establish a base of 1 million satisfied customer by 2010 We will create this by

being a responsible trustworthy partner.

Corporate action

An approach to business that reflects responsibility, transparency and ethical

behaviour Respect for employee client and stake holder group.

PROMOTER OF THE COMPANY

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IL&FS Investsmart securities Limited (IISL) is one of India’s leading companies in the

Financial Services industry. It was promoted in 1997 by Infrastructure Leasing & Financial

Services (IL&FS), one of India's leading infrastructure development and finance companies.

The company is now held by HSBC, one of the world’s largest banking and financial

services organizations.

In India, The HSBC Group offers a range of financial services including corporate,

commercial, retail and private banking, insurance, asset management, investment banking,

equities and capital markets, institutional brokerage, custodial services. It also provides software

development expertise and global services facilities for the HSBC Group’s operations

worldwide.

HSBC ACQUIRED 93.86 % OF IL&FS INVESTSMART IN INDIA

HSBC has completed the acquisition of 93.86 % of IL&FS investsmart limited

(investsmart). A leading retail brokerage in India for a total consideration of INR 1311 crore

(approx. US $296.4 million)

Sandy flockhart Group managing director and CEO of HSBC Asia pacific said “investsmart

gives HSBC access to the world’s third-largest investor base with over 20 million retail

investors. In fact ,the business already has 1,43,000 customers and operates in 128 cities with

Indian GDP expected to grow by 7.8% in 2009. The opportunity here is obvious and underlines

why HSBC has a stated strategic aim of focusing on high-growth economics”

Under the transaction agreement, HSBC acquired 43.85% of Investsmart from

E*TRADE Mauritius Limited, an indirectly wholly-owned subsidiary of E*TRADE

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Financial Corporation, and 29.36 per cent from Infrastructure Leasing and Financial

Services Limited (IL&FS). The decision to acquire a controlling stake in Investsmart

triggered an open offer to public shareholders, through which HSBC has accepted shares

equivalent to 20.65 per cent of Investsmart's capital.

E*TRADE Mauritius Limited, IL&FS and those that tendered shares through the open

offer received INR200 per share for their Investsmart shares. In addition, IL&FS was

paid, as part of a three-year non-compete agreement, INR82.0 crore (approximately

US$17.9 million). In accordance with local regulations, HSBC paid interest of INR2.3

per share to the public shareholders who tendered their shares. This amounted to INR3.31

crore approximately US$0.72 million).

Naina Lal Kidwai, Group General Manager and Chief Executive Officer, HSBC in India,

added: "Investsmart is a great addition to our current operations, which already constitute

the second largest foreign banking network in India. We look forward to working with

Investsmart's management team and growing this business."

HSBC was advised on the acquisition by the investment banking division of HSBC

Global Banking and Markets. The HSBC Group in India is represented by several entities

including The Hongkong and Shanghai Banking Corporation Limited which offers a

full range of banking and financial services to its over 2.8 million customers in India

through its 47 branches and 170 ATMs across 26 cities. HSBC is one of India's leading

financial services groups, with over 34,000 employees in its banking, investment banking

and capital markets, asset management, insurance broking, two global IT development

centres and six global resourcing operations in the country. The Bank is the founding and

a principal member of the HSBC Group which, with over 9,500 offices in 85 countries

and territories and assets of US$2,547 billion at 30 June 2008, is one of the world's

largest banking and financial services organizations.

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In September 2008, HSBC Securities & Capital Markets (HSCI) and HSBC Violet

Investments (Mauritius) had acquired 29.35% and 43.85% stakes held by IL&FS and E

Trade in IL&FS Investsmart. Post the stake acquisition, HSCI’s total holding in IL&FS

Investsmart increased to 50.01%, taking the total stake held by HSBC and HSCI together

in the company to 93.86%

HSBC Securities & capital markets (India) private limited 34,922,751 50.01 %

HSBC Violet investment (Mauritius) limited 30,625,692 43.85 %

Others 4,287,830 6.14 %

Total 69836273 100 %

Currently HSBC group is having 93.86% of share in IL&FS investsmart securities limited.

HSBC securities and capital markets (INDIA) private limited has 50.01% HSBC violet

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investment (maturities) limited has 43.85% in investsmart. Now the company is running under

the management of HSBC group.

3. INTRODUCTION TO DERIVATIVESDERIVATIVES

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.

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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 favorable

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.

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.

3.1DERIVATIVES 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.

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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 include-

A 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

Figure.1 Types of Derivatives Market

3.2 TYPES OF DERIVATIVES MARKET

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Derivatives

Future Option Forward Swaps

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

Interest

rate Futures

3.3 TYPES OF DERIVATIVES

Figure.2 Types of Derivatives

FORWARD CONTRACTS

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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.

The salient features of forward contracts are:

• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• On the expiration date, the contract has to be settled by delivery of the asset.

• If the party wishes to reverse the contract, it has to compulsorily go to the same

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

However forward contracts in certain markets have become very standardized,

as in the case of foreign exchange, thereby reducing transaction costs and

increasing transactions volume. This process of standardization reaches its limit in

the organized futures market. Forward contracts are often confused with futures

contracts. The confusion is primarily because both serve essentially the same

economic functions of allocating risk in the presence of future price uncertainty.

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However futures are a significant improvement over the forward contracts as

they eliminate counterparty risk and offer more liquidity.

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.

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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

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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.

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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, non-dividend paying

asset, the value of the future/forward, , will be found by discounting the present

value at time to maturity 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.

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TABLE 1-

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURES FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between two

parties (not traded on the

exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized contracts.

Counter-party

risk

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

made contracts catering to the

needs of the needs of the

parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets are

scattered.

Efficient, as markets are centralized and

all buyers and sellers come to a common

platform to discover the price.

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Examples Currency market in India. Commodities, futures, Index Futures and

Individual stock Futures in India.

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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 AND 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.

b. 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.

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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:

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.

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

5. BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options are

most popular form of baskets.

6. 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.

7. 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.

8. 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.

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3.1 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 1700’s 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 1860’s. 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

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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 Dealer’s Association was set up in early 1900’s 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.

30


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.

3.5 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 India’s

(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 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 framework for

31


index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and

interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian

index.

25 May 2000 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 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

3.6 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 India’s 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

India’s efforts in allowing forward contracts, cross currency options etc. which have

developed into a very large market.

3.7 Myths and realities about derivatives

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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?

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

33


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.

34


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:

PRE-REQUISITES INDIAN SCENARIO

Large market Capitalisation India is one of the largest market-capitalised countries in

Asia with a market capitalisation of more than Rs.765000

crores.

High Liquidity in the

underlying

The daily average traded volume in Indian capital market

today is around 7500 crores. Which means on an average

every month 14% of the country’s Market 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.

A Strong Depository National Securities Depositories Limited (NSDL) which

started functioning in the year 1997 has revolutionalised

the security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange Board

of India) today the Indian capital market enjoys a strong,

35


independent, and innovative legal guardian who is helping

the market to evolve to a healthier place for trade

practices.

36


What kind of people will use derivatives?

Derivatives will find use for the following set of people:

• Speculators: People who buy or sell in the market to make profits. For example, if you

will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1

month future of Reliance at Rs 350 and make profits

• Hedgers: People who buy or sell to minimize their losses. For example, an importer has

to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the

importer can minimize his losses by buying a currency future at Rs 49/$

• Arbitrageurs: People who buy or sell to make money on price differentials in different

markets. For example, a futures price is simply the current price plus the interest cost. If

there is any change in the interest, it presents an arbitrage opportunity. We will examine

this in detail when we look at futures in a separate chapter. Basically, every investor

assumes one or more of the above roles and derivatives are a very good option for him.

3.8 Comparison of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options and

banning of Badla is disadvantageous and introduced early, 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

37


Figure 3.3a

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum

Trading, margin loss to extent of on delivery basis loss possible

trading& carry price change. 2) Buy Call &Put to premium

forward transactions. by paying paid

2) Buy Index Futures premium

hold till expiry.

Advantages

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

38


Figure 3.3b

Arbitrageurs

Existing SYSTEM New


1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free

one and selling in whichever way the promising as still game.

another exchange. 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 SYSTEM New

39



1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional

offload holding available risk latter by paying premium. cost is only

during adverse reward dependant 2)For Long, buy ATM Put premium.

market conditions on market prices Option. If market goes up,

as circuit filters long position benefit else

limit to curtail losses. 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 SYSTEM New


1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downside

40


stocks else sell it. implies unlimited based on market outlook remains

profit/loss. 2) Hedge position if protected &

holding underlying upside

stock unlimited.

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 exchange-traded

derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

41


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

exchange’s 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

42


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.

3.9 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 one’s 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.

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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 1990’s 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-à-vis depreciated currencies. Export of certain goods

from India declined because of this crisis. Steel industry in 1998 suffered its worst set

44


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 break

through. 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 world wide 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.

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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 1970’s, 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

3.10 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

46


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.

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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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4.1 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 24–member

committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop

appropriate regulatory framework for derivatives trading in India. The committee

submitted its report on March 17, 1998 prescribing necessary pre–conditions for

introduction of derivatives trading in India. The committee recommended that derivatives

should be declared as ‘securities’ so that regulatory framework applicable to trading of

‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998

under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment

in derivatives market in India. The report, which was submitted in October 1998, worked

out the operational details of margining system, methodology for charging initial

margins, broker net worth, deposit requirement and real–time monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to

include derivatives within the ambit of ‘securities’ and the regulatory framework were

developed for governing derivatives trading. The act also made it clear that derivatives

shall be legal and valid only if such contracts are traded on a recognized stock exchange,

thus precluding OTC derivatives. The government also rescinded in March 2000, the

three decade old notification, which prohibited forward trading in securities. Derivatives

trading commenced in India in June 2000 after SEBI granted the final approval to this

effect in May 2001. SEBI permitted the derivative segments of two stock exchanges,

NSE and BSE, and their clearing house/corporation to commence trading and settlement

in approved derivatives contracts. To begin with, SEBI approved trading in index futures

contracts based on S&P CNX Nifty and BSE–30 (Sense) index. This was followed by

49


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 single-stock

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.

50


• 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 intra-day 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 but the

derivative segment has also grown. In the derivative market foreign exchange

swaps account for the largest share of the total turnover of derivatives in India

followed by forwards and options. Significant milestones in the development of

derivatives market have been (i) permission to banks to undertake cross currency

derivative transactions subject to certain conditions (1996) (ii) allowing corporates to

undertake long term foreign currency swaps that contributed to the development

of the term currency swap market (1997) (iii) allowing dollar rupee options (2003)

and (iv) introduction of currency futures (2008). 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

51


exchange earnings. But often corporate assume these risks due to interest rate

differentials and views on currencies.

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.

Table 4.1ForexMarketActivity

April’05-

Mar’06

April’06-

Mar’07

April’07-

Mar’08

April’08-

Mar’09Total turnover (USD billion) 4,404 6,571 12,304 9,621

Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1

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Spot/Total Turnover (%) 50.5 51.9 49.7 54.9

Forward/Total Turnover (%) 19.0 17.9 19.3 21.5

Swap/Total Turnover (%) 30.5 30.1 31.1 32.7

Source: RBI

5. 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

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MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised 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 of India, Bank of Baroda, Canera 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.

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

54


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.

55


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 soyabean meal.

56


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

To know the investors perception towards investment in derivative market

RESARCH METHODOLOGY

Method of data collection:-

Secondary sources:-

It is the data which has already been collected by some one or an organization for

some other purpose or research study .The data for study has been collected from various

sources:

Books

Journals

Magazines

Internet sources

57


Second Phase is Collection of Primary Data and Analysis:

After collecting the Secondary data the next phase will be collection of primary data using

Questionnaires. The questionnaire will be filled by around 50 people who will be mainly from

Delhi/NCR region. The sample will consist of people who are employed or work as free lancers

dealing in derivative market to know their perception towards investment in derivative market.

The data collected will be then entered into MS Excel for analysis of the data collected from the

questionnaire.

RESEARCH DESIGN

Non probability

The non –probability respondents have been researched by selecting the persons who do the

trading in derivative market. Those persons who do not trade in derivative market have not been

interviewed.

Exploratory and descriptive research

The research is primarily both exploratory and descriptive in nature. The sources of

information are both primary and secondary. The secondary data has been taken by referring to

various magazines, newspapers, internal sources and internet to get the figures required for the

research purposes. The objective of the exploratory research is to gain insights and ideas. The

objective of the descriptive research study is typically concerned with determining the frequency

with which something occurs. A well structured questionnaire was prepared for the primary

58


research and personal interviews were conducted to collect the responses of the target

population.

SAMPLING METHODOLOGY

Sampling Technique

Initially, a rough draft was prepared a pilot study was done to check the accuracy of the

Questionnaire and certain changes were done to prepare the final questionnaire to make it more

judgmental.

Sampling Unit

The respondents who were asked to fill out the questionnaire in the National Capital Region are

the sampling units. These respondents comprise of the persons dealing in derivative market. The

people have been interviewed in the open market, in front of the companies, telephonic

interviews and through other sources also

Sample Size

The sample size was restricted to only 50 respondents.

Sampling Area

The area of the research was National Capital Region (NCR).

Time:

2 months

59


Statistical Tools Used:

Simple tools like bar graphs, tabulation, line diagrams have been used.

ANALYSIS

Q. Education qualification of investors who investing in derivative market.

Education No. of result

Under graduate 6

Graduate 10

Post graduate 23

Professional 11

60


Q. Income range of investors who investing in derivative market.

Income range No. of Result

below 1,50,000 1

1,50,000-3,00,000 9

3,00,000-5,00,000 14

above 5,00,000 26

61


Q. Normally what percentage of your monthly household income could be available for

investment

Investment No. of result

Between 5% to 10% 2

Between 11% to 15% 6



More than 25% 11

62


Q. What is your primary investment purpose?

63


Q. What kind of risk do you perceive while investing in the stock market?

Risk in stock market No.of result

Uncertainty of returns 19

Slump in stock market 22

Fear of windup of company 6

Others 3

64


Q. Why people do not invest in derivative market?

Reasons No.of result

Lack of knowledge & understanding 27

Increase speculation 2

Risky & highly leveraged 17

Counter party risk 4

Q. What is the purpose of investing in derivative market?

65


Purpose of investment No. of Result

Hedge their fund 27

Risk control 9

More stable 1

Direct investment without buying & holding assets 13

Q. You participate in derivative market as

Participation as No. of Result

investor 23

Speculator 2

Broker/Dealer 8

Hedger 17

66


Q. From where you prefer to take advice before investing in derivative market?

Advice From No. of Result

Brokerage houses 15

Research analyst 7

Websites 2

News Networks 23

Others 3

67


Q. In which of the following would you like to participate?

Participate in No. of Result

Stock index futures 19

Stock index Options 13

Future on individual stock 6

Currency futures 9

Options on individual stock 3

68


Q. What contract maturity period would interest you for trading in?

69


Q. How often do you invest in derivative market?

Q. What was the result of your investment?

Result of investment No.of result

Great results 4

Moderate but acceptable 24

Disappointed 22

70


Q. What is best describes the overall approach to invest as a mean of achieving investors goals.

OPTIONS NO. of ResultRelative level of stability in overall investment portfolio 17increasing investment value while minimizing potential for loss of principal 19Investment growth with moderate high levels of risk 4Maximum long term returns with high risk 10

71


INTERPRETATION

Most of the investors who invest in derivatives market are post graduate.

Investors who invest in derivative market have a income of above 5,00,000

Investors generally perceive slump in stock market kind of risk while investing in

derivative market.

People are generally not investing in derivative market due to lack of knowledge

and difficulty in understanding and it is very risky also.

Most of investor purpose of investing in derivative market is to hedge their fund.

72


People generally participate in derivative market as a investor or hedger.

People generally prefer to take advice from news network before investing in

derivative market.

Most of investors participate in stock index futures.

From this survey we come to know that most of investors make a contract of 3

month maturity period.

Investors invest regularly in derivative market.

The result of investment in derivative market is generally moderate but

acceptable.

RECOMMENDATIONS & SUGGESTIONS

A knowledge need to be spread concerning the risk and return of the derivative

market.

73


More variation in stock index future need to be made looking a demand side of

investors.

RBI should play a greater role in supporting derivatives

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

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 anything about it

whether you trade through online or offline

4. ASPECTS COVERAGE:

Some of the aspects may not be covered in my study.

BIBLIOGRAPHY

74


Books referred:

Options Futures, and other Derivatives by John C Hull

Derivatives FAQ by Ajay Shah

NSE’s 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

75

http://www.derivativesindia.com/

http://www.google.com/

http://www.ncdex.com/

http://www.sebi.gov.in/

http://www.bseindia.com/

http://www.nse-india.com/


ANNEXURE

SURVEY QUESTIONNAIRE OF INVESTORS

FOR

PERCEPTION TOWARDS INVESTMENT IN DERIVATIVE MARKET

Sir/Ma’am,

This questionnaire is meant for educational purposes only.

The information provided by you will be kept secure and confidential.

NAME- __________________________________________________

CONTACT- ______________________________________________

GENDER-________________________________________________

OCCUPATION-___________________________________________

1. Educational Qualification

<INPUT TYPE=\ Undergraduate <INPUT TYPE=\ Graduate

<INPUT TYPE=\ Post Graduate <INPUT TYPE=\

Professional Degree Holder

2. Income Range:

<INPUT TYPE=\ Below 1,50,000 <INPUT TYPE=\ 1,50,000 –

3,00,000

<INPUT TYPE=\ 3,00,000 – 5,00,000 <INPUT TYPE=\ Above

5,00,000

76


3. Normally what percentage of your monthly household income could be available for

investment?

<INPUT TYPE=\ Between 5% to 10% <INPUT TYPE=\ Between

11% to 15%

<INPUT TYPE=\ Between 16% to 20% <INPUT TYPE=\ Between

21% to 25%

<INPUT TYPE=\ More than 25%

4. What is your primary investment purpose?

<INPUT TYPE=\ Retirement Planning

<INPUT TYPE=\ Building up a corpus for charity donations

<INPUT TYPE=\ Supporting future education of your children

<INPUT TYPE=\ Other (Specify) _____________________

5. What kind of risk do you perceive while investing in the stock market?

<INPUT TYPE=\ Uncertainty of returns <INPUT TYPE=\ Slump in

stock market

<INPUT TYPE=\ Fear of being windup of company <INPUT TYPE=\ Other

(Specify) _________________

6. Why people do not invest in derivative market? (Rank your preference 1-4)

<INPUT TYPE=\ Lack of knowledge and difficulty in understanding

<INPUT TYPE=\ Increase speculation

<INPUT TYPE=\ Very risky and highly leveraged instrument

77


<INPUT TYPE=\ Counter party risk

7. What is the purpose of investing in derivative market?

<INPUT TYPE=\ To hedge their fund

<INPUT TYPE=\ Risk control

<INPUT TYPE=\ More stable

<INPUT TYPE=\ Direct investment without buying and holding assets

8. You participate in derivative market as:

<INPUT TYPE=\ Investor <INPUT TYPE=\ Speculator

<INPUT TYPE=\ Broker/Dealer <INPUT TYPE=\ Hedger

9. From where you prefer to take advice before investing in derivative market?

<INPUT TYPE=\ Brokerage houses <INPUT TYPE=\ Research

analyst

<INPUT TYPE=\ Websites <INPUT TYPE=\ News

Networks

<INPUT TYPE=\ Other (Specify) _________________

10. In which of the following would you like to participate?

<INPUT TYPE=\ Stock Index Futures <INPUT TYPE=\ Stock Index

Options

<INPUT TYPE=\ Future on individual stock <INPUT TYPE=\ Options on

individual stock

<INPUT TYPE=\ Currency futures

78


11. What contract maturity period would interest you for trading in?

<INPUT TYPE=\ 1 month <INPUT TYPE=\ 2 month



12. How often do you invest in derivative market?

<INPUT TYPE=\ 1-10 times in a year <INPUT TYPE=\ 11-50 times

<INPUT TYPE=\ More than 50 times <INPUT TYPE=\ Regularly

13. Which of the following statements best describes your overall approach to invest as a

mean of achieving your goals?

<INPUT TYPE=\ Having a relative level of stability in my overall investment portfolio.

<INPUT TYPE=\ Moderately increasing my investment value while minimizing potential

for loss of

principal.

<INPUT TYPE=\ Pursue investment growth, accepting moderate to high levels of risk

and

principal fluctuation.

<INPUT TYPE=\ Seek maximum long-term returns, accepting maximum risk with

principal

fluctuation.

14. What was the result of your investment?

<INPUT TYPE=\ Great results

<INPUT TYPE=\ Moderate but acceptable

<INPUT TYPE=\ Disappointed

79


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

80


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

81


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

82


DERIVATIVE MARKET- INDIA’’

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