Financial Derivatives Myths and Realities(Idbi)=Mohit Sharma

A

Project Study Report

On

Training Undertaken at

IDBI

FINANCIAL DERIVATIVES MYTHS AND REALITIES

Submitted in partial fulfillment for the

Award of degree of

Master of Business Administration

Submitted By: - Submitted To:-

Mr. MOHIT SHARMA

PREFACE

Derivatives are defined as financial instruments whose value derived from the prices of one or

more other assets such as equity securities, fixed-income securities, foreign currencies, or

commodities. Derivatives are also a kind of contract between two counterparties to exchange

payments linked to the prices of underlying assets. Derivative can also be defined as a

financial instrument that does not constitute ownership, but a promise to convey ownership.

Examples are options and futures. The simplest example is a call option on a stock. In the

case of a call option, the risk is that the person who writes the call (sells it and assumes the

risk) may not be in business to live up to their promise when the time comes. In standardized

options sold through the Options Clearing House, there are supposed to be sufficient

safeguards for the small investor against this.

I the student of SHRINATHJI INSTITUTE OF MANAGEMENT, ODAN have done

research work on subject.

Acknowledgement

I express my sincere thanks to my project guide, Mr.MOHIT SIR, Designation Assistance

professor, Deptt SITE, for guiding me right form the inception till the successful completion

of the project. I sincerely acknowledge him for extending their valuable guidance, support

for literature, critical reviews of project and the report and above all the moral support

he/she/they had provided to me with all stages of this project

I would also like to thank the supporting staff Department, for their help and cooperation

throughout our project.

(Signature of Student)

Executive Summary

Derivatives have had a long presence in India. The commodity derivative market

has been functioning in India since the nineteenth century with organized trading in cotton

through the establishment of Cotton Trade Association in 1875. Since then contracts on

various other commodities have been introduced as well.’

Exchange traded financial derivatives were introduced in India in June 2000 at the two

major stock exchanges, NSE and BSE. There are various contracts currently traded on

these exchanges.The National Stock Exchange of India Limited (NSE) commenced trading

in derivatives with the launch of index futures on June 12, 2000. The futures contracts are

based on the popular benchmark S&P CNX Nifty Index.The Exchange introduced trading in

Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange

to launch trading in options on individual securities from July 2, 2001. Futures on individual

securities were introduced on November 9, 2001. Futures and Options on individual

securities are available on 227 securities stipulated by SEBI.The Exchange provides trading

in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY

MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and options)

contracts on S&P CNX Nifty index w.e.f. January 1,2008.National Commodity & Derivatives

Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform

for commodities trading.The derivatives market in India has grown exponentially, especially

at NSE. Stock Futures are the most highly traded contracts.

CONTENTS

UNIT 1

INTRODUCTION OF FINANCIAL DERIVATIVES

DERIVATIVE MARKET

DEVLOPMENT OF DERIVATIVE MARKET IN INDIA

RISKS INVOLVED IN TRADING IN DERIVATIVES CONTRACTS

REGULATORY FRAMEWORK FOR DERIVATIVES

UNIT 2

INTRODUCTION OF IDBI

MYTHS AND REALITIES OF DERIVATIVES

RESEARCH METHODILOGY:-

Title of study

Durations of study

Objective of study

Type of research

Sample size and method of selecting sample

Limitation of study

DATA ANALYSIS AND INTERPRETATION

CONCLUSION

RECOMMENDATION AND SUGGESTION

APPENDIX

BIBLIOGRAPHY

FINANCIAL DERIVATIVES

INTRODUCTION

Derivatives are defined as financial instruments whose value derived from the prices of one

or more other assets such as equity securities, fixed-income securities, foreign currencies,

or commodities. Derivatives are also a kind of contract between two counterparties to

exchange payments linked to the prices of underlying assets. Derivative can also be defined

as a financial instrument that does not constitute ownership, but a promise to convey

ownership. Examples are options and futures. The simplest example is a call option on a

stock. In the case of a call option, the risk is that the person who writes the call (sells it and

assumes the risk) may not be in business to live up to their promise when the time comes.

In standardized options sold through the Options Clearing House, there are supposed to be

sufficient safeguards for the small investor against this. The most common types of

derivatives that ordinary investors are likely to come across are futures, options, warrants

and convertible bonds. Beyond this, the derivatives range is only limited by the imagination

of investment banks. It is likely that any person who has funds invested an insurance policy

or a pension fund that they are investing in, and exposed to, derivatives-wittingly or

unwittingly.

HISTORY OF DERIVATIVE

The history of derivatives is surprisingly longer than what most people think. Some texts

even find the existence of the characteristics of derivative contracts in incidents of

Mahabharata. Traces of derivative contracts can even be found in incidents that date back

to the ages before Jesus Christ.However, the advent of modern day derivative contracts is

attributed to the need for farmers to protect themselves from any decline in the price of their

crops due to delayed monsoon, or verproduction.The first 'futures' contracts can be traced

to the Yodoya rice market in Osaka, Japan around 1650. These were evidently

standardized contracts, which made them much like today's futures.The Chicago Board of

Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where

forward contracts on various commodities were standardised around 1865. From then on,

futures contracts have remained more or less in the same form, as we know them today.

Derivatives have had a long presence in India. The commodity derivative market

has been functioning in India since the nineteenth century with organized trading in cotton

through the establishment of Cotton Trade Association in 1875. Since then contracts on

various other commodities have been introduced as well.’

Exchange traded financial derivatives were introduced in India in June 2000 at the two

major stock exchanges, NSE and BSE. There are various contracts currently traded on

these exchanges.The National Stock Exchange of India Limited (NSE) commenced trading

in derivatives with the launch of index futures on June 12, 2000. The futures contracts are

based on the popular benchmark S&P CNX Nifty Index.The Exchange introduced trading in

Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange

to launch trading in options on individual securities from July 2, 2001. Futures on individual

securities were introduced on November 9, 2001. Futures and Options on individual

securities are available on 227 securities stipulated by SEBI.The Exchange provides trading

in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY

MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and options)

contracts on S&P CNX Nifty index w.e.f. January 1,2008.National Commodity & Derivatives

Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform

for commodities trading.The derivatives market in India has grown exponentially, especially

at NSE. Stock Futures are the most highly traded contracts.

The size of the derivatives market has become important in the last 15 years or so. In

2007 the total world derivatives market expanded to $516 trillion.With the opening of the

economy to multinationals and the adoption of the liberalized economic policies, the

economy is driven more towards the free market economy. The complex nature of

financial structuring itself involves the utilization of multi currency transactions. It exposes

the clients, particularly corporate clients to various risks such as exchange rate risk, interest

rate risk, economic risk and political risk.With the integration of the financial markets and

free mobility of capital, risks also multiplied. For instance, when countries adopt floating

exchange rates, they have to face risks due to fluctuations in the exchange rates.

Deregulation of interest rate cause interest risks. Again, securitization has brought with it the

risk of default or counter party risk. Apart from it, every asset—whether commodity or metal

or share ocurrency—is subject to depreciation in its value. It may be due to certain inherent

factors and external factors like the market condition, Government’s policy, economic and

political condition prevailing in the country and so on. In the present state of the economy,

there is an imperative need of the corporate clients to protect there operating profits by

shifting some of the uncontrollable financial risks to those who are able to bear and manage

them. Thus, risk management becomes a must for survival since there is a high volatility in

the present financial markets In this context, derivatives occupy an important place as risk

reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In

fact, the financial service companies can play a very dynamic role in dealing with such risks.

They can ensure that the above risks are hedged by using derivatives like forwards, future,

options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to he

financial service companies. This really protects the clients from unforeseen risks and helps

them to get there due operating profits or to keep the project well within the budget costs.

To hedge the various risks that one faces in the financial market today, derivatives are

absolutely essential.

SCOPE OF DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital

market. The National Stock Exchange has been planning to introduce index-based futures.

A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to

enroll for such trading. But, it has not yet received the necessary permission from the

securities and Exchange Board of India.In the forex market, there are brighter chances of

introducing derivatives on a large scale. Infact, the necessary groundwork for the

introduction of derivatives in forex market was prepared by a high-level expert committee

appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee’s report was already

submitted to the Government in 1995. As it is, a few derivative products such as interest

rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a

limited scale. It is easier to introduce derivatives in forex market because most of these

products are OTC products (Over-the-counter) and they are highly flexible. These are

always between two parties and one among them is always a financial intermediary.

However, there should be proper legislations for the effective implementation of derivative

contracts. The utility of derivatives through Hedging can be derived, only when, there is

transparency with honest dealings. The players in the derivative market should have a

sound financial base for dealing in derivative transactions. What is more important for the

success of derivatives is the prescription of proper capital adequacy norms, training of

financial intermediaries and the provision of well-established indices. Brokers must also be

trained in the intricacies of the derivative-transactions. Now, derivatives have been

introduced in the Indian Market in the form of index options and index futures. Index options

and index futures are basically derivate tools based on stock index. They are really the risk

management tools. Since derivates are permitted legally, one can use them to insulate his

equity portfolio against the vagaries of the market

Every investor in the financial area is affected by index fluctuations. Hence, risk

management using index derivatives is of far more importance than risk management using

individual security options. Moreover, Portfolio risk is dominated by the market risk,

regardless of the composition of the portfolio. Hence, investors would be more interested in

using index-based derivative products rather than security based derivative products. There

are no derivatives based on interest rates in India today. However, Indian users of hedging

services are allowed to buy derivatives involving other currencies on foreign markets. India

has a strong dollar- rupee forward market with contracts being traded for one to six month

expiration. Daily trading volume on this forward market is around $500 million a day. Hence,

derivatives available in India in foreign exchange area are also highly beneficial to the

users.

FACTORS CONTRIBUTED TOWARDS THE GROWTH OF DERIVATIVES:-

1) Increased Volatility in asset prices in financial markets.

2) Increased integration of national financial markets with the international markets,

3) Marked improvement in communication facilities and sharp decline in their costs,

4) Development of more sophisticated risk management tools, providing economic agents a

, wider choice of risk management strategies.

Innovations in the derivatives markets, which optimally combine the risks and returns over a

large number of financial assets, leading to higher returns, reduced risk as well as

transaction costs as compared to individual financial assets.

The need for a derivatives market :-

1) They help in transferring risks from risk adverse people to risk oriented people

2) They help in the discovery of future as well as current prices.

3) They increase the volume traded in markets because of participation of risk adverse

People in greater numbers. They increase savings and investment in the long run.

TYPES OF DERIVATIVES:-

There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.

The most commonly used derivatives contracts are Forward, Futures and Options.

FORWARD:-

A forward contract is an agreement between two parties – a buyer and a seller to

purchase or sell something at a later date at a price agreed upon today. Forward

contracts, sometimes called forward commitments, are very common in everyone life. For

example, an apartment lease is a forward commitment. By signing a one-year lease, the

tenant agrees to purchase the service – use of the apartment – each month for the next

twelve months at a predetermined rate. Like-wise, the landlord agrees to provide the

service each month for the next twelve months at the agreed-upon rate. Now suppose that

six months later the tenant finds a better apartment and decides to move out. The forward

commitment remains in effect, and the only way the tenant can get out of the contract is to

sublease the apartment. Because there is usually a market for subleases, the lease is

even more like a futures contract than a forward contract. Any type of contractual

agreement that calls for the future purchase of a good or service at a price agreed upon

today and without the right of cancellation

FUTURES:-

The future contract is an agreement to buy or sell an asset at a certain time in the future for

a certain price. Equities, bonds, hybrid securities and currencies are the commodities of the

investment business. They are traded on organized exchanges in which a clearing. house

interposes itself between buyer and seller and guarantees all transactions, so that the identity

of the buyer or seller is a matter of indifference to the opposite party.

Futures contracts protect those who use these commodities in their business. Future contract

based on financial investment or a financial index are known as:-financial futures. Financial

futures can be classified in three categories which is as follows:-

a) stock index futures ;

b) interest rate futures

c) currency futures.

SWAPS:-

Swaps are private agreements between two parties to exchange cash flows in the future

according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are interest rate swaps and currency swaps.

Interest rate swaps: These involve swapping only the interest related cash flows between

the parties in the same currency. Currency swaps: These entail swapping both principal

and interest between the parties, with the cash flows in one direction being in a different

currency than those in the opposite direction.

OPTION:-

An option is a contract whereby one party (the holder or buyer) has the right, but not

the obligation, to exercise the contract (the option) on or before a future date (the exercise

date or expiry). The other party (the writer or seller) has the obligation to honour the

specified feature of the contract. Since the option gives the buyer a right and the seller an

obligation, the buyer has received something of value. The amount the buyer pays the seller

for the option is called the option premium. Because this is a security whose value is

determined by an underlying asset, it is classified as a derivative.

Types of Options:-

There are two main types of options:

a. American options can be exercised at any time between the date of purchase and the

expiration date.

b. European options can only be exercised at the end of their lives.

c. Long-Term Options are options with holding times of one, two or multiple years, which

may be more appealing for long-term investors, which are called long-term equity

anticipation securities (LEAPS).

DERIVATIVE MARKET

The Derivatives Market is meant as the market where exchange of derivatives takes

place. Derivatives are one type of securities whose price is derived from the underlying

assets. And value of these derivatives is determined by the fluctuations in the underlying

assets. These underlying assets are most commonly stocks, bonds, currencies, interest

rates, commodities and market indices. As Derivatives are merely contracts between two or

more parties, anything like weather data or amount of rain can be used as underlying

assets.

PARTICIPANTS OF THE DERIVATIVE MARKET

Market participants in the future and option markets are many and they perform multiple

roles, depending upon their respective positions. A trader acts as a hedger when he

transacts in the market for price risk management. He is a speculator if he takes an open

position in the price futures market or if he sells naked option contracts. He acts as an

arbitrageur when he enters in to simultaneous purchase and sale of a commodity, stock or

other asset to take advantage of misruling. He earns risk less profit in this activity. Such

opportunities do not exist for long in an efficient market. Brokers provide services to others,

while market makers create liquidity in the market.

a)Hedgers

Hedgers are the traders who wish to eliminate the risk (of price change) to which they are

already exposed. They may take a long position on, or short sell, a commodity and would,

therefore, stand to lose should the prices move in the adverse direction. hedgers want to

eliminate an exposure to movements in the price of an asset. Hedging with financial futures

is an art as well as a science. By future hedging, we mean to take a position in futures

contracts that offset some of the risk associated with some given market commitment. The

essence of hedging is the adoption of a future position that, on average, generates profits

when the market value of the commitment is higher than expected. The notion of designing

a futures strategy to generate losses under certain circumstances may seem quixotic to

some. . One must keep in mind the well-repeated adage:” There are no free lunches”.

One cannot expect trading profits as well as risk reduction (although that sometimes

happens). The key is to coordinate losses in futures with gains elsewhere, and vice versa.

How does one achieve that kind of coordination? Such futures are not an answer to all

investment management problems, but they do provide the finance manager with new

means to act upon market decisions. An understanding of the futures contracts and how the

futures markets operate is critical to designing a successful hedge strategy. As with any

innovative technique, potential hedgers need to take the time to study the markets and

determine the risk/return potential for each application In order to profit from a spread

transaction the trader attempts to determine whether the size of the difference between the

prices of the two contracts will increase or decrease. A spread earns a profit if the correct

direction of the price difference is forecasted and the appropriate spread transaction is set

up in conjunction with the changing price structure of the future contracts.

b) Speculators

If hedgers are the people who wish to avoid the price risk, speculators are those who

are willing to take such risk. These people take position in the market and assume risk to

profit from fluctuations in prices. In fact, speculators consume information, make forecasts

about the prices and put their money in these forecasts. In this process, they feed

information into prices and thus contribute to market efficiency. By taking position, they are

betting that a price would go up or they are betting that it would go down.The speculators in

the derivative markets may be either day trader or position traders. The day traders

speculate on the price movements during one trading day, open and close position many

times a day and do not carry any position at the end of the day.They monitor the prices

continuously and generally attempt to make profit from just a few ticks per trade. On the

other hand, the position traders also attempt to gain from price fluctuations but they keep

their positions for longer durations may is for a few days, weeks or even months.

Speculators wish to take a position in the market. Either they are betting that a price will go

up or they are betting that it will go down. In other words, a speculative position can be

either a long or a short. A long position occurs when the futures contract is purchased;

profits arise when prices increase. A short position when its futures contract is sold, a short

trader profits when prices decrease. Speculative futures positions are very profitable for

those who are able to forecast correctly both market direction and the extent of the market

move. This profitability is enhanced because the speculator needed to put up only a small

percentage of the value of the underlying cash instrument for margin, there by allowing a

significant degree of leverage.

Of course, if a speculator forecasts incorrectly, then the mark-to-market rules cause a cash

outflow as the future position deteriorates. Consequently, a speculator needs forecasting

ability and substantial knowledge of the underlying cash markets, plus sufficient funds to

overcome a short-term (or permanent) loss of funds from losing trades.

There is an important difference between speculating using forward markets and

speculating by buying the underlying asset in the spot market.Buying a certain amount of

the underlying asset in the spot market requires an initial cash payment equal to the total

value of what is bought. Entering into a forward contract on the same amount of the asset

requires no initial cash payment. Speculating using forward markets therefore provide an

investor with a much higher level of leverage than speculating using spot markets. In the

highly leveraged futures markets, minimums are set to ensure that the speculators can

afford any potential losses. For this very reason a levy of 15 percent margin on the contract

price has been suggested in the Bombay Stock Exchange plans to introduce futures trading

on the exchange parallel to cash transactions on the market. The percentage of margin is to

be constant throughout the contract but the amount of margin will vary based on the mark to

market price. Members are to pay margins on all futures contracts on a gross basis.

In a volatile market, the speculator needs to establish realistic goals for trades. After

reaching these goals, it is best to cover the trade. If a speculator becomes emotionally

involved in a position (which generates greed and fear), the ability to make a realistic

decision about covering a position is impaired. Some speculators attempt to circumvent

such emotional considerations by Placing special trading orders with the broker so that the

trader is automatically removed from a disadvantageous situation. Although such orders are

useful for speculators who are not in constant contact with the market and have specific

forecasts of market movements, many active traders believe that recognizing the current

trend in the market and then adapting to that trend is more important than mechanical

position trading.

c) Arbitrageurs

Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a given

commodity, or other item, that sells for different prices in different markets. The Institute of

Chartered Accountant of India, the word “ARBITRAGE” has been defines as

follows:-“Simultaneous purchase of securities in one market where the price there of is low

and sale thereof in another market, where the price thereof is comparatively higher. These

are done when the same securities are being quoted at different prices in the two markets,

with a view to make profit and carried on with conceived intention to derive advantage from

difference in prices of securities prevailing in the two different markets”Thus, arbitrage

involves making risk-less profits by simultaneously entering into transactions in two or more

markets.

Arbitrage exists when a trader is able to obtain risk-free profits by taking one position in the

cash market and an exact opposite position in the futures market. The arbitrage position is

covered later by delivering the cash security into the futures position. The arbitrageur can

close the position prior to delivery if the profit potential has been achieved; this situation

occurs principally in the stock index futures market because of the price swings. Arbitrage

keeps the futures and cash prices in line with one another.

This relationship between the cash and fair futures prices is expressed by the simple cost

of carry pricing. This pricing shows that the fair futures prices are the set of buying the cash

asset now and financing this asset until delivery into the futures contract. If the current

futures price is higher than the fair price dictated by the cost of carry pricing, then arbitrage

is possible by buying the cheaper instrument (the cash) and selling the more expensive

instrument (the futures). Alternatively, if the current futures price is less than the fair price,

then the arbitrageur purchases futures and sells the cash short. This activity forces the

prices of the cash and futures instruments back into their appropriate relationship.

THE TREND OF DERIVATIVE MARKET IN INDIA

Derivative products made a debut in the Indian market during 1998 and overall progress

of derivatives market in India has indeed been impressive. The Indian equity derivatives

market has registered an "explosive growth" and is expected to continue its dream run in the

years to come with the various pieces that are crucial for the market's growth slowly falling

in place.

Over the counter derivatives market in Interest Rate and Foreign Exchange has also

witnessed impressive growth with RBI allowing the local banks to run books in Indian Rupee

Interest Rate and FX derivatives.

The complexity of market continues to increase as clients have become savvier,

demanding more fine tuned solution to meet their risk management objectives, rather than

using the vanilla roducts.Besides Rupee derivatives offered by the local players, RBI has

also allowed the client to use more exotic products like barrier options. These products are

offered by the local bank on back-to-back basis, wherein they buy similar product from

market maker from the offshore markets.

The complexity of derivatives market has increased, but the growth in deployment of

risk management systems required to manage such complex business has not grown at the

same pace.

The reason being, the very high cost of such system and absence of any local player

who could offer the solution, which could compete with product offered by the international

vendors.

DERIVATIVE MARKET GROWTH

The Derivatives Market Growth was about 30% in the first half of 2008 when it reached

a size of $US 370 trillion. This growth was mainly due to the increase in the participation of

the bankers, investors and different companies. The derivative market instruments are used

by them to hedge risks as well as to satisfy their speculative needs

.

The derivative market growth for different derivative market instruments may be

discussed under the following heads.

a) Derivative Market Growth for the Exchange-traded-Derivatives

The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the

futures and options market grew by 38 % while the interest rate futures grew by 42%.

Hence the derivative market size for the futures and the options market was $49 trillion.

b) Derivative Market Growth for the Global Over-the-Counter Derivatives

The contracts traded through Over-the-Counter market witnessed a 24 % increase in its

face value and the over-the -counter derivative market size reached $70,000 billion. This

shows that the face value of the derivative contracts has multiplied 30 times the size of the

US economy. Notable increases were recorded for foreign exchange, interest rate, equity

and commodity based derivative following an increase in the size of the Over-the Counter

derivative market.

The Derivative Market Growth does not necessitate an increase in the risk taken by the

different investors. Even then, the overshoot in the face value of the derivative contracts

shows that these derivative instruments played a pivotal role in the financial market of

today.

c) Derivative Market Growth for the Credit Derivatives

The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market

growth is attributed to the increase in the trading in the synthetic collateral Debt

obligations and also to the electronic trading systems that have come into existence. The

Bank of International Settlements measures the size and the growth of the derivative

market. the derivative market growth in the over the counter derivative market witnessed

a slump in the second half of 2008.

Although the credit derivative market grew at a rapid pace, such growth was made offset

by a slump somewhere else. The notional amount of the Credit Default Swap witnessed a

growth of 42%. Credit derivatives grew by 54%. The single name contracts grew by 36%.

The interest derivatives grew by 11%. The OTC foreign exchange derivatives slowed by

5%, the OTC equity derivatives slowed by 10%. Commodity derivatives also experienced

crawling growth pattern.

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 was 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(Sensex) index. This was followed by

approval for trading in options based on these two indexes and options on individual

securities

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options

on individual securities commenced in July 2001. Futures contracts on individual stocks

were launched in November 2001. The derivatives trading on NSE commenced with S&P

CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on

June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.

Single stock futures were launched on November 9, 2001.

The index futures and options contract on NSE are based on S&P CNX Trading and

settlement in derivative contracts is done in accordance with the rules, byelaws, and

regulations of the respective exchanges and their clearing house/corporation duly approved

by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are

permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE

report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O segment. It

constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to

this phenomenon is that traders are comfortable with single-stock futures than equity

options, as the former closely resembles the erstwhile badla system.

• On relative terms, volumes in the index options segment continues to remain poor. This

may be due to the low volatility of the spot index. Typically, options are considered more

valuable when the volatility of the underlying (in this case, the index) is high. A related issue

is that brokers do not earn high commissions by recommending index options to their

clients, because low volatility leads to higher waiting time for round-trips.

• Put volumes in the index options and equity options segment have increased since

January 2002. The call-put volumes in index options have decreased from2.86 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 aless 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. Calls on Satyam fall,

while puts rise when Satyam falls intraday. 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.

Commodity Derivatives

Futures contracts in pepper, turmeric, guar (jaggery), hessian (jute fabric), jute sacking,

castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18

commodity exchanges located in various parts of the country. Futures trading in other edible

oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities,

especially in edible oils, is expected to commence in the near future. The sugar industry is

exploring the merits of trading sugar futures contracts.

The policy initiatives and the modernisation programme include extensive training,

structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and

the thrust towards the establishment of a national commodity exchange. The Government of

India has constituted a committee to explore and evaluate issues pertinent to the

establishment and funding of the proposed national commodity exchange for the nationwide

trading of commodity futures contracts, and the other institutions and institutional processes

such as warehousing and clearinghouses.

With commodity futures, delivery is best affected using warehouse receipts (which are like

dematerialized securities). Warehousing functions have enabled viable exchanges to

augment their strengths in contract design and trading.

The viability of the national commodity exchange is predicated on the reliability of the

warehousing functions. The program for establishing a system of warehouse receipts is in

progress. The Coffee Futures Exchange India (COFEI) has operated a system of

warehouse receipts since 1998. There are two exchanges for commodity in India:

1) National Commodity & Derivatives Exchange Limited-(Herein referred to as ‘NCDEX’ or

‘Exchange’),

2) Multi Commodity Exchange ( MCX)

Foreign Exchange Derivatives

The Indian foreign exchange derivatives market owes its origin to the important step that the

RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange; as a

consequence, the stipulation of maintaining square or near square position was to be

complied with only at the close of each business day.

This was followed by use of products like cross-currency options, interest rate and currency

swaps, caps/collars and forward rate agreements in the international foreign exchange

market; development of a rupee-foreign currency swap market; and introduction of

additional hedging instruments such as foreign currency-rupee options.

Cross-currency derivatives with the rupee as one leg were introduced with some restrictions

in the April 1997 Credit Policy by the RBI. In the April 1999 Credit Policy, Rupee OTC

interest rate derivatives were permitted using pure rupee benchmarks, while in April 2000,

Rupee interest rate derivatives were permitted using implied rupee benchmarks.

In 2001, a few select banks introduced Indian National Rupee (INR) Interest Rate

Derivatives (IRDs) using Government of India security yields as floating benchmarks.

Interest rate futures (long bond and t-bill) were introduced in June 2003 and Rupee-foreign

exchange options were allowed in July 2003.

.

Fixed income derivatives

Scheduled Commercial Banks, Primary Dealers (PDs) and FIs have been allowed by RBI

since July 1993 to write Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAs)

as products for their own asset liability management(ALM) or for market making (risk

trading) purposes. Since October 2000, IRS can be written on benchmarks in domestic

money or debt market (e.g. NSE MIBOR, Reuter Mibor, GoI Treasury Bills) or on implied

foreign currency interest rates [e.g. Mumbai Interbank Forward Offer Rate (MIFOR),

Mumbai Interbank Tom Offer Rate (MITOR)].

IRS based on MIFOR/MITOR could well be written on a stand-alone basis, and need not be

a part of a Cross Currency Interest Rate Swap (CC-IRS). This enables corporates to

benchmark the servicing cost on their rupee liabilities to the foreign currency forward yield

curve.

There is now an active Over-The-Counter (OTC) IRS and FRA market in India. Yet, the bulk

of the activity is concentrated around foreign banks and some private sector banks (new

generation) that run active derivatives trading books in their treasuries. The presence of

Public Sector Bank (PSB) majors (such as SBI, BoB, BoI, PNB, amongst others) in the

rupee IRS market is marginal, at best. Most PSBs are either unable or unwilling to run a

derivatives trading book enfolding IRS or FRAs.

Further, most PSBs are not yet actively offering IRSs or FRAs to their corporate customers

on a “covered” basis with back-to-back deals in the inter-institutional market. The

consequence is a paradox.

On the one side you have foreign banks and new generation private sector banks that run a

derivatives trading book but do not have the ability to set significant counter party (credit)

limits on a large segment of corporate customers of PSBs. And, on the other side are PSBs

who have the ability and willingness to set significant counter party (credit) limits on

corporate customers, but are unable or unwilling to write IRS or FRAs with them. Thereby,

the end user corporates are denied access through this route to appropriate hedging and

yield enhancing products, to better manage the assetliability portfolio. This inability or

unwilling of PSB majors seemingly stems from the following key impediments they are yet to

overcome:

1. Inadequate technological and business process readiness of their treasuries to run

a derivatives trading book, and manage related risks.

2. Inadequate readiness of human resources/talent in their treasuries to run a derivatives

trading book, and manage related risks.

3. Inadequate willingness of bank managements to the “risk” being held accountable for

bona-fide trading losses in the derivatives book, and be exposed to subsequent onerous

investigative reviews, in a milieu where there is no penal consequence for lost opportunity

profit

4.Inadequate readiness of their Board of Directors to permit the bank to run a derivatives

trading book, partly for reasons cited above, and partly due to their own “discomfort of the

unfamiliar.”s

Interest rate options and futures:

The RBI is yet to permit banks to write rupee (INR) interest rate options.Indeed, for banks to

be able to write interest rate options, a rupee interest rate futures market would need to first

exist, so that the option writer can delta hedge the risk in the interest rate options positions.

And, according to one school of thought, perhaps the policy dilemma before RBI is: how to

permit an interest rate futures market when the current framework does not permit short

selling of sovereign securities. Further, even if short selling of sovereign securities were to

be permitted, it may be of little consequence unless lending and borrowing of sovereign

securities is first permitted.

.

.

RISKS INVOLVED IN TRADING IN DERIVATIVES CONTRACTS

Effect of "Leverage" or "Gearing"

The amount of margin is small relative to the value of the derivatives contract so the

transactions are 'leveraged' or 'geared'.

Derivatives trading, which is conducted with a relatively small amount of margin, provides

the possibility of great profit or loss in comparison with the principal investment amount. But

transactions in derivatives carry a high degree of risk.

You should therefore completely understand the following statements before actually trading

in derivatives trading and also trade with caution while taking into account one's

circumstances, financial resources, etc. move against you, you may lose a part of or whole

margin equivalent to the principal investment amount in a relatively short period of time.

Moreover, the loss may exceed the original margin amount.

A. Futures trading involve daily settlement of all positions. Every day the open positions are

marked to market based on the closing level of the index. If the index has moved against

you, you will be required to deposit the amount of loss (notional) resulting from such

movement. This margin will have to be paid within a stipulated time frame, generally before

commencement of trading next day.

B. If you fail to deposit the additional margin by the deadline or if an outstanding debt

occurs in your account, the broker/member may liquidate a part of or the whole position or

substitute securities. In this case, you will be liable for any losses incurred due to such

close-outs.

C. Under certain market conditions, an investor may find it difficult or impossible to execute

transactions. For example, this situation can occur due to factors such as illiquidity i.e. when

there are insufficient bids or offers or suspension of trading due to price limit or circuit

breakers etc.

D. In order to maintain market stability, the following steps may be adopted: changes in the

margin rate, increases in the cash margin rate or others. These new measures may be

applied to the existing open interests. In such conditions, you will be required to put up

additional margins or reduce your positions.

E. You must ask your broker to provide the full details of the derivatives contracts you plan

to trade i.e. the contract specifications and the associated obligations.

1) Risk-reducing orders or strategies

The placing of certain orders (e.g., "stop-loss" orders, or "stop-limit" orders) which are

intended to limit losses to certain amounts may not be effective because market conditions

may make it impossible to execute such orders. Strategies using combinations of

positions, such as "spread" positions, may be as risky as taking simple "long" or "short"

positions

2) Suspension or restriction of trading and pricing relationships

Market conditions (e.g., illiquidity) and/or the operation of the rules of certain markets (e.g.,

the suspension of trading in any contract or contact month because of price limits or "circuit

breakers") may increase the risk of loss due to inability to iquidate/offset positions

3) Deposited cash and property

You should familiarise yourself with the protections accorded to the money or other property

you deposit particularly in the event of a firm insolvency or bankruptcy. The extent to which

you may recover your money or property may be governed by specific legislation or local

rules. In some jurisdictions, property which has been specifically identifiable as your own will

be pro-rated in the same manner as cash for purposes of distribution in the event of a

shortfall. In case of any dispute with the member, the same shall be subject to arbitration as

per the byelaws/regulations of the Exchange

. 4) Risk of Option holders

1. An option holder runs the risk of losing the entire amount paid for the option in a relatively

short period of time. This risk reflects the nature of an option as a wasting asset which

becomes worthless when it expires. An option holder who neither sells his option in the

secondary market nor exercises it prior to its expiration will necessarily lose his entire

investment in the option. If the price of the underlying does not change in the anticipated

direction before the option expires to the extent sufficient to cover the cost of the option, the

investor may lose all or a significant part of his investment in the option.

. 2. The Exchange may impose exercise restrictions and have authority to restrict the

exercise of options at certain times in specified circumstances.

5) Risks of Option Writers

1. not well understood is, in itself, a risk factor. While this is not to suggest that combination

strategies should not be If the price movement of the underlying is not in the anticipated

direction the option writer runs the risks of losing substantial amount.

2. The risk of being an option writer may be reduced by the purchase of other options on the

same underlying interest-and thereby assuming a spread position-or by acquiring other

types of hedging positions in the options markets or other markets. However, even where

the writer has assumed a spread or other hedging position, the risks may still be significant.

A spread position is not necessarily less risky than a simple 'long' or 'short' position.

3. Transactions that involve buying and writing multiple options in combination, or buying or

writing options in combination with buying or selling short the underlying interests, present

additional risks to investors. Combination transactions, such as option spreads, are more

complex than buying or writing a single option. And it should be further noted that, as in any

area of investing, a complexity considered, it is advisable, as is the case with all

investments in options, to consult with someone who is experienced and knowledgeable

with respect to the risks and potential rewards of combination transactions under various

market circumstances.

6) Commission and other charges

Before you begin to trade, you should obtain a clear explanation of all commission, fees and

other charges for which you will be liable. These charges will affect your net profit (if any) or

increase your loss.

7) Trading facilities

The Exchange offers electronic trading facilities which are computerbased systems for

order-routing, execution, matching, registration or clearing of trades. As with all facilities and

systems, they are vulnerable to temporary disruption or failure. Your ability to recover

certain losses may be subject to limits on liability imposed by the system provider, the

market, the clearing house and/or member firms. Such limits may vary; you should ask the

firm with which you deal for details in this respect.

This document does not disclose all of the risks and other significant aspects involved in

trading on a derivatives market. The constituent should therefore study derivatives trading

carefully before becoming involved in it.

REGULATORY FRAMEWORK FOR DERIVATIVES THE GUIDING

PRINCIPLES

Regulatory objectives

1. The Committee believes that regulation should be designed to achieve specific, well-

defined goals. It is inclined towards positive regulation designed to encourage healthy

activity and behaviour. It has been guided by the following objectives :

a).Investor Protection: Attention needs to be given to the following four

aspects:

b). Fairness and Transparency: The trading rules should ensure that trading is

conducted in a fair and transparent manner. Experience in other countries shows that in

many cases, derivative brokers/dealers failed to disclose potential risk to the clients. In this

context, sales practices adopted by dealers for derivatives would require specific

regulation. In some of the most widely reported mishaps in the derivatives market

elsewhere, the underlying reason was inadequate internal control system at the user-firm

itself so that overall exposure was not controlled and the use of derivatives was for

speculation rather than for risk hedging. These experiences provide useful lessons for us for

designing regulations.

c). Safeguard for clients' moneys : Moneys and securities deposited by clients with

the trading members should not only be kept in a separate clients' account but should also

not be attachable for meeting the broker's own debts. It should be ensured that trading by

dealers on own account is totally segregated from that for clients.

d). Competent and honest service: The eligibility criteria for trading members

should be designed to encourage competent and qualified personnel so that

investors/clients are served well. This makes it necessary to prescribe qualification for

derivatives brokers/dealers and the sales persons appointed by them in terms of a

knowledge base.

e). Market integrity: The trading system should ensure that the market's integrity is

safeguarded by minimising the possibility of defaults. This requires framing appropriate

rules about capital adequacy, margins, clearing corporation, etc.

Quality of markets: The concept of "Quality of Markets" goes well beyond market

integrity and aims at enhancing important market qualities, such as cost-efficiency, price-

continuity, and price-discovery. This is a much broader objective than market integrity.

.

Innovation: While curbing any undesirable tendencies, the regulatory framework should

not stifle innovation which is the source of all economic progress, more so because financial

derivatives represent a new rapidly developing area, aided by advancements in information

technology.

Major issues concerning regulatory framework

The Committee's attention had been drawn to several important issues in connection with

derivatives trading. The Committee has considered such issues, some of which have a

direct bearing on the design of the regulatory framework. They are listed below :

a. Should a derivatives exchange be organised as independent and separate from an

existing stock exchange?

b. What exactly should be the division of regulatory responsibility, including both framing

and enforcing the regulations, between SEBI and the derivatives exchange?

c. How should we ensure that the derivatives exchange will effectively fulfill its regulatory

responsibility?

d. What criteria should SEBI adopt for granting permission for derivatives trading to an

exchange?

e. What conditions should the clearing mechanism for derivatives trading satisfy in view of

high leverage involved?

f. What new regulations or changes in existing regulations will have to be introduced by

SEBI for derivatives trading?

Should derivatives trading be conducted in a separate exchange?

1. A major issue raised before the Committee for its decision was whether regulations

should mandate the creation of a separate exchange for derivatives trading, or allow an

existing stock exchange to conduct such trading.

The Committee has examined various aspects of the problem. It has also reviewed the

position prevailing in other countries. Exchange-traded financial derivatives originated in

USA and were subsequently introduced in many other countries.

Organisational and regulatory arrangements are not the same in all countries. Interestingly,

in U.S.A., for reasons of history and regulatory structure, a future trading in financial

instruments, including currency, bonds and equities, was started in early 1970s, under the

auspices of commodity futures markets rather than under securities exchanges where the

underlying bonds and equities were being traded.

This may have happe ned partly because currency futures, which had nothing to do with

securities markets, were the first to emerge among financial derivatives in U.S.A. and partly

because derivatives were not "securities" under U.S. laws.

Cash trading in securities and options on securities were under the Securities and

Exchange Commission (SEC) while futures trading were under the Commodities Futures

Trading Commission (CFTC). In other countries, the arrangements have varied.

2. The Committee examined the relative merits of allowing derivatives trading to be

conducted by an existing stock exchange vis-a-vis a separate exchange for derivatives.

The arguments for each are summarised below.

Arguments for allowing existing stock exchanges to start futures trading:

a. The weightiest argument in this regard is the advantage of synergies arising from the

pooling of costs of expensive information technology networks and the sharing of expertise

required for running a modern exchange. Setting-up a separate derivatives exchange will

involve high costs and require more time.

b. The recent trend in other countries seems to be towards bringing futures andcash trading

under coordinated supervision. The lack of coordination was recognised as an important

problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level

supervisory coordination between futures and cash markets is greatly facilitated if both are

parts of the same exchange.

.

Arguments for setting-up separate futures exchange:

a. The trading rules and entry requirements for futures trading would have to be different

from those for cash trading.

b. The possibility of collusion among traders for market manipulation seems to be greater if

cash and futures trading are conducted in the same exchange.

c. A separate exchange will start with a clean slate and would not have to restrict the entry

to the existing members only but the entry will be thrown open to all potential eligible

players.

Recommendation

From the purely regulatory angle, a separate exchange for futures trading seems to be a

neater arrangement. However, considering the constraints in infrastructure facilities, the

existing stock exchanges having cash trading may also be permitted to trade derivatives

provided they meet the minimum eligibility conditions as indicated below:

1. The trading should take place through an online screen-based trading system, which

also has a disaster recovery site. The per-half-hour capacity of the computers and the

network should be at least 4 to 5 times of the anticipated peak load in any half hour, or of

the actual peak load seen in any half-hour during the preceding six months. This shall be

reviewed from time to time on the basis of experience.

2. The clearing of the derivatives market should be done by an independent clearing

corporation, which satisfies the conditions listed in a later chapter of this report.

3. The exchange must have an online surveillance capability which monitors positions,

prices and volumes in realtime so as to deter market manipulation. Price and position limits

should be used for improving market quality.

4. Information about trades, quantities, and quotes should be disseminated by the exchange

in realtime over at least two information vending networks which are accessible to investors

in the country.

5. The Exchange should have at least 50 members to start derivatives trading.

6. If derivatives trading are to take place at an existing cash market, it should be done in a

separate segment with a separate membership; i.e., all members of the existing cash

market would not automatically become members of the derivatives market.

7. The derivatives market should have a separate governing council which shall

not have representation of trading/clearing members of the derivatives Exchange beyond

whatever percentage SEBI may prescribe after reviewing the working of the present

governance system of exchanges.

8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a

member of the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not

carry on any Broking or Dealing Business on any Exchange during his tenure as Chairman.

9. The exchange should have arbitration and investor grievances redressal mechanism

operative from all the four areas/regions of the country.

10. The exchange should have an adequate inspection capability.

11. No trading/clearing member should be allowed simultaneously to be on the

governing council of both the derivatives market and the cash market.

12. If already existing, the Exchange should have a satisfactory record of monitoring its

members, handling investor complaints and preventing irregularities in trading

Working of Derivatives markets in India

Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for

derivative trading in India. SEBI has also framed suggestive byelaw for Derivative

Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions

for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the

Derivative Segment of the Exchanges and their Clearing Corporation/House have to be

framed in line with the suggestive Bye-laws.

SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its

Clearing Corporation/House. The eligibility conditions have been framed to ensure that

Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading

environment, safety & integrity and provide facilities for redressal of investor grievances.

Some of the important eligibility conditions are- Derivative trading to take place through an

on-line screen based Trading System.

The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor

positions, prices, and volumes on a real time basis so as to deter market manipulation.

The Derivatives Exchange/ Segment should have arrangements for dissemination of

information about trades, quantities and quotes on a real time basis through atleast two

information vending networks, which are easily accessible to investors across the country.

The Derivatives Exchange/Segment should have arbitration and investor grievances

redressal mechanism operative from all the four areas / regions of the country.The

Derivatives Exchange/Segment should have satisfactory system of monitoring investor

complaints and preventing irregularities in trading.

The Derivative Segment of the Exchange would have a separate Investor Protection Fund.

The Clearing Corporation/House shall perform full notation, i.e., The Clearing

Corporation/House shall interpose itself between both legs of every trade, becoming the

legal counterparty to both or alternatively should provide an unconditional guarantee for

settlement of all trades.

The Clearing Corporation/House shall have the capacity to monitor the overall position of

Members across both derivatives market and the underlying securities market for those

Members who are participating in both. The level of initial margin on Index Futures

Contracts shall be related to the risk of loss on the position. The concept of value-at-risk

shall be used in calculating required level of initial margins. The initial margins should be

large enough to cover the one-day loss that can be encountered on the position on 99% of

the days.

The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT)

for swift movement of margin payments. In the event of a Member defaulting in meeting its

liabilities, the Clearing Corporation/House shall transfer client positions nd assets to another

solvent Member or close-out all open positions. The Clearing co- rporation/House should

have capabilities to segregate initial margins deposited by Clearing Members for trades on

their own account and on account of his client.

The Clearing Corporation/House shall hold the clients’ margin money in trust for the client

purposes only and should not allow its diversion for any other purpose.The Clearing

Corporation/House shall have a separate Trade Guarantee Fund for the trades executed

on Derivative Exchange / Segment. Presently, SEBI has permitted Derivative Trading on the

Derivative Segment of BSE and the F&O Segment of NSE.

Membership categories in the Derivatives Market

The various types of membership in the derivatives market are as follows:

1. Professional Clearing Member (PCM):

PCM means a Clearing Member, who is permitted to clear and settle trades on his own

account, on account of his clients and/or on account of trading members and their lients.

2. Custodian Clearing Member (CCM):

CCM means Custodian registered as Clearing Member, who may clear and settle trades on

his own account, on account of his clients and/or on account of trading members and their

clients.

3. Trading Cum Clearing Member (TCM):

A TCM means a Trading Member who is also a Clearing Member and can clear and settle

trades on his own account, on account of his clients and on account of associated Trading

Members and their clients.

4. Self Clearing Member (SCM):

A SCM means a Trading Member who is also Clearing Member and can clear and settle

trades on his own account and on account of his clients.

5. Trading Member (TM):

A TM is a member of the Exchange who has only trading rights and whose trades are

cleared and settled by the Clearing Member with whom he is associated.

6. Limited Trading Member (LTM):

A LTM is a member, who is not the members of the Cash Segment of the Exchange, and

would like to be a Trading Member in the Derivatives Segment at BSE. An LTM has only the

trading rights and his trades are cleared and settled by the Clearing Member with whom he

is associated. As on January 31, 2002, there are 1 Professional Clearing Member, 3

Custodian Clearing Members, 75 trading cum Clearing Members, 93 Trading Members and

17 Limited Trading Members in the Derivative Segment of the Exchange.

Financial Requirement for Derivatives Membership:

The most basic means of controlling counterparty credit and liquidity risks is to deal only

with creditworthy counterparties. The Exchange seeks to ensure that their members are

creditworthy by laying down a set of financial requirements for membership.

The members are required to meet, both initially and on an ongoing basis, minimum

networth requirement. Unlike Cash Segment membership where all the trading members

are also the clearing members, in the Derivatives Segment the trading and clearing rights

are segregated.

In other words, a member may opt to have both clearing and trading rights or he may opt

for trading rights only in which case his trades are cleared and settled by the Clearing

Member with whom he is associated. Accordingly, the networth requirement is based on the

type of membership and is as under:

Networth requirement is based on the type of membership:

Type of Membership Networth

Requirement

Professional Clearing Member, Custodian Clearing

Member and Trading cum Clearing Member

300 lakhs

Self Clearing Member 100 lakhs

Trading Member 25 lakhs

Limited Trading Member 25 lakhs

Limited Trading Member ( for members of other stock

exchange whose Clearing Member is a subsidiary company

of a Regional Stock Exchange)

10 lakhs

Requirements to be a member of the derivatives exchange/ clearing corporation Balance

Sheet Networth Requirements: SEBI has prescribed a networth requirement of Rs. 3 crores

for clearing members. The clearing members are required to furnish an auditor's certificate

for the networth every 6 months to the exchange. The networth requirement is Rs. 1 crore

for a self-clearing member.

SEBI has not specified any networth requirement for a trading member. Liquid Networth

Requirements: Every clearing member (both clearing members and self-clearing members)

has to maintain atleast Rs. 50 lakhs as Liquid Networth with the exchange / clearing

corporation. Certification requirements:

The Members are required to pass the certification programme approved by SEBI. Further,

every trading member is required to appoint atleast two approved users who have passed

the certification programme. Only the approved users are permitted to operate the

derivatives trading terminal.

Requirements for a Member with regard to the conduct of his business

The derivatives member is required to adhere to the code of conduct specified under

the SEBI Broker Sub-Broker regulations. The following conditions stipulations have been

laid by SEBI on the regulation of sales practices:

Sales Personnel: The derivatives exchange recognizes the persons recommended by

the Trading Member and only such persons are authorized to act as sales personnel of the

TM. These persons who represent the TM are known as Authorised Persons.

Know-your-client: The member is required to get the Know-your-client form filled by

every one of client. Risk disclosure document: The derivatives member must educate his

client on the risks of derivatives by providing a copy of the Risk disclosure document to the

client. Member-client agreement: The Member is also required to enter into the Member-

client agreement with all his clients.

Derivative contracts that are permitted by SEBI

Derivative products have been introduced in a phased manner starting with Index Futures

Contracts in June 2000. Index Options and Stock Option were introduced in june 2001 and

July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for

derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill

priced off ZCYC have been introduced in June 2003 and exchange traded interest rate

futures on a notional bond priced off a basket of Government Securities were permitted for

trading in January 2004.

Eligibility criteria for stocks on which derivatives trading may be

permitted

A stock on which stock option and single stock future contracts are proposed to be

introduced is required to fulfill the following broad eligibility criteria:-

The stock shall be chosen from amongst the top 500 stock in terms of average daily

market capitalization and average daily traded value in the previous six month on a rolling

basis.

The stock’s median quarter-sigma order size over the last six months shall be not less

than Rs.1 Lakh. A stock’s quarter-sigma order size is the mean order size (in value terms)

required to cause a change in the stock price equal to one-quarter of a standard deviation.

The market wide position limit in the stock shall not be less than Rs.50 crores.

A stock can be included for derivatives trading as soon as it becomes eligible. However, if

the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted

to derivatives trading, then derivative contracts on such a stock would be discontinued.

Minimum contract size

The Standing Committee on Finance, a Parliamentary Committee, at the time of

recommending amendment to Securities Contract (Regulation) Act, 1956 had

recommended that the minimum contract size of derivative contracts traded in the Indian

Markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has

specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the

time of introducing the contract in the market. In February 2004, the Exchanges were

advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakhs.

Subsequently, the Exchanges were authorized to align the contracts sizes as and when

required in line with the methodology prescribed by SEBI.

Lot size of a contract

Lot size refers to number of underlying securities in one contract. The lot size is determined

keeping in mind the minimum contract size requirement at the time of introduction of

derivative contracts on a particular underlying.

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum

contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be

200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

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IDBI Capital Market Services Ltd. (head quartered in Mumbai), is a leading provider of financial

services and is a 100% subsidiary of IDBI Bank Ltd.

The company was set up in 1993 with the objective of catering to specific financial

requirements of financial institutions, banks, mutual funds and corporate houses. The company

provides a complete range of financial products and services that includes:

Stock Broking-Institutional and Retail

Derivatives Trading

Distribution of Mutual Funds

Financial Advisory

Financial Advisory has been considered as a strategic function requiring innovative and distinct

financial solutions both long and short term focused on delivering greater shareholder value.

IDBI Capital Market Services Limited occupies a leading position being a wholly owned

subsidiary of IDBI Bank in the Corporate Finance Market place. We support our clients by

offering those creative ideas and solutions that facilitates in enhancing the value.

We broadly advise on the following on the Financial Advisory space:

Business Valuation

Financial & Commercial Due Diligence

Merchant Financial Appraisal

Joint Venture & Contract

Bid Process Management

Disinvestments

Infrastructure Advisory

Financial / Debt Restructuring

Structured Finance & Securitisation

Capital Markets

IDBI Capital as an institutional player provides the entire gamut of Capital Market services

encompassing:

1. Public Offerings

2. Qualified Institutional Placements

3. Buyback

4. Takeover

5. Preferential Allotments

6. External Commercial Borrowings, FCCBs, etc.

The above activities entails liasioning with institutional investors such as treasury departments

of Domestic Institutions, Banks and corporates, fund managers of mutual funds, private equity

firms, FIIs, HNIs.

IPO / FPO / RIGHT ISSUES

IDBI Capital Market Services Ltd. (ICMS), as a Securities and Exchange Board of India (SEBI)

registered Merchant Banker, provides the following services:

Public issue of Equity and Debt Instruments in Indian markets through Initial Public

Offering (IPO), Follow on Public Offering (FPO) and Rights Issue

Acts as a Book Running Lead Manager, a Lead Manager, a Co-Manager or an Advisor

to the Issue.

Underwrites Issues of Equity and Debt Instruments.

Markets various instruments with Qualified Institutional Buyers (QIBs), High Networth

Individuals (HNIs), Corporate and Retail investors.

Prepares all documents like Prospectus / Letter of Offer and assists the Issuer in

complying with legal and statutory requirements of SEBI, Stock Exchanges, Registrar of

Companies (ROC) and authorities under various corporate laws and economic laws for

issue of securities.

Advisory services on structuring of capital and debt, timing for raising the same, choice of

agencies to assist in the process of raising funds, etc.

Takeover

IDBI Capital helps corporate and institutional clients to carry out successful takeovers on the

Exchange listed companies. IDBI Capital helps carry out the Due Diligence exercise in

accordance with relevant SEBI Rules / Regulations / Guidelines followed by the preparation of

legal documentation connected with Buybacks and Take-overs.

Buyback of Securities

IDBI Capital is active in assisting its clients in buy-back programmes. With the presence of a

strong Broking services, the Company is in a position to offer comprehensive solutions to

accomplish buy-back programmes.

Qualified Institutional Placement

IDBI Capital adds value to QIP issues which can be done only by listed Companies to raise

additional equity from Qualified Institutional Buyers (QIBs). The strong relationship of IDBI

Capital with the different categories of QIB, FIIs, Fis, Mutual Funds, Banks etc., makes a

difference to the QIP placement programmes of the Companies. This is backed by a strong

research support.

Private Equity

We have developed strong expertise across different industries, which enable us to structure

the transaction in that context. In Private Equity (PE), we focus on sectors ranging from

Infrastructure, Power, Telecom, Healthcare & Life Sciences, Pharmaceuticals, Hospitality,

Banking, Logistics, Media, Auto Ancillaries / Components, Cement, Steel, etc to name a few.

Our strength in Private Equity advisory is on account of:

Strong relationships with PE funds and their key decision makers

Strong execution team gives an edge on optimal structuring and efficient closure of

transactions

Value addition on entire structure of activities

Our PE transaction doesn’t come to an end with the transfer of funds but also cater to entire

gamut of Investment Banking needs. IDBI Capital enables strong growth oriented companies

raise capital through;

Preparation of Business and Financial Plans

Preparation of the Information Memorandum

Discussions and Negotiations with prospective investors

Deal closure and Execution

INVESTMENT BANKING

Our Clients

We represent Government organizations, Public Sector Enterprises and Indian Corporates

covering sectors such as Steel and other metals, Mines, Minerals, Chemicals, Healthcare,

Hospitality, Financial Services and other Core Sectors.

Our Team

We have a combination of professionals with varied background who shares our values of

truthfulness, objectivity, innovation and analytical accuracy. The professional qualification of

our team provide a rock solid foundation for giving consulting services and our depth of

experience ranges from young management graduates from premier business schools to

experienced finance professional and qualified chartered accountants as well.

PROJECT ADVISORY

IDBI Capital has considerable expertise in Project Advisory / Finance. We advise our clients

right from the project conception stage followed by preparation of the Project Report and its

Techno-Commercial Appraisal with the support of accredited institutions with optimal financial

structuring. These reports pave the way for contracting project loans for green-field as well as

expansion projects. 

Our Project Advisory would also include turnkey advisory services on financial structuring,

implementation and documentation aspects of Green-field Projects, Brown Field Projects and

Public Private Partnership Projects. The scope of work ranges from negotiations with Banks,

Financial Institutions and Multilateral agencies for obtaining the final loan sanctions. Our Project

Advisory Services broadly include:

Overview of the promoting company / SPV

Review of the Project Structure and Project Costs including various assumptions. 

Capital Structuring

Real Estate Advisory

Identification and evaluation of various sources of finance

Financial modeling

Risk Analysis and Allocation

Development of a Security Package

Corporate Advisory

IDBI Capital Market Services Limited support Promoters and Senior Management

professionals of Corporate to acquire new perspectives and dimensions on Competitive

Strategy that will give Competitive Advantage. Our deliverables and advice focuses on

delivering timely and researched information for the ultimate decision-making. Our financial

and strategic advisory and analysis will provide necessary inputs to key stake holder (s) for

taking decisions for enhancing shareholder value. Our key advisory areas are:

a. Mergers and Acquisitions

b. Strategic Advisory

MERGERS & ACQUISTIONS

There are several means a Corporate adopt to improve shareholder value e.g. increased

revenue, market share, geographical expansion, diversification, economies of scale; or to

integrate through Merger & Acquisition. Broadly speaking, M&A drivers could be customer

acquisition and top line growth, new market entry or competence building. IDBI Capital’s M&A

Advisory services covers right from the initial negotiation stage to the final deal conclusion. We

address the following while taking up Mergers and Acquisitions;

Business valuations and managing the entire merger process

Assisting companies in acquisitions as sell off as joint ventures

Assisting the Company in financing the deal

Managing Open Offers

Evaluating bids on the basis of the evaluation criteria set out

Assisting in closing the deal

Post Merger Integration

STRATEGIC ADVISORY

Strategic Planning provides the framework for all the major business decisions of an

enterprises-decision on businesses, products & markets, manufacturing facilities, investments

& organizational structure. It is indeed act as a pathfinder to various business opportunities.

IDBI Capital assists clients in formulating strategy, developing solutions and successfully

managing results. We work with clients to define their business strategy and implement

interactive solutions that redefine relationships with customers, suppliers and employees. We

help clients improve business performance by delivering a complete, business-focused menu

of end-to-end business solutions. We broadly cover:

Business and Strategic Planning

Business Restructuring

Entry Strategy

Policy Advisory

Organization Restructuring

Bid Process Management

Process Consulting

INSTITUTIONAL BROKING & DISTRIBUTION

Institutions and Corporates have surplus funds to manage on daily basis as well as investible

surplus for a defined period. The risk differs for Institution and Corporates subject to their

preferences. The reward by way of return is always in proportion to the risk taken. IDBI Capital

define, advise and manage the same by blending caution with aggression in the desired

proportion to teach client. The range of services include from Equity Broking with customized

research, advisory and distribution services for investment in Mutual Funds, Debt/Bonds,

Equity IPOs to placement of Equities etc

EQUITY SALES & DEALING

The Institutional Broking Desk offers the Clients with a dealing platform for trading in

NSE and BSE. The parameters on market conditions with an astute technical analysis

from the Dealing Desk enable the clients to take an apt decision. The intra day analysis

and reports are also available to clients on customized basis.

Further the Institutional Clients are provided with the Derivatives Trading desk for

Futures and Option. The Institutional Clients are updated with fresh research Ideas on

the happening Scrip and Sectors.

Being well connected with the global market Via Bloomberg, the updates are shared

from time to time.

The interpreted brief report on the Futures and Option positions before the Expiry is

published for Client’s Circulation.

Daily market information is disseminated to the clients under ‘Heard on Street’ News heads.

EQUITY RESEARCH

We have research desks covering all aspects of the equities. Our equities research desk

publishes high quality research on all major sectors of the industry and covers a wide spectrum

of companies listed on the Indian stock exchanges. Our derivatives research team publishes

daily/monthly reports on the trends in the equity derivatives markets.

Our objective, uncomplicated and reliable research reports on global markets and equity

empower institutional investors and make it possible for them to make informed investment

decisions. Our research teams have made a name for themselves in a very short time.

MUTUAL FUND SALES & DEALING

Several factors need to be taken into account when choosing an instrument for investment –

among these being safety, liquidity & return related to the risk undertaken. Coming to the

choice of instruments, we have equity, debt, money market, commodity based or even global

equities. Mutual funds provide all this and more.

Mutual funds offer an investment portfolio which can be either diversified in nature or specific

in category with risk skewed towards debt to equity in varying proportions, all in one under one

umbrella. Mutual Funds cater to the specific requirement of the Investor be it Institutional or

Individual.

IDBI Capital Market Services Ltd. is into Mutual Fund Distribution, Advisory and Fund

Management. We address the needs of any type of investor from corporate, banks, trusts,

firms, and societies to NRIs, HNIs and individual retail clients

We have been recognized as among the best financial advisers in the country, and have been

conferred with the CNBC TV 18 Financial Advisor Awards as the Best Performing National

Financial Advisor –Institutional segment in India for the past two consecutive years.

As a distributor registered with almost all the SEBI Registered Mutual Funds in India, we have

also started offering Mutual funds to our retail customers, both off-line and on-line.

MUTUAL FUND RESEARCH

The degree of risk in a Mutual Fund varies with the diversity in portfolio and the combination of

assets. Add to this the different classes of instruments. Judging the best investments avenues

calls for astute incisive knowledge on markets and individual companies.

The research desk of IDBI Capital Market Ltd. publishes a number of detailed research

Reports on the Mutual Fund Industry viz. 

(i) Daily Report – detailing the NAV and growth of the schemes on various periods 

(ii) MF Monthly – with coverage on the Equity, Debt and Mutual Fund market

(iii) Customised Sector Reports and

(iv) Scheme Reports for Special Clients.

Customized Reports are provided to specific institutional / corporate clients. The universe for

every category is selected from the entire industry and rigorous analysis undertaken including

peer comparison. Various tools and techniques are used, from studying the Alpha of every

scheme with Standard Deviation to Beta Analysis to Tryenor and Sortino.

RETAIL BROKING & DISTRIBUTION

In addition to offering corporate, institutional clients, IDBI Capital also offers a gamut of

financial products and services that cater to a varied cross section of investors.

IDBI Capital also offers to financial planners, retail intermediaries and consumers to deliver

lasting, innovative solutions.

Looking at the opportunities in our market and the growth of our country, we believe it is high

time investors are educated about the nuances of investments. The knowledge and awareness

gained will empower investors and help them create wealth. We firmly believe brokers, media

and regulators have a pivotal role in assisting the individuals to become wealthy. We will go

extra mile to empower the investors in managing their wealth to ensure a more rewarding future.

IDBI Capital aims to provide a single-point source for retail investors in their requirements for

trading and investment products.

ONLINE INVESTING

Online investing provides investors with a convenient method to take part in today’s financial

markets. With our commitment to enhancing investor education and awareness as a

foundation stone, we have created an online investing website www.idbipaisabuilder.in for

trading and depository services. This platform enables easy and informed investing in Equity

shares, Futures & Options (F&O), IPO’s and Mutual Funds, for the retail investors with a

wealth of information, news, analysis and tools sourced from the best in the industry. It also

brings a large database of information about companies which will assist them in making an

informed investment decision.

We strive to empower you with information that helps you make informed decisions and bank

upon the right opportunity. We bring you lots of useful information by way of our varied market

research reports on equity, derivatives, and mutual funds

We offer an integrated three-in-one account linking savings account, trading account and the

demat account. Now investing in Equity, Mutual funds and IPO’s is just a click away.

IPO DISTRIBUTION

Investment Banking Activities

We have in the last financial year successfully lead managed public/rights issues mobilizing

more than Rs.900 crores. Some of the notable examples were the Central Bank of India ‘s IPO

and Varun Industries Ltd fixed price issue. The responses to our issues have been heartening.

Initial Public Offerings (IPO)

We are reaching out to the investors thru

10,000 sub-brokers/agents spread across the country.

Our 40 thousands online investors.

and our own 25 branches.

We market and distribute IPOs of all lead investment bankers, including our owned lead

managed issues. In IPO distribution, the marketing effort is the key, which enables us to carry

out the vigorous exercise of

Putting the banners of the IPO on our portal and all across our branches.

Sending the emails to all our investors about the impending IPOs and the product note.

Sending SMS to all of them.

Making available the IPO application forms, in all our branches.

All our branches are in marketing & distribution of IPO application forms, where we accept and

bid the application forms to the exchange.

Our Credentials

We are a leading full service securities house, offering a complete suite of financial products

and services to individual, institutional and corporate clients:

Wholly owned subsidiary of IDBI Bank Ltd.

A well-capitalized financial position - networth of over Rs.350 crores as on 31st March

2008.

A private equity fund of Rs.100 crores for investment in Mid Cap and SME Growth

Companies

A leading player in Private Placement of Tier II bonds and debentures for institutions,

banks and corporates.

We manage Provident and Pension Funds of more than Rs.8,250 crores

MUTUAL FUND DISTRIBUTION

Several factors need to be taken into account when choosing an instrument for investment –

among these being safety, liquidity & return related to the risk undertaken. Coming to the

choice of instruments, we have equity, debt, money market, commodity based or even global

equities. Mutual funds provide all this and more.

Mutual funds offer an investment portfolio which can be either diversified in nature or specific

in category with risk skewed towards debt to equity in varying proportions, all in one under one

umbrella. Mutual Funds cater to the specific requirement of the Investor be it Institutional or

Individual.

IDBI Capital Market Services Ltd. is into Mutual Fund Distribution, Advisory and Fund

Management. We address the needs of any type of investor from corporate, banks, trusts,

firms, and societies to NRIs, HNIs and individual retail clients

We have been recognized as among the best financial advisers in the country, and have been

conferred with the CNBC TV 18 Financial Advisor Awards as the Best Performing National

Financial Advisor –Institutional segment in India for the past two consecutive years.

As a distributor registered with almost all the SEBI Registered Mutual Funds in India, we have

also started offering Mutual funds to our retail customers, both off-line and on-line.

We distribute and advise on the schemes of all the Mutual Fund Houses registered with SEBI. 

FUND MANAGEMENT

IDBI Capital Market Services Ltd. (ICMS) is a leading Fund Manager in the country for

Provident, Pension and Retirement Benefit Funds. The Company is a SEBI registered Portfolio

Manager and manage its Client’s assets under both discretionary and non-discretionary

mandates. These services are provided to various public and private sector undertakings and

their provident, pension, retirement benefit and surplus funds. The Company’s client base

includes leading pension and provident funds in the country.

IDBI capital has been advising institutions, banks and corporates for their investment in Debt,

Mutual Funds and Equities over several years. Its services include managing Client Assets--

Pension & Provident Funds, Surplus fund Management, Equity Portfolio Management and

Mutual Fund Advisory.

The funds have continuously yielded superior returns, which are significantly higher than the

benchmark.

ISO Certification 9001:2000

Keeping in view the importance of standardized processes and service levels, the Company

has gone in for ISO Certification for Fund Management, and is the only company to have done

so in this sector. Being a public sector, the Company is also audited by Comptroller and

Auditor General (CAG) office and follows transparent practices.

Regulatory Approval

IDBI Capital is a registered Portfolio Manager with Securities and Exchange Board of India

(SEBI) since 1998 and is authorised to undertake Funds Management activities (Debt &

Equity) for clients. These activities would be governed by Securities and Exchange Board of

India (Portfolio Managers) Rules and Regulations, 1993. SEBI Regisration No. of IDBI Capital

is INP000000209, valid till the year 2010.

The Key strengths of IDBI capital Market Services in the areas of Debt Fund

Management are:

1. Fund Management experience of 10 years

2. Expertise in managing large corpus

3. Expertise in both Debt & Equity Market

4. IDBI Capital is the only Portfolio Manager in the Country to achieve ISO 9001: 2000

Standard for Quality Management Systems in Fund Management operations, with

certification from TUV NORD an accredited German standards firm

5. Substantial Returns Over Benchmark

6. IDBI Capital is a SEBI registered Portfolio Manager

7. Minimum Idle Days

8. Our fund management skill covers Portfolio Analysis that includes ALM, Asset

Allocation, Risk Analysis, Maturity Analysis and Yield Analysis

9. Transparency of Operations

10.Strict adherence to Compliance Procedures

11.Highly Rated Debt Research

12.Presence in All Segment/ Asset of the Financial Services: IDBI Capital deals in Equity

and Equity related products and is one of the highly rated Mutual Fund Distributor (won

two consecutive CNBC TV18 Institutional Financial Advisor Award). In Investment

Banking and Debt Capital Market- Rated in Top 15 by Prime Database

13.Group Strength in Debt Market: IDBI Capital is one of the leading players in debt market

with presence in primary dealership since July 2007. The current operations of primary

dealership is conducted by a group company, IDBI Gilts

INFRASTRUCTURE

Experienced Fund Management Team: The Fund Management team comprises of

experienced professionals (experience ranges between 2 years to 15 years) in Portfolio

Management with requisite exposure in the fixed income and equity segment and

qualifications

Experienced Back-Office: The Clearing and Settlement Operations are manned by

experienced personnel with requisite exposure to capital market and particularly debt

market. The process is standardized as per the regulatory and other specific norms and

mainly technology driven in most areas Accounting: Real time accounting of

Remittances, Investments, Interest and Redemption proceeds ensures accurate

reconciliation

Professional Custodian: Member of NSDL for demat services and offers Constituent

SGL Account facility for Government securities through IDBI Gilts Ltd.

Functional Separation of Front and Back Office: Separate personnel handle the front

and back office functions to ensure transparency and complete regulatory compliance

Internal Controls: Adequate Risk Management systems in place to ensure complete

regulatory compliance

Audit Systems: Audit of all transactions and reports by an independent firm of

chartered accountants. The accounts and transactions are also subject to CAG audit

and other regulators

Belongs to IDBI Group: IDBI is a leading bank, classified under ‘Other Public Sector Bank’.

Established in 1964 by Government of India under an Act of Parliament, IDBI has essayed a

significant role in the country’s industrial and economic progress for over 40 years – first as

apex Development Financial Institution (DFI) and now as a full service commercial bank.

.

MYTHS AND REALITIES ABOUT DERIVATIVES

In our fast-changing financial services industry, coercive regulations intended to restrict

banks' activities will be unable to keep up with financial innovation. As the lines of

demarcation between various types of financial service providers continues to blur, the

bureaucratic leviathan responsible for reforming banking regulation must face the fact that

fears about derivatives have proved unfounded. New regulations are unnecessary. Indeed,

access to risk-management instruments should not be feared but, with caution, embraced to

help firms manage the vicissitudes of the market.

In this paper 10 common misconceptions about financial derivatives are explored. Believing

just one or two of the myths could lead one to advocate tighter legislation and regulatory

measures designed to restrict derivative activities and market participants. A careful review

of the risks and rewards derivatives offer, however, suggests that regulatory and legislative

restrictions are not the answer. To blame organizational failures solely on derivatives is to

miss the point. A better answer lies in greater reliance on market forces to control

derivative-related risk taking.

Financial derivatives have changed the face of finance by creating new ways to understand,

measure, and manage risks. Ultimately, financial derivatives should be considered part of

any firm's risk-management strategy to ensure that value-enhancing investment

opportunities are pursued. The freedom to manage risk effectively must not be taken away.

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?

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial Products Myth

Number 2: Derivatives Are Purely Speculative, Highly Leveraged Instruments

Myth Number 3: The Enormous Size of the Financial Derivatives Market Dwarfs Bank

Capital, Thereby Making Derivatives Trading an Unsafe and Unsound Banking Practice

Myth Number 4: Only Large Multinational Corporations and Large Banks Have a Purpose

for Using Derivatives

Myth Number 5: Financial Derivatives Are Simply the Latest Risk-Management Fad

Myth Number 6: Derivatives Take Money Out of Productive Processes and Never Put

Anything Back.

Myth Number 7: Only Risk-Seeking Organizations Should Use Derivatives

Myth Number 8: The Risks Associated with Financial Derivatives Are New and Unknown

Myth Number 9: Derivatives Link Market Participants More Tightly Together, Thereby

Increasing Systemic Risks

Myth Number 10: Because of the Risks Associated with Derivatives, Banking Regulators

Should Ban Their Use by Any Institution Covered by Federal Deposit Insurance

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial

Products Created by Wall Street's Rocket Scientists

Financial derivatives are not new; they have been around for years. A description of the first

known options contract can be found in Aristotle's writings. He tells the story of Thales, a

poor philosopher from Miletus who developed a "financial device, which involves a principle

of universal application." People reproved Thales, saying that his lack of wealth was proof

that philosophy was a useless occupation and of no practical value. But Thales knew what

he was doing and made plans to prove to others his wisdom and intellect.

Thales had great skill in forecasting and predicted that the olive harvest would be

exceptionally good the next autumn. Confident in his prediction, he made agreements with

area olive-press owners to deposit what little money he had with them to guarantee him

exclusive use of their olive presses when the harvest was ready.

Thales successfully negotiated low prices because the harvest was in the future and no one

knew whether the harvest would be plentiful or pathetic and because the olive-press

owners were willing to hedge against the possibility of a poor yield.

Aristotle's story about Thales ends as one might guess: "When the harvest-time came, and

many [presses] were wanted all at once and of a sudden, he let them out at any rate which

he pleased, and made a quantity of money.

Thus he showed the world that philosophers can easily be rich if they like, but that their

ambition is of another sort." So Thales exercised the first known options contracts some

2,500 years ago. He was not obliged to exercise the options. If the olive harvest had not

been good, Thales could have let the option contracts expire unused and limited his loss to

the original price paid for the options. But as it turned out, a bumper crop came in, so

Thales exercised the options and sold his claims on the olive presses at a high profit.

Options are just one type of derivative instrument. Derivatives, as their name implies, are

contracts that are based on or derived from some underlying asset, reference rate, or index.

Most common financial derivatives, described later, can be classified as one, or a

combination, of four types: swaps, forwards, futures, and options that are based on interest

rates or currencies.

Most financial derivatives traded today are the "plain vanilla" variety--the simplest form of a

financial instrument. But variants on the basic structures have given way to more

sophisticated and complex financial derivatives that are much more difficult to measure,

manage, and understand. For those instruments, the measurement and control of risks can

be far more complicated, creating the increased possibility of unforeseen losses.

Wall Street's "rocket scientists" are continually creating new, complex, sophisticated

financial derivative products. However, those products are all built on a foundation of the

four basic types of derivatives.

Most of the newest innovations are designed to hedge complex risks in an effort to reduce

future uncertainties and manage risks more effectively. But the newest innovations require

a firm understanding of the tradeoff of risks and rewards.

To that end, derivatives users should establish a guiding set of principles to provide a

framework for effectively managing and controlling financial derivative activities. Those

principles should focus on the role of senior management, valuation and market risk

management, credit risk measurement and management, enforceability, operating systems

and controls, and accounting and disclosure of risk-management positions. [4]

Myth Number 2: Derivatives Are Purely Speculative, Highly Leveraged

Instruments

Put another way, this myth is that "derivatives" is a fancy name for gambling. Has

speculative trading of derivative products fueled the rapid growth in their use? Are

derivatives used only to speculate on the direction of interest rates or currency exchange

rates? Of course not. Indeed, the explosive use of financial derivative products in recent

years was brought about by three primary forces: more volatile markets, deregulation, and

new technologies.

The turning point seems to have occurred in the early 1970s with the breakdown of the

fixed-rate international currency exchange regime, which was established at the 1944

conference at Bretton Woods and maintained by the International Monetary Fund. Since

then currencies have floated freely. Accompanying that development was the gradual

removal of government-established interest-rate ceilings when Regulation Q interest-rate

restrictions were phased out. Not long afterward came inflationary oil-price shocks and wild

interest-rate fluctuations. In sum, financial markets were more volatile than at any time since

the Great Depression.

Banks and other financial intermediaries responded to the new environment by developing

financial risk-management products designed to better control risk. The first were simple

foreign-exchange forwards that obligated one counterparty to buy, and the other to sell, a

fixed amount of currency at an agreed date in the future.

By entering into a foreign-exchange forward contract, customers could offset the risk that

large movements in foreign-exchange rates would destroy the economic viability of their

overseas projects. Thus, derivatives were originally intended to beused to effectively hedge

certain risks; and, in fact, that was the key that unlocked their explosive development.

Beginning in the early 1980s, a host of new competitors accompanied the deregulation of

financial markets, and the arrival of powerful but inexpensive personal computers ushered

in new ways to analyze information and break down risk into component parts. To serve

customers better, financial intermediaries offered an ever-increasing number of novel

products designed to more effectively manage and control financial risks. New technologies

quickened the pace of innovation and provided banks with superior methods for tracking

and simulating their own derivatives portfolios.

From the simple forward agreements, financial futures contracts were developed. Futures

are similar to forwards, except that futures are standardized by exchange clearinghouses,

which facilitates anonymous trading in a more competitive and liquid market. In addition,

futures contracts are marked to market daily, which greatly decreases counterparty risk--the

risk that the other party to the transaction will be unable to meet its obligations on the

maturity date.

Around 1980 the first swap contracts were developed. A swap is another forward-based

derivative that obligates two counterparties to exchange a series of cash flows at specified

settlement dates in the future. Swaps are entered into through private negotiations to meet

each firm's specific risk-management objectives. There are two principal types of swaps:

interest-rate swaps and currency swaps.

Today interest-rate swaps account for the majority of banks' swap activity, and the fixed-for-

floating-rate swap is the most common interest-rate swap. In such a swap, one party agrees

to make fixed-rate interest payments in return for floating-rate interest payments from the

counterparty, with the interest-rate payment calculations based on a hypothetical amount of

principal called the notional amount.

Myth Number 3: The Enormous Size of the Financial Derivatives Market

Dwarfs Bank Capital, Thereby Making Derivatives Trading an Unsafe and

Unsound Banking Practice

The financial derivatives market's worth is regularly reported as more than $20 trillion. That

estimate dwarfs not only bank capital but also the nation's $7 trillion annual gross domestic

product. Those often-quoted figures are notional amounts. For derivatives, notional principal

is the amount on which interest and other payments are based. Notional principal typically

does not change hands; it is simply a quantity used to calculate payments.

While notional principal is the most commonly used volume measure in derivatives markets,

it is not an accurate measure of credit exposure. A useful proxy for the actual exposure of

derivative instruments is replacement-cost credit exposure. That exposure is the cost of

replacing the contract at current market values should the counterparty default before the

settlement date.

For the 10 largest derivatives players among U.S. bank holding companies, derivative credit

exposure averages 15 percent of total assets. The average exposure is 49 percent of

assets for those banks' loan portfolios. In other words, if those 10 banks lost 100 percent on

their loans, the loss would be more than three times greater than it would be if they had to

replace all of their derivative contracts.

Derivatives also help to improve market efficiencies because risks can be isolated and sold

to those who are willing to accept them at the least cost. Using derivatives breaks risk into

pieces that can be managed independently. Corporations can keep the risks they are most

comfortable managing and transfer those they do not want to other companies that are

more willing to accept them. From a market-oriented perspective, derivatives offer the free

trading of financial risks.

The viability of financial derivatives rests on the principle of comparative advantage--that is,

the relative cost of holding specific risks. Whenever comparative advantages exist, trade

can benefit all parties involved. And financial derivatives allow for the free trading of

individual risk components.

Myth Number 4: Only Large Multinational Corporations and Large Banks

Have a Purpose for Using Derivatives

Very large organizations are the biggest users of derivative instruments. However, firms of

all sizes can benefit from using them. For example, consider a small regional bank (SRB)

with total assets of $5 million (Figure 1). [5] The SRB has a loan portfolio composed primarily

of fixed-rate mortgages, a portfolio of government securities, and interest-bearing deposits

that are often repriced. Two illustrations of how SRBs can use derivatives to hedge risks

follow.

First, rising interest rates will negatively affect prices in the SRB's $1 million securities

portfolio. But by selling short a $1 million Treasury-bond futures contract, the SRB can

effectively hedge against that interest-rate risk and smooth its earnings stream in a volatile

market. If interest rates went higher, the SRB would be hurt by a drop in value of its

securities portfolio, but that loss would be offset by a gain from its derivative contract.

Similarly, if interest rates fell, the bank would gain from the increase in value of its securities

portfolio but would record a loss from its derivative contract. By entering into derivatives

contracts, the SRB can lock in a guaranteed rate of return on its securities portfolio and not

be as concerned about interest-rate volatility.

The economic benefits of derivatives are not dependent on the size of the institution trading

them. The decision about whether to use derivatives should be driven, not by the company's

size, but by its strategic objectives. The role of any risk-management strategy should be to

ensure that the necessary funds are available to pursue value-enhancing investment

opportunities.

However, it is important that all users of derivatives, regardless of size, understand how

their contracts are structured, the unique price and risk characteristics of those instruments,

and how they will perform under stressful and volatile economic conditions. A prudent risk-

management strategy that conforms to corporate goals and is complete with market

simulations and stress tests is the most crucial prerequisite for using financial derivative

products

Myth Number 5: Financial Derivatives Are Simply the Latest Risk-

Management Fad

Financial derivatives are important tools that can help organizations to meet their specific

risk-management objectives. As is the case with all tools, it is important that the user

understand the tool's intended function and that the necessary safety precautions be taken

before the tool is put to use.

Builders use power saws when they construct houses. And just as a power saw is a useful

tool in building a house--increasing the builder's efficiency and effectiveness--so financial

derivatives can be useful tools in helping corporations and banks to be more efficient and

effective in meeting their risk-management objectives. But power saws can be dangerous

when not used correctly or when used blindly.

If users are not careful, they can seriously injure themselves or ruin the project. Likewise,

when financial derivatives are used improperly or without a plan, they can inflict pain by

causing serious losses or propelling the organization in the wrong direction so that it is ill

prepared for the future.

When used properly, financial derivatives can help organizations to meet their risk-

management objectives so that funds are available for making worthwhile investments.

Again, a firm's decision to use derivatives should be driven by a risk-management strategy

that is based on broader corporate objectives.

The most basic questions about a firm's risk-management strategy should be addressed:

Which risks should be hedged and which should remain unhedged? What kinds of

derivative instruments and trading strategies are most appropriate? How will those

instruments perform if there is a large increase or decrease in interest rates? How will those

instruments perform if there are wild fluctuations in exchange rates?

Without a clearly defined risk-management strategy, use of financial derivatives can be

dangerous. It can threaten the accomplishment of a firm's long-range objectives and result

in unsafe and unsound practices that could lead to the organization's insolvency. But when

used wisely, financial derivatives can increase shareholder value by providing a means to

better control a firm's risk exposures and cash flows.

Clearly, derivatives are here to stay. We are well on our way to truly global financial markets

that will continue to develop new financial innovations to improve risk-management

practices. Financial derivatives are not the latest risk-management fad; they are important

tools for helping organizations to better manage their risk exposures.

Myth Number 6: Derivatives Take Money Out of Productive Processes

and Never Put Anything Back

Financial derivatives, by reducing uncertainties, make it possible for corporations to initiate

productive activities that might not otherwise be pursued. For example, an Italian company

may want to build a manufacturing facility in the United States but is concerned about the

project's overall cost because of exchange-rate volatility between the lira and the dollar.

To ensure that the company will have the necessary cash available when it is needed for

investment, the Italian manufacturer should devise a prudent risk-management strategy that

is in harmony with its broader corporate objective of building a manufacturing facility in the

United States. As part of that strategy, the Italian firm should use financial derivatives to

hedge against foreign-exchange risk. Derivatives used as a hedge can improve the

management of cash flows at the individual firm level.

To ensure that productive activities are pursued, corporate finance and treasury groups

should transform their operations from mundane bean counting to activist financial risk

management. They should integrate a clear set of risk-management goals and objectives

into the organization's overall corporate strategy. The ultimate goal is to ensure that the

organization has the necessary funds at its disposal to pursue investments that maximize

shareholder value. Used properly, financial derivatives can help corporations to reduce

uncertainties and promote more productive activities.

Myth Number 7: Only Risk-Seeking Organizations Should Use Derivatives

Financial derivatives can be used in two ways: to hedge against unwanted risks or to

speculate by taking a position in anticipation of a market movement. The olive-press

owners, by locking in a guaranteed return no matter how good or bad the harvest, hedged

against the risk that the next season's olive harvest might not be plentiful. Thales speculated

that the next season's olive harvest would be exceptionally good and therefore paid an up-

front premium in anticipation of that event.

Similarly, organizations today can use financial derivatives to actively seek out specific risks

and speculate on the direction of interest-rate or exchange-rate movements, or they can use

derivatives to hedge against unwanted risks. Hence, it is not true that only risk-seeking

institutions use derivatives. Indeed, organizations should use derivatives as part of their

overall risk-management strategy for keeping those risks that they are comfortable

managing and selling those that they do not want to others who are more willing to accept

them. Even conservatively managed institutions can use derivatives to improve their cash-

flow management to ensure that the necessary funds are available to meet broader

corporate objectives. One could argue that organizations that refuse to use financial

derivatives are at greater risk than are those that use them.

When using financial derivatives, however, organizations should be careful to use only

those instruments that they understand and that fit best with their corporate risk-

management philosophy. It may be prudent to stay away from the more exotic instruments,

unless the risk/reward tradeoffs are clearly understood by the firm's senior management and

its independent risk-management review team. Exotic contracts should not be used unless

there is some obvious reason for doing so.

Myth Number 8: The Risks Associated with Financial Derivatives Are New

and Unknown

The kinds of risks associated with derivatives are no different from those associated with

traditional financial instruments, although they can be far more complex. There are credit

risks, operating risks, market risks, and so on.

Risks from derivatives originate with the customer. With few exceptions, the risks are man-

made, that is, they do not readily appear in nature. For example, when a new homeowner

negotiates with a lender to borrow a sum of money, the customer creates risks by the type

of mortgage he chooses--risks to himself and the lending company. Financial derivatives

allow the lending institution to break up those risks and distribute them around the financial

system via secondary markets. Thus, many risks associated with derivatives are actually

created by the dealers' customers or by their customers' customers. Those risks have been

inherent in our nation's financial system since its inception.

Banks and other financial intermediaries should view themselves as risk managers--

blending their knowledge of global financial markets with their clients' needs to help their

clients anticipate change and have the flexibility to pursue opportunities that maximize their

success. Banking is inherently a risky business. Risk permeates much of what banks do.

And, for banks to survive, they must be able to understand, measure, and manage financial

risks effectively.

The types of risks faced by corporations today have not changed; rather, they are more

complex and interrelated. The increased complexity and volatility of the financial markets

have paved the way for the growth of numerous financial innovations that can enhance

returns relative to risk. But a thorough understanding of the new financial-engineering tools

and their proper integration into a firm's overall risk-management strategy and corporate

philosophy can help turn volatility into profitability.

Risk management is not about the elimination of risk; it is about the management of risk:

selectively choosing those risks an organization is comfortable with and minimizing those

that it does not want. Financial derivatives serve a useful purpose in fulfilling risk-

management objectives. Through derivatives, risks from traditional instruments can be

efficiently unbundled and managed independently. Used correctly, derivatives can save

costs and increase returns.

Myth Number 9: Derivatives Link Market Participants More Tightly

Together, Thereby Increasing Systemic Risks

Financial derivative participants can be divided into two groups: end-users and dealers. As

end-users, banks use derivatives to take positions as part of their proprietary trading or for

hedging as part of their asset/liability management. As dealers, banks use derivatives by

quoting bids and offers and committing capital to satisfy customers' needs for managing

risk.

In the developmental years of financial derivatives, dealers, for the most part, acted as

brokers, finding counterparties with offsetting requirements. Then dealers began to offer

themselves as counterparties to intermediate customer requirements. Once a position was

taken, a dealer immediately either matched it by entering into an opposing transaction or

"warehoused" it--temporarily using the futures market to hedge unwanted risks--until a

match could be found.

Today dealers manage portfolios of derivatives and oversee the net, or residual, risk of their

overall position. That development has changed the focus of risk management from

individual transactions to portfolio exposures and has substantially improved dealers' ability

to accommodate a broad spectrum of customer transactions. Because most active

derivatives players today trade on portfolio exposures, it appears that financial derivatives

do not wind markets together any more tightly than do loans. Derivatives players do not

match every trade with an offsetting trade; instead, they continually manage the residual risk

of the portfolio. If a counterparty defaults on a swap, the defaulted party does not turn

around and default on some other counterparty that offset the original transaction. Instead,

a derivatives default is very similar to a loan default. That is why it is important that

derivatives players perform with due diligence in determining the financial strength and

default risks of potential counterparties.

For banking supervisors in the United States, probably the most important question today is,

What could go wrong to engender systemic risk--the danger that a failure at a single bank

could cause a domino effect, precipitating a banking crisis? Because financial derivatives

allow different risk components to be isolated and passed around the financial system,

those who are willing and able to bear each risk component at the least cost will become the

risk holders. That clearly reduces the overall cost of risk bearing and enhances economic

efficiency.

Furthermore, a major shock that would jolt financial markets in the absence of derivatives

would also affect financial markets in which the use of derivatives was widespread. But

because the holders of various risks would be different, the impact would be different and

presumably not as great because the holders of the risks should be better able to absorb

potential losses.

Myth Number 10: Because of the Risks Associated with Derivatives,

Banking Regulators Should Ban Their Use by Any Institution

The problem is not derivatives but the perverse incentives banks have under the current

system of federal deposit guarantees. Deposit insurance and other deposit reforms were

first introduced to address some of the instabilities associated with systemic risk. Through

federally guaranteed deposit insurance, the U.S. government attempted to avoid, by

increasing depositor confidence, the experience of deposit runs that characterized banking

crises before the 1930s.

The current deposit guarantee structure has, indeed, reduced the probability of large-scale

bank panics, but it has also created some new problems. Deposit insurance effectively

eliminates the discipline provided by the market mechanism that encourages banks to

maintain appropriate capital levels and restrict unnecessary risk taking. Therefore, banks

may wish to pursue higher risk strategies because depositors have a diminished incentive to

monitor banks. Further, federal deposit insurance may actually encourage banks to use

derivatives as speculative instruments to pursue higher risk strategies, instead of to hedge,

or as dealers.

Since federal deposit insurance discourages market discipline, regulators have been put in

the position of monitoring banks to ensure that they are managed in a safe and sound

manner. Given the present system of federal deposit guarantees, regulatory proposals

involving financial derivatives should focus on market-oriented reforms as opposed to laws

that might eliminate the economic risk-management benefits of derivatives.

To that end, banking regulators should emphasize more disclosure of derivatives positions

in financial statements and be certain that institutions trading huge derivatives portfolios

have adequate capital. In addition, because derivatives could have implications for the

stability of the financial system, it is important that users maintain sound risk-management

practices.

Regulators have issued guidelines that banks with substantial trading or derivatives activity

should follow. Those guidelines include active board and senior management oversight of

trading activities; establishment of an internal risk-management audit function that is

independent of the trading function; thorough and timely audits to identify internal control

weaknesses; and risk-measurement and risk-management information systems that include

stress tests, simulations, and contingency plans for adverse market movements.

It is the responsibility of a bank's senior management to ensure that risks are effectively

controlled and limited to levels that do not pose a serious threat to its capital position.

Regulation is an ineffective substitute for sound risk management at the individual firm level.

Should Company Use Derivatives?

Financial derivatives should be considered for inclusion in any corporation's risk-control

arsenal. Derivatives allow for the efficient transfer of financial risks and can help to ensure

that value-enhancing opportunities will not be ignored. Used properly, derivatives can

reduce risks and increase returns.

Derivatives also have a dark side. It is important that derivatives players fully understand the

complexity of financial derivatives contracts and the accompanying risks. Users should be

certain that the proper safeguards are built into trading practices and that appropriate

incentives are in place so that corporate traders do not take unnecessary risks.

The use of financial derivatives should be integrated into an organization's overall risk-

management strategy and be in harmony with its broader corporate philosophy and

objectives. There is no need to fear financial derivatives when they are used properly and

with the firm's corporate goals as guides.

What Should Regulators Do?

Believing the 10 myths presented here, indeed, believing just one or two of them, could lead

one to advocate legislative and regulatory measures to restrict the use of derivatives. [9]

Derivatives-related disasters, such as the Orange County bankruptcy and the collapse of

Barings, have led to questions about the ability of individual derivatives participants to

internally manage their trading operations. In addition, concerns have surfaced about

regulators' ability to detect and control potential derivatives losses.

But regulatory and legislative restrictions on derivatives activities are not the answer,

primarily because simple, standardized rules most likely would only impair banks' ability to

manage risk effectively. A better answer lies in greater reliance on market forces to control

derivatives-related risk taking, together with more emphasis on government supervision, as

opposed to regulation.

The burden of managing derivatives activities must rest squarely on trading organizations,

not the government. Such an approach will promote self-regulation and improve

organizations' internal controls through the discipline of market mechanisms. Government

guarantees will serve only to strengthen moral-hazard behavior by derivatives traders.

The best regulations are those that guard against the misuse of derivatives, as opposed to

those that severely restrict, or even ban, their use. Derivatives-related losses can typically

be traced to one or more of the following causes: an overly speculative investment strategy,

a misunderstanding of how derivatives reallocate risk, an ineffective internal risk-

management audit function, and the absence of systems that simulate adverse market

movements and help develop contingency solutions. To address those concerns,

supervisory reforms should focus on increasing disclosure of derivatives holdings and the

strategies underlying their use, appropriate capital adequacy standards, and sound risk-

management guidelines.

For the most part, however, policymakers should leave derivatives alone. Derivatives have

become important tools that help organizations manage risk exposures. The development of

derivatives was brought about by a need to isolate and hedge against specific risks.

Derivatives offer a proven method of breaking risk into component pieces and managing

those components independently.

Almost every organization--whether a corporation, a municipality, or an insured commercial

bank--has inherent in its business and marketplace a unique risk profile that can be better

managed through derivatives trading. The freedom to manage risks effectively must not be

taken away.

RESEARCH METHODOLOGY

Research Methodology: An Introduction

Research in common parlance refers to a search for knowledge. Once can also define

research as scientific and systematic search for pertinent information on a specific topic. In fact,

research is a base of scientific investigation. The Advanced Learner's Dictionary of Current

English lays down the leaning of research as "a careful investigation or inquiry especially

through search for new facts in. branch of knowledge." Redman and Mory define research as a

"systematized effort to gain knowledge." Some people consider research as a movement, a

movement from the known to unknown. It is actually a voyage of discovery. We all possess the

vital instinct of in quantitative-ness . When the unknown confronts us, we wonder and our

inquisitiveness makes us probe and attain and fuller understanding of the unknown. This

inquisitiveness is the mother of all knowledge and method, which mean employs for obtaining

the knowledge of whatever the unknown, can be ed as research.

Research is an academic activity and as such, the term should be used in a technical sense.

According to Clifford Woody, research comprises defining and redefining problems, formulating

thesis or suggested solutions; collecting, organising and evaluating data; making deductions

and Drawing conclusions; and at last carefully testing the conclusions to determine whether

they fit the stipulating hypothesis. D. Slesinger and M. Stephenson in the Encyclopaedia of

Social Sciences - e research as "the manipulation of things, concepts or symbols for the

purpose of generalising to d, correct or verify knowledge, whether that knowledge aids in

construction of theory or in the . e of an art."3 Research is, thus, an original contribution to the

existing stock of knowledge ° g for its advancement. It is the pursuit of truth with the help of

study, observation, comparison - experiment. In short, the search for knowledge through

objective and systematic method of solution to a problem is research. Such the term 'research'

refers to the systematic method

The purpose of research is to discover answers to questions through the application of

scientific procedures. The main aim of research is to find out the truth which is hidden and

which has not been discovered as yet. Though each research study has its own specific

purpose, we may think of research objectives as falling into a number of following broad

groupings:

1. To gain familiarity with a phenomenon or to achieve new insights into it (studies with this

object in view are termed as exploratory or formulates research studies);

2. To portray accurately the characteristics of a particular individual, situation or a group

(studies with this object in view are known as descriptive research studies);

3. To determine the frequency with which something occurs or with which it is associated

with something else (studies with this object in view are known as diagnostic research

studies);

4. To test a hypothesis of a causal relationship between variables (such studies are known

as hypothesis-testing research studies).

Types of Research

(i) Descriptive vs. Analytical: Descriptive research includes surveys and fact-finding enquirie of

different kinds. The major purpose of descriptive research is description of the state 0 affairs

as it exists at present. In social science and business research we quite often use the term Ex

post facto research for descriptive research studies. The main characteristic of this method is

that the researcher has no control over the variables; he can only report what has happened or

what is happening. Most ex post facto research projects are used for descriptive studies in

which the researcher seeks to measure such items as, for example, frequency of shopping,

preferences of people, or similar data. Ex post facto studies also include attempts by

researchers to discover causes even when they cannot control the variables. The methods of

research utilized in descriptive research are survey methods of all kinds, including comparative

and correlation methods. In analytical research, on the other hand, the researcher has to use

facts or information already available, and analyze these to make a critical evaluation of the

material.

(ii) Applied vs. Fundamental: Research can either be applied (or action) research or

fundamental (to basic or pure) research. Applied research aims at finding a solution for an

immediate problem facing a society or an industrial/business organisation, whereas

fundamental research is mainly concerned with generalisations and with the formulation of a

theory. "Gathering knowledge for knowledge's sake is termed 'pure' or 'basic' research."4

Research concerning some natural phenomenon or relating to pure mathematics are examples

of fundamental research. Similarly, research studies, concerning human behaviour carried on

with a view to make generalisations about human behaviour, are also examples of

fundamental research, but research aimed at certain conclusions (say, a solution) facing a

concrete social or business problem is an example of applied research. Research to identify

social, economic or political trends that may affect a particular institution or the copy research

(research to find out whether certain communications will be read and understood) or the

marketing research or evaluation research are examples of applied research. Thus, the central

aim of applied research is to discover a solution for some pressing practical problem, whereas

basic research is directed towards finding information that has a broad base of applications

and thus, adds to the already existing organized body of scientific knowledge.

(iii) Quantitative vs. Qualitative: Quantitative research is based on the measurement of quantity

or amount. It is applicable to phenomena that can be expressed in terms of quantity.

Qualitative research, on the other hand, is concerned with qualitative phenomenon, i.e.,

phenomena relating to or involving quality or kind. For instance, when we are interested in

investigating the reasons for human behaviour (i.e., why people think or do certain things), we

quite often talk of 'Motivation Research', an important type of qualitative research. This type of

research aims at discovering the underlying motives and desires, using in depth interviews for

the purpose. Other techniques of such research are word association tests, sentence

completion tests, story completion tests and similar other projective techniques. Attitude or

opinion research i.e., research designed to find out how people feel or what they think about a

particular subject or institution is also qualitative research. Qualitative research is specially

important in the behavioural sciences where the aim is to discover the underlying motives of

human behaviour. Through such research we can analyse the various factors which motivate

people to behave in a particular manner or which make people like or dislike a particular thing.

It may be stated, however, that to apply qualitative research in

practice is relatively a difficult job and therefore, while doing such research, one should seek

guidance from experimental psychologists.

(iv) Conceptual vs. Empirical: Conceptual research is that related to some abstract idea(s) or

theory. It is generally used by philosophers and thinkers to develop new concepts or to

reinterpret existing ones. On the other hand, empirical research relies on experience or

observation alone, often without due regard for system and theory. It is data-based research,

coming up with conclusions which are capable of being verified by observation or experiment.

We can also call it as experimental type of research. In such a research it is necessary to get

at facts firsthand, at their source, and actively to go about doing certain things to stimulate the

production of desired information. In such a research, the researcher must first provide himself

with a working hypothesis or guess as to the probable results. He then works to get enough

facts (data) to prove or disprove his hypothesis. He then sets up experimental designs which

he thinks will manipulate the persons or the materials concerned so as to bring forth the

desired information. Such research is thus characterised by the experimenter's control over the

variables under study and his deliberate manipulation of one of them to study its effects.

Empirical research is appropriate when proof is sought that certain variables affect other

variables in some way. Evidence gathered through experiments or empirical studies is today

considered to be the most powerful support possible for a given hypothesis.

(v) Some Other Types of Research: All other types of research are variations of one or more of

the above stated approaches, based on either the purpose of research, or the time required to

accomplish research, on the environment in which research is done, or on the basis of some

other similar factor. Form the point of view of time, we can think of research either as one-time

research or longitudinal research. In the former case the research is conformed to a single

time-period, whereas in the latter case the research is carried on over several time-periods.

Research can be field-setting research or laboratory research or simulation research,

depending upon the environment in which it is to be carried out. Research can as· well be

understood as clinical or diagnostic research. Such research follows case-study methods or in-

depth approaches to reach the basic causal relations. Such studies usually go deep into the

causes of things or events that interest us, using very small samples and very deep probing

data gathering devices. The research may be exploratory or it may be formalized. The

objective of exploratory research is the development of hypotheses rather than their testing,

whereas formalized research studies are those with substantial structure and with specific

hypotheses to be tested. Historical research is that which utilizes historical sources like

documents, remains, etc. to study events or ideas of the past, including the philosophy of

persons and groups at any remote point of time. Research can also be classified as

conclusion-oriented and decision-oriented. While doing conclusion oriented research, a

researcher is free to pick up a problem, redesign the enquiry as he proceeds and is prepared

to conceptualize as he wishes. Decision-oriented research is always for ten need of a decision

maker and the researcher in this case is not free to embark upon research according to his

own inclination. Operations research is an example of decision oriented research since it is a

scientific method of providing executive departments with a quantitative basis for decisions

regarding operations under their control.

Research Problem

A research problem, in general, refers to some difficulty which a researcher experiences in

context of either a theoretical or practical situation and wants to obtain a solution for the same.

Usually we say that a research problem does exist if the following conditions are met with:

(i) There must be an individual (or a group or an organisation), let us call it 'I,' to whom problem

can be attributed. The individual or the organisation, as the case may be, occupies an

environment, say 'N', which is defined by values of the uncontrolled variables, Y.

(ii) There must be at least two courses of action, say C, and C2, to be pursued. A course action

is defined by one or more values of the controlled variables. For example, the number of items

purchased at a specified time is said to be one course of action.

(iii) There must be at least two possible outcomes, say 0, and 02' of the course of action which

one should be preferable to the other. In other words, this means that there must be at least

one outcome that the researcher wants, i.e., an objective.

(iv) The courses of action available must provides some chance of obtaining the objective they

cannot provide the same chance, otherwise the choice would not matter

Research Design

The formidable problem that follows the task of defining the research problem is the

preparation of the research project, popularly known jis the "research design". Decisions

regarding where, when, how much, by what means concerning an inquiry or a research study

constitute a research design. "A research design i s the arrangement of condition and anal sis

of data in a manner that aim’s combine relevance to the research purpose with economy. In

procedure." The research design is the conceptual structure within which research is

conducted; it constitutes the blueprint for the collection, measurement and analysis of data. As

such the design includes an e of what the researcher will do from writing the hypothesis and its

operational implications to the analysis of data. More explicitly, the design decisions happen to

be in respect of:

i) What is the study about?

ii) Why is the study being made?

iii) Where will the study be carried out?

iv) What type of data is required?

v) Where can the required data be found?

vi) What periods of time will the study include?

vii) What will be the sample design?

viii) What techniques of data collection will be used?

ix) How will the data be analysed?

x) In what style will the report be prepared?

Data collection

Data collection begins after a research problem has been defined and research design. While

deciding about the method of data collection to be used for the study, they should keep in mind

two types of data viz., primary and secondary. The primary data are collected afresh and for

the first time, and thus happen to be original in character. Secondary data, on the other hand,

are those which have already been collected by someone & have already been passed

through the statistical process. The researcher would have h sort of data he would be using

(thus collecting) for his study and accordingly he will one or the other method of data

collection. The methods of collecting primary and secondary data differ since primary data are

to be originally collected, while in case of secondary of data collection work is merely that of

compilation. We describe the different collection, with the pros and cons of each method.

Primary data during the course of doing experiments in an experimental research but in order

to the descriptive type and perform surveys, whether sample surveys or census Scan obtain

primary data either through observation or through direct communication in one form Or

another or through personal interviews.' This, in other words, means refers to an investigation

in which a factor or variable under test is isolated and its effect(s) measured. . Investigator

measures the effects of an experiment which he conducts intentionally. Survey refers to

information concerning phenomena under study from all or a selected number of respondents

of ere. In a survey,' the investigator examines those phenomena which exist in the universe"

independent of deference between an experiment.

there are several methods of collecting primary data,· particularly in surveys and the

researches. Important ones are: (i) observation method, (ii) interview method, (iii) through

questionnaire (iv) through schedules, and (v) other methods which include (a) warranty cards;

(b) discount audits; (c) pantry audits; (d) consumer panels; (e) using mechanical devices; (f)

through pro· techniques; (g) depth interviews, and (h) content analysis. We briefly take up

each method

Observation Method

The observation method is the most commonly used method specially in studies relating to

behavioural sciences. In a way we all observe things around us, but this sort of observation is

not observation. Observation becomes a scientific tool and the method of data collection for

the re when it serves a formulated research purpose, is systematically planned and recorded

and is s to checks and controls on validity and reliability. Under the observation method, the

info sought by way of investigator's own direct observation without asking from the respond

instance, in a study relating to consumer behaviour, the investigator instead of , asking the

wrist watch used by the respondent, may himself look at the watch. The main advantage

method is that subjective bias is eliminated, if observation is done accurately. Secondly, the

information obtained under this method relates to what is currently happening; iris not

complicated by i.e., past behaviour or future intentions or attitudes. Thirdly, this method is

independent of rest willingness to respond and as such is relatively less demanding of active

cooperation on the respondents as happens to be the case in the interview or the

questionnaire method. This particularly suitable in studies which deal with subjects (i.e.,

respondents) who are not e giving verbal reports of their feelings for one reason or the other

However, observation method has various limitations. Firstly, it is an expensive method. the

information provided by this method is very limited. Thirdly, sometimes unforeseen interfere

with the observational task. At times, the fact that some people are rarely ace direct

observation creates obstacle for this method to collect data effectively.

While using this method, the researcher should keep in mind things like: What should be how

the observations should be recorded? Or how the accuracy of observation can be e case the

observation is characterised by a careful definition of the units to be observed, recording the

observed information, standardised conditions of observation and the selection data of

observation, then the observation is called as structured observation. But when is to take place

without these characteristics to be thought of in advance, the same is unstructured

observation. Structured observation is considered appropriate in descriptive. Whereas in an

exploratory study the observational procedure is most likely to be relatively

We often talk about participant and non-participant types of observation in the context

particularly of social sciences, This distinction depends upon the observer's sharing or the life

~f the group he is observing. If the observer observes by making himself, more member of the

group he is observing so that he can experience what the members of experience, the

observation is called as the participant observation. But when the observe as a detached

emissary without any attempt on his part to experience through patrician others feel, the

observation of this type is often termed as non-participant observation. observer is observing in

such a manner that his presence may be unknown to the observing, such an observation is

described as disguised observation.)

Their are several merits of the participant type of observation: (i) the researcher is enabled to

--'" natural behaviour of the group. (ii) The researcher can even gather information which

specially be obtained if he observes in a disinterested fashion. (iii) The researcher can even

give the statements made by informants in the context of a questionnaire or a schedule. But

there are also certain demerits of this type of observation viz., the observer may lose the

objectivity he participates emotionally; the problem of observation-control is not solved; and it

may narrow down the researcher's range of experience.

We talk of controlled and uncontrolled observation. If the observation takes place setting, it

may be termed as uncontrolled observation, but when observation takes place 5'0 definite pre-

arranged plans, involving experimental procedure, the same is then termed derivation. In non-

controlled observation, no attempt is made to use precision instruments. The major aim of this

type of observation is to get a spontaneous picture of life and persons. It has a tendency to

supply naturalness and completeness of behaviour, allowing sufficient time for observing

controlled observation, we use mechanical (or precision) instruments as aids to accuracy

desertion. Such observation has a tendency to supply formalised data upon which . ones can

be built with some degree of assurance. The main pitfall of non-controlled i that of subjective

interpretation. There is also the danger of having the feeling that we _ about the observed

phenomena than we actually do. Generally, controlled observation " in various experiments

that are carried out in a laboratory or under controlled conditions, ~controlled observation is

resorted to in case of exploratory researches .

The method of collecting data involves presentation of oral-verbal stimuli and reply in verbal

responses. This method can be used through personal interviews and, if possible, through

telephonic interviews.

Personnel interviews: Personal interview method requires a person known as the interviewer.

Ones generally in a. face-to face contact. to the other person or persons. yet times they may

also ask certain questions and the interviewer responds to these, but usually the interviewer

initiates the interview and collects the information.) This sort of interview may be in the foam of

personal investigation or it may be indirect oral investigation. In the case of direct investigation

the interviewer has to collect the information personally from the sources He has to be on the

spot and has to meet people from whom data have to be collected particularly suitable 'for

intensive investigations. But in certain cases it may not be worthwhile to contact directly the

persons concerned or on account of the extensive dairy, the direct personal investigation

technique may not be used. In such cases an exanimation can be conducted under which the

interviewer has to cross-examine other are supposed to have knowledge about the problem

under investigation and the trained is recorded. Most of the commissions and committees

appointed by government investigations make use of this method.

Data collection begins after a research problem has been defined and research design. While

deciding about the method of data collection to be used for the study, they should keep in mind

two types of data viz., primary and secondary. The primary data are collected afresh and for

the first time, and thus happen to be original in character. Secondary data, on the other hand,

are those which have already been collected by someone & have already been passed

through the statistical process. The researcher would have h sort of data he would be using

(thus collecting) for his study and accordingly he will one or the other method of data

collection. The methods of collecting primary and secondary data differ since primary data are

to be originally collected, while in case of secondary of data collection work is merely that of

compilation. We describe the different collection, with the pros and cons of each method.

Primary data during the course of doing experiments in an experimental research but in order

to the descriptive type and perform surveys, whether sample surveys or census Scan obtain

primary data either through observation or through direct communication in one form Or

another or through personal interviews.' This, in other words, means refers to an investigation

in which a factor or variable under test is isolated and its effect(s) measured. . Investigator

measures the effects of an experiment which he conducts intentionally. Survey refers to

information concerning phenomena under study from all or a selected number of respondents

of ere. In a survey,' the investigator examines those phenomena which exist in the universe"

independent of deference between experiments.

There are several methods of collecting primary data,· particularly in surveys and the

researches. Important ones are: (i) observation method, (ii) interview method, (iii) through

questionnaire (iv) through schedules, and (v) other methods which include (a) warranty cards;

(b) discount audits; (c) pantry audits; (d) consumer panels; (e) using mechanical devices; (f)

through pro· techniques; (g) depth interviews, and (h) content analysis. We briefly take up

each method

Observation Method

The observation method is the most commonly used method specially in studies relating to

behavioural sciences. In a way we all observe things around us, but this sort of observation is

not observation. Observation becomes a scientific tool and the method of data collection for

the re when it serves a formulated research purpose, is systematically planned and recorded

and is s to checks and controls on validity and reliability. Under the observation method, the

info sought by way of investigator's own direct observation without asking from the respond

instance, in a study relating to consumer behaviour, the investigator instead of , asking the

wrist watch used by the respondent, may himself look at the watch. The main advantage

method is that subjective bias is eliminated, if observation is done accurately. Secondly, the

information obtained under this method relates to what is currently happening; iris not

complicated by i.e., past behaviour or future intentions or attitudes. Thirdly, this method is

independent of rest willingness to respond and as such is relatively less demanding of active

cooperation on the respondents as happens to be the case in the interview or the

questionnaire method. This particularly suitable in studies which deal with subjects (i.e.,

respondents) who are not e giving verbal reports of their feelings for one reason or the other

However, observation method has various limitations. Firstly, it is an expensive method. the

information provided by this method is very limited. Thirdly, sometimes unforeseen fa interferes

with the observational task. At times, the fact that some people are rarely ace direct

observation creates obstacle for this method to collect data effectively.

While using this method, the researcher should keep in mind things like: What should be How

the observations should be recorded? Or how the accuracy of observation can be e case the

observation is characterised by a careful definition of the units to be observed, recording the

observed information, standardised conditions of observation and the selection data of

observation, then the observation is called as structured observation. But when is to take place

without these characteristics to be thought of in advance, the same is unstructured

observation. Structured observation is considered appropriate in descriptive. Whereas in an

exploratory study the observational procedure is most likely to be relatively

We often talk about participant and non-participant types of observation in the context

particularly of social sciences, this distinction depends upon the observer's sharing or the life

of the group he is observing. If the observer observes by making himself, more member of the

group he is observing so that he can experience what the members of experience, the

observation is called as the participant observation. But when the observe as a detached

emissary without any attempt on his part to experience through practical others feel, the

observation of this type is often termed as non-participant observation. Observer is observing

in such a manner that his presence may be unknown to the observing, such an observation is

described as disguised observation.)

Their are several merits of the participant type of observation: (i) the researcher is enabled to

know about natural behaviour of the group. (ii) The researcher can even gather information

which specially be obtained if he observes in a disinterested fashion. (iii) The researcher can

even give the statements made by informants in the context of a questionnaire or a schedule.

But there are also certain demerits of this type of observation viz., the observer may lose the

objectivity he participates emotionally; the problem of observation-control is not solved.

We talk of controlled and uncontrolled observation. If the observation takes place setting, it

may be termed as uncontrolled observation, but when observation takes place 5'0 definite pre-

arranged plans, involving experimental procedure, the same is then termed derivation. In non-

controlled observation, no attempt is made to use precision instruments. The major aim of this

type of observation is to get a spontaneous picture of life and persons. It has a tendency to

supply naturalness and completeness of behaviour, allowing sufficient time for observing

controlled observation, we use mechanical (or precision) instruments as aids to accuracy

desertion. Such observation has a tendency to supply formalised data upon which. ones can

be built with some degree of assurance. The main pitfall of non-controlled i that of subjective

interpretation. There is also the danger of having the feeling that we _ about the observed

phenomena than we actually do. Generally, controlled observation " in various experiments

that are carried out in a laboratory or under controlled conditions, ~controlled observation is

resorted to in case of exploratory researches .

The method of collecting data involves presentation of oral-verbal stimuli and reply in verbal

responses. This method can be used through personal interviews and, if possible, through

telephonic interviews.

1. Personnel interviews: Personal interview method requires a person known as the

interviewer. Ones generally in a. face-to face contact. to the other person or persons.

yet times they may also ask certain questions and the interviewer responds to these,

but usually the interviewer initiates the interview and collects the information.) This sort

of interview may be in the foam of personal investigation or it may be indirect oral

investigation. In the case of direct investigation the interviewer has to collect the

information personally from the sources He has to be on the spot and has to meet

people from whom data have to be collected particularly suitable 'for intensive

investigations. But in certain cases it may not be worthwhile to contact directly the

persons concerned or on account of the extensive dairy, the direct personal

investigation technique may not be used. In such cases an exanimation can be

conducted under which the interviewer has to cross-examine other are supposed to

have knowledge about the problem under investigation and the trained is recorded.

Most of the commissions and committees appointed by government investigations make

use of this method.

Method of collecting information through personal interviews is usually carried out in a

structured way. As such we call the interviews as structured interviews. Such interviews

involve the use of a set of predetermined questions and of highly standardised techniques of

recording; Thus, the interviewer in a structured interview follows a rigid procedure laid down,

asking question form and order prescribed. As against it, the unstructured interviews are

characterised by a flexibility of approach to-questioning. Unstructured interviews do not follow

a system of pre-determined questions and standardised techniques of recording information. In

a non-structured interview the interviewer is allowed much greater freedom to ask, in case of

need, supplementary question or at times he may omit certain questions if the situation so

requires. He may even change the sequence of questions. He has relatively greater freedom

while recording the responses to include se and exclude others. But this sort of flexibility

results in lack of comparability of one interview with another and the analysis of unstructured

responses becomes much more difficult and time consuming than that of the structured

responses obtained in case of structured interviews

We may as well talk about focussed interview, clinical interview and the non-directive

interviews. Focussed interview is meant to focus attention on the given experience of the

response effects. Under it the interviewer has the freedom to .decide the manner and

sequence the questions would be asked and has also the freedom to explore reasons and

motives. The interviewer in case of a focussed interview is to confine the respondent to it

discuss] with which he seeks conversance. Such interviews are used generally in the

development of the hypothesis and constitute a major type of unstructured interviews. The

clinical interview. With broad underlying feelings or motivations or with the course of

individual's life' experience. The method of eliciting information under it is generally left to the

interviewer's discretion. In case of non-directive interview, the interviewer's function is simply to

encourage the respondent to talk about the given topic with a bare minimum of direct

questioning. The interviewer of catalyst to a comprehensive expression of the respondents'

feelings and beliefs and of reference within which such feelings and beliefs take on personal

significance.

Despite the variations in interview-techniques, the major advantages and weaknesses

interviews can be enumerated in a general way. The chief merits of the interview ill follows:

(i) More information and that too in greater depth can be obtained.

(ii) Interviewer by his own skill can overcome the resistance, if any, of the despondence: the

interview method can be made to yield an almost perfect sample of the general population

(iii) There is greater flexibility under this method as the opportunity to restructure questions is

always there, specially in case of unstructured interviews.

(iv) Observation method can as well be applied to recording verbal answers to various

questions.

(v) Personal information can as well be obtained easily under this method.

(vi) Samples can be controlled more effectively as there arises no difficulty 0 returns; non-

response generally remains very low.

(vii) The interviewer can usually control which person(s) will answer the question possible in

mailed questionnaire approach. If so desired, group discussion held.

(viii) The interviewer may catch the informant off-guard and thus may secure the most

spontaneous reactions than would be the case if mailed questionnaire is used.

(ix) The language of the interview can be adapted to the ability or educational level of the

person interviewed and as such misinterpretations concerning questions can be avoided.

(x) The interviewer can collect supplementary information about the respondent's personal

characteristics and environment which is often of great value in interpreting results.

But their are also certain weaknesses of the interview method. Among the important

weaknesses, may be made of the following:

(i) It is a very expensive method, specially when large and widely spread geographical sample·

is taken.

(ii) There remains the possibility of the bias of interviewer as well as that of the respondent;

there also remains the headache of supervision and control of interviewers.

(iii) Certain types of respondents such as important officials or executives or people in high

income groups may not be easily approachable under this method and to that extent the data

may prove inadequate.

(iv) This method is relatively more-time-consuming, specially when the sample is large and

recalls upon the respondents are necessary.

(v)The presence of the interviewer on the spot may over-stimulate the respondent, sometimes

e en to the extent that he may give imaginary information just to make the interview·

interesting.

(vi) Under the interview method the organisation required for selecting, training and

supervising the field-staff is more complex with formidable problems.

Pre-requisites and basic tenets of interviewing: For successful implementation of the interview

method. Interviewers should be carefully selected, trained and briefed. They should be honest,

sincere, hardworking, and impartial and must possess the technical competence and

necessary practical experience. Occasional field checks should be made to ensure that

interviewers are neither cheating, nor deviating from instruction given to them for performing

their job efficiently. In addition, some provision should also be made in advance so that

appropriate action may be taken if some of the selected respondents cooperate or are not

available when an interviewer calls upon them.

In fact, interviewing is an art governed by certain scientific principles. Every effort should be

create friendly atmosphere of trust and confidence, so that respondents may feel at ease while

taking to and discussing with the interviewer. The interviewer must ask questions properly and

intelligently and must record the responses accurately and completely. At the same time, the

interviewer must answer legitimate question(s), if any, asked by the respondent and must clear

doubts.

(b) Telephonic interviews: This method of collecting information consists in contacting re on

telephonic itself. It is not a very widely used method, but plays important part in industry

particularly In developed regions. The chief merits of such a system are:

1. It is more flexible in comparison to mailing method.

2. It is faster than other methods i.e., a quick way of obtaining information.

3. It is cheaper than personal interviewing method; here the cost per response is relatively

low.

4. Recall is easy; call backs are simple and economical.

5. There is a higher rate of response than what we have in mailing method; the non-

response is generally very low.

6. Replies can be recorded without causing embarrassment to respondents.

7. Interviewer can explain requirements more easily.

8. At times, access can be gained to respondents who otherwise cannot be contact reason

or the other.

9. No field staffs are required.

10. Representative and wider distribution of sample is possible.

But this system of collecting information is not free from demerits. Some of 'the highlighted.

1. Little time is given to respondents for considered answers; interview period is not likely

to exceed five minutes in most cases.

2. Surveys are restricted to respondents who have telephone facilities.

3. Extensive geographical coverage may get restricted by cost considerations.

4. It is not suitable for intensive surveys where comprehensive answers are required

questions.

5. Possibility of the bias of the interviewer is relatively more.

6. Questions have to be short and to the point; probes are difficult to handle.

COLLECTION OF DATA THROUGH THE QUESTIONNAIRES

This method of data collection is quite popular, particularly in case of big enquiries. It is be by

private individuals, research workers, private and public organisations and even by go In this

method a questionnaire is sent (usually by post) to the persons concerned with a request to

answer the questions and return the questionnaire. A questionnaire consists of a number ~

printed or typed in a definite order on a form or set of forms. The questionnaire is mailed to 1

who are expected to read and understand the questions and write down the reply in the space

ment for the purpose in the questionnaire itself. The respondents have to answer the

questionnaires on their own.

The method of collecting data by mailing the questionnaires to respondents is most employed

in various economic and business surveys. The merits claimed on behalf of this method are as

follows:

1 It is free from the bias of the interviewer; answers are in respondents' own words.

2. Respondents have adequate time to give well thought out answers.

3. Respondents, who are not easily approachable, can also be reached conveniently.

4 Large samples can be made use of and thus the results can be made more

dependable and reliable.

MAIN DEMARITS

1. Low rate of return of the duly filled in questionnaires; bias due to no-response is often

indeterminate.

2. It can be used only when respondents are educated and cooperating. The control over

questionnaire may be lost once it is sent.

3. There is inbuilt inflexibility because of the difficulty of amending the approach once

questionnaires have been despatched.

4. There is also the possibility of ambiguous replies or omission of replies altogether to

certain questions; interpretation of omissions is difficult.

5. It is difficult to know whether willing respondents are truly representative. - This method

is likely to be the slowest of all.

Main aspects of a questionnaire: Quite often questionnaire is considered as the heart of a

survey operation. Hence it should be very carefully constructed. If it is not properly set up, then

the survey is bound to fail. This fact requires us to study the main aspects of a questionnaire

viz., the general form, question sequence and question formulation and wording. Researcher

should note the. Following with regard to these three main aspects of a questionnaire:

1. General form: So far as the general form of a questionnaire is concerned, it can either be or

unstructured questionnaire. Structured questionnaires are those questionnaires in which their

are definite, concrete and pre-determined questions. The questions are presented with exactly

according and in the same order to all respondents. Resort is taken to this sort of

standardisation that all respondents reply to the same set of questions. The form of the

question may be either closed (i.e., of the type 'yes' or 'no') or open. ( i .e., inviting free response)

but should be stated in advance and not constructed during questioning. Structured

questionnaires may also have fixed alternative question which responses of the informants are

limited to the stated alternatives. Thus a highly structured questionnaire is one in which all

questions and answers are specified and comments respondents own words are held to the

minimum. When these characteristics are not present in a questionnaire, it can be termed as

unstructured or non-structured questionnaire. More specifically, we can say that in an

unstructured questionnaire, the interviewer is provided with a general guide on the type of

information to be obtained, but the exact question formulation is largely his own responsibility.

And the replies are to be taken down in the respondent's own words to the extent possible; in

some - rape recorders may be used to achieve this goal. Structured questionnaires are simple

to administer and relatively inexpensive to anal provision of alternative replies, at times, helps

to understand the meaning of the question such questionnaires have limitations too. For

instance, wide range of data and that too in rest own words cannot be obtained with structured

questionnaires. They are usually considered in in investigations where the aim happens to be

to probe for attitudes and reasons for certain feelings. They are equally not suitable when a

problem is being first explored and working h sought. In such situations, unstructured

questionnaires may be used effectively. Then on the results obtained in protest (testing before

final use) operations from the use of us questionnaires, one can construct a structured

questionnaire for use in the main study.

2. Question sequence: In order to make the questionnaire effective and to ensure quality to the

replies' received, a researcher should pay attention to the question-sequence in preparing the

questionnaire. A proper sequence of questions reduces considerably the chances of individual

being misunderstood. The question-sequence must be clear and smoothly-moving, meaning

.that the relation of one question to another should be readily apparent to the respondent, with

that are easiest to answer being put in the beginning. The first few questions are particularly'

because they are likely to influence the attitude of the respondent and in seeking' his

cooperation. The opening questions should be such as to arouse human interest. The

following type of questions should generally be avoided as opening questions in a

questionnaire:

1. Questions that put too great a strain; on the memory or intellect of the respondent;

2...Questions of a personal character;

3. Questions related to personal wealth, etc.

Following the opening questions, we should have questions that are really vital to the problem

and a connecting thread should run through successive questions. Ideally, the sequence

should conform to the respondent's way of thinking. Knowing what information the researcher

can rearrange the order of the questions (this is possible in case of us questionnaire) to fit the

discussion in each particular case. But in a structured questionnaire that can be done is to

determine the question-sequence with the help of a Pilot Survey which' to produce good

rapport with most respondents. Relatively difficult questions must be towards the end so that

even if the respondent decides not to answer such questions, co. information would have

already been obtained. Thus, question-sequence should usually go general to the more

specific and the researcher must always remember that the answer to question is a function

not only of the question itself, but of all previous questions as well. For instance if one question

deals with the price usually paid for coffee and the next with reason for that particular brand,

the answer to this latter question may be couched largely in terms differences.

3. Question formulation and wording.' With regard to this aspect of questionnaire, the should

note that each question must be very clear for any sort o~ misunderstanding can do. Harm to a

survey. Question should also be impartial in order not to give a biased picture state of affairs.

Questions should be constructed with a view to their forming a logical part thought out

tabulation plan. In general, all questions should meet the following standards--- (be easily

understood; (b) should be simple i.e., should convey only one thought at a time; (be concrete

and should conform as much as possible to the respondent's way of thinking. for instead of

asking. "How many razor blades do you use annually?" The more realistic n would be to ask,

"How many razor blades did you use last week?"

Concerning the form of questions, we can talk about two principal forms, viz., multiple choice

questions and the open-end question. In the former the respondent selects one of the

alternative possible answers put to him, whereas in the latter he has to supply the answer in

his own words. The question in with only two possible answers (usually 'Yes' or 'No') can be

taken as a special case of the multiple choice question, or can be named as a 'closed

question.' There are some advantages and disadvantages of each possible form of question.

Multiple choice or closed questions have the · goes of easy handling, simple to answer, quick

and relatively inexpensive to analyse. They are enable-to statistical analysis. Sometimes, the

provision of alternative replies helps to make

COLLECTION OF DATA THROUGH SCHEDULE

This method of data collection is very much like the collection of data through little difference

which lies in the fact that schedules (perform containing a 1 being filled in by the enumerators

who are specially appointed for the purpose along with schedules, go to respondents, put to

them the questions from the proof questions are listed and record the replies in the space

meant for the same in the situations, schedules may be handed over to respondents and

enumerators may he their answers to various questions in the said schedules. Enumerators

explain the investigation and also remove the difficulties which any respondent may feel

implications of a particular question or the definition or concept of difficult term

This method requires the selection of enumerators for filling up schedules or a to fill up

schedules and as such enumerators should be very carefully selected should be trained to

perform their job well and the nature and scope of the explained to them thoroughly so that

they may well understand the implications 0 put in the schedule. Enumerators should be

intelligent and must possess the examination in order to find out the truth. Above all, they

should be honest, since] should have patience and perseverance.

This method of data collection is very useful in extensive enquiries and can lead to fairly

reliable results. It is, however, very expensive and is usually adopted in investigations

conducted by governmental agencies or by some big organisations. Population census all over

the world is conducted through this method.

Both questionnaire and schedule are popularly used methods of collecting data in research

survey. There is much resemblance in the nature of these two methods and this fact has made

many people to remark that from a practical point of view, the two methods can be taken to be

the same but for the technical point of view there is difference between the two. The important

points of the difference are as under:

1. The questionnaire is generally sent through mail to informants to be answered as specified

in covering letter but otherwise without further assistance from the sender. The schedule is

generally filled out by the research worker or the enumerator, who can interpret questions

when necessary.

2. To collect data through questionnaire is relatively cheap and economical since we have to

spend money only in preparing the questionnaire and in mailing the same to respond here no

field staff required. To collect data through schedules is relatively more experience

considerable amount of money has to be spent in appointing enumerators and in importing

training to them. Money is also spent in preparing schedules.

3. Non-response is usually high in case of questionnaire as many people do not respond many

return the questionnaire without answering all questions. Bias due to non-resp' often remains

indeterminate. As against this, non-response is generally very low in case of schedules

because these are filled by enumerators who are able to get answers to questions. But there

remains the danger of interviewer bias and cheating.

4. In case of questionnaire, it is not always clear as to who replies, but in case of schedule

identity of respondent is known.

5. The questionnaire method is likely to be very slow since many respondents do not re me

questionnaire in time despite several reminders, but in case of schedules the information.

Collected well in time as they are filled in by enumerators.

6. Personal contact is generally not possible in case of the questionnaire questionnaires are

sent to respondents by post who also in turn return the same by r 3ut in case of schedules

direct personal contact is established with respondents.

7. Questionnaire method can be used oi:J1y when respondents are literate and cooperative,

case of schedules the information can be gathered even when the respondents happen to

illiterate.

8. Wider and more representative distribution of sample is possible under the questionnaire

Method, but in respect of schedules there usually remains the difficulty in semi enumerators

over a relatively wider area.

9. Risk of collecting incomplete and wrong information is relatively more under the

questionnaire Method, particularly when people are unable to understand questions properly.

But in Schedules, the information collected is generally complete and accurate as enumerators

can remove the difficulties, if any, faced by respondents in correctly understanding questions.

As a result, the information collected through schedules is relatively more accurate' an that

obtained through questionnaires.

10. The success of questionnaire method lies more on the quality of the questionnaire itself,

me case of schedules much depends upon the honesty and competence of enumerators order

to attract the attention of respondents, the physical appearance of questionnaire, but be quite

attractive, but this may not be so in case of schedules as they are to be filled by enumerators

and not by respondents.

12. Along with schedules, observation method can also be used but such a thing is not

possible

Methodology Adopted

TITAL OF THE STUDY

The research methodology of present study is been designed for find out FINANCIAL

DERIVATIES MYTHS AND REALITIES.

TIME DURATION: the time taken for collecting the Data was one month.

OBJECTIVES

The purpose of research is to discover answer to questions through the application of

scientific procedures. Through each research study has its own specific purpose, we may

think of research objectives as falling into a number of following groups: -

To study myths and realties of financial derivatives

To highlight realities of derivatives

Data Sources

The data collection process was carried out in various stages. These stages can be

clubbed under two major heads.

Primary Source Survey

Secondary Source

(A) Primary Source Survey:-

A small survey was carried out to collect opinions of the retail investor about myths and

realities from different parts of jaipur.This type of survey collected data is known as primary

data. The Primary data are those, which are collected afresh and for the first time and thus happen

to be original in character.

(B) Secondary Source:-

Data collected in this method is known as secondary data. Secondary data means data that

re already available i.e. they refer to the data which have already been collected and

segregated by someone else. The researcher has to determine the various sources of

obtaining secondary data. Secondary data may be published or unpublished in nature.

Published data are available in:-

1. Technical or trade journals

2. Books, magazines and newspapers and Internet

3. Public record, statistics, historical documents and sources of public information

Data used for the project was the secondary and primary data.

SAMPLING SIZE: 50 Respondents

Data Collection Techniques

The Data was collected through questionnaire. The data was collected through open

and close ended questionnaire, in which questions were asked in a logical order. Each

question has a specific meaning. The data analysis is based on the data collected through

these questions.

Market Segmentation

The market segmentation was done keeping in mind that what types of customer were

available in the market. These segments are namely:

A. Business Class

B. Service Class

PLANNING AND SCOPE:

The planning and scope of present study is designed to cover Udaipur IDBI activities. This

relevant data can be downloaded from Net.

LIMITATIONS: -

Every research has its own limitation and present work is no exception to unit general rule.

The inherent limitation of the study is as under:Questionnaire method, can be used only

when respondents are literate and co-operative.Non-response by source of the

respondents.

The sample size was small as compared to the population size as the time period was

limited and large number of respondents cannot be assimilated in study.Study was

geographically restricted to some part of jaipur Sampling error is an inherent error

associated with random sampling.

DATA ANALYSIS & INTERPRETATION

Analysis of the data was done by drawing inferences through what was collected as input

from the respondents.

. Quantitative analysis

Qualitative analysis

Thus analysis of data require a number of closely related operations such as establishment

of categories, the application of these categories into raw data through tabulation, chart and

then draw inferences. Analysis work is generally based on the computation of various

percentage, co-efficient etc. by applying various statistical formulae.

Analysis and interpretation are the central steps in the research process. The goal of

analysis is to summaries the collected data in such a way that they provide answer to

questions that triggered while research. Interpretation is the research for border, meaning

of research finding.

Hence, questionnaire was analyzed separately and interpretation was done to bring

meaning and implication of the study. Hence analysis could not be completed without

interpretation and interpretation cannot proceed without analysis.

.

Data Analysis & Interpretation: -

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial

Products.

Customer View Answer

Yes 55%

No 38%

Cant say 7%

It founds that 55% small investors are of the opinion that derivatives are new ,complex And

high tecth products .38% of the respondents said no and 7% investors couldnot answer the

question.

Myth Number 2: Derivatives Are Purely Speculative, Highly Leveraged

Instruments

Customer View Answer

Yes 62%

No 28%

Cant say 10%

It founds that 62% small investors are of the opinion that derivatives are purely speculative,

high leveraged instruments 28% of the respondents said no and 10% investors couldnot

answer the question.

Myth Number 3: Only Large Multinational Corporations and Large Banks

Have a Purpose for Using Derivatives

Coustmer view Answer

Yes 49%

No 40%

Can’t say 11%

founds that 49%small investors are of the opinion that derivatives are Only Large

Multinational Corporations and Large Banks Have a Purpose for Using Derivatives 40% of

the respondents said no and 10% investors couldnot answer the question.

Myth Number4. Financial Derivatives Are Simply the Latest Risk-Management Fad

Coustmer view Answer

Yes 50%

No 37%

Can’t say 13%

It founds that50%small investors are of the opinion that derivatives are Financial Derivatives

Are Simply the Latest Risk-Management Fad,37 % of the respondents said no and 13%

investors couldnot answer the question.

Myth Number5: Derivatives Take Money Out of Productive Processes and

Never Put Anything Back

Coustmer view Answer

Yes 39%

No 42%

Can’t say 19%

It founds that 39%small investors are of the opinion that derivatives Take Money Out of

Productive Processes and Never Put Anything Back,42 % of the respondents said no and

19% investors couldnot answer the question.

Myth Number 6: Only Risk-Seeking Organizations Should Use Derivatives

Coustmer view Answer

Yes 49%

No 36%

Can’t say 15%

It founds that 49%small investors are of the opinion that derivatives Only Risk-Seeking

Organizations Should Use Derivatives36% of the respondents said no and15% investors

couldnot answer the question.

Myth Number7: The Risks Associated with Financial Derivatives Are New and

Unknown

Coustmer view Answer

Yes 43%

No 38%

Can’t say 19%

It founds that 43%small investors are of the opinion that The Risks Associated with

Financial Derivatives Are New and Unknown 38% of the respondents said no and19%

investors couldnot answer the question.

Myth Number8: Derivatives Trading an Unsafe and Unsound Banking

Practice

Coustmer view Answer

Yes 56%

No 38%

Can’t say 6%

It founds that 56%small investors are of the opinion that Derivatives Trading an Unsafe and

Unsound Banking Practice 38% of the respondents said no and6% investors couldnot

answer the question.

Myth Number 9: Derivatives trading Increases Systemic Risks

Coustmer view Answer

Yes 53%

No 34%

Can’t say 13%

.

It founds that 53%small investors are of the opinion that Derivatives Trading Increases

Systemic Risks 34% of the respondents said no and13% investors couldnot answer the

question.

Myth Number 10: Because of the Risks Associated with Derivatives, Banking

Regulators Should Ban Their Use by Any Institution

Coustmer view Answer

Yes 31%

No 52%

Can’t say 17%

It founds that 25%small investors are of the opinion that the Risks Associated with

Derivatives, Banking Regulators Should Ban Their Use by Any Institution ,55% of the

respondents said no and20% investors couldnot answer the question.

CONCLUSION AND SUGGESTION

Believing that the 10 myths presented here just one or two of them could lead and

regulatory major to restrict the use of derivatives. Regulatory restriction on derivative

activities are not the answers because standardized rules most likely would only impact

ones ability to mange risk effectively. The best regulation are those that guard against the

miss use or derivatives, as opposed to that severely restrict or even ban there use.

Derivative related losses can typically be traced to one or more of the following causes:

1. Speculative investment strategy.

2. Misunderstanding of how derivative relocate risk.

ANNEXURE

QUESTIONNAIRE

1.PERSONAL DETAILS :-

NAME

ADDRESS

AGE

a. Below 25 b. 25 to 40 c. 35 to 50

d. 50 to 60 e. Above 60 (years)

2. OCCUPATION:-

a. Business Profession Service

d. Student Other

3. Type of Business:-

Proprietorship Partnership Unlisted

Private ltd. Other

4.Are you dealing in f&o segment :-

yes no

If yes:-

Why did you choose this segment for investment:-

………………………………………………………………………………………………

………………………………………………………………………………………………

What bank you prefer for f&o trading:-

………………………………………………………………………………………………

………………………………………………………………………………………………

Why choosen this bank for f&o trading

………………………………………………………………………………………………

………………………………………………………………………………………………

5. Are derivatives new ,complex ,high tech financial product:-

Yes No Can’t Say

6.Are derivatives purely speculative and highly leveraged instruments:-

9 Yes No Can’t Say

7.Only large organizations have purpose for using derivatives:-

9 Yes No Can’t Say

8.Are derivatives take money out of productive process and never put

any things:-

9 Yes No Can’t Say

9.Are derivatives simply the latest risk management tool:-

Yes No Can’t Say

10.Should it used by only risk seeking organization:-

Yes No Can’t Say

11.Are the risk associated with derivatives new or unknown:-

Yes No Can’t Say

12.Is derivative trading unsafe and risky:-

Yes No Can’t Say

13.Is it increases systematic risk:-

Yes No Can’t Say

14.Should derivative trading ban by regulators for their use:-

Yes No Can’t Say

If NO:-

Why you are not dealing in this segment?

.................................................................................................................................

.................................................................................................................................

LEAD SHEETs

NAME:

ADDRESS:

CONTACT NO:

BIBLIOGRAPHY

www.wikipedia.com

www.cato.org

www.yahoo.com

www.google.com

www.idbi.co

www.idbi capital.com,

John c hull (third Indian print, 2004) options, future and other deritives, (5th ed) Pearson education, India

Future and option-----N.D. vohra and B.R. bagri

Financial derivatives: options ICFAI press. (risk management series) (2003)

Thomas F siems. “10 myths about financial derivatives

Bseindia.com

Nseindia.com