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Himanshu Khosla
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    SUMMER TRANING PROJECT REPORTSUMMER TRANING PROJECT REPORT

    Submitted to the

    SHIVA INSTITUTE OF MANAGEMENT STUDIES

    UNDER THE GUIDANCE OFKapil bansal (R.M)

    SUBIMITED BY

    B. jagadeswar rao.B. j agadeswar rao.

    PGDBM (2005-07)

    ROLL No. 10

    Enrollment No. 205210

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    2

    ACKNOWLEDGEMENT

    I express my sincerest gratitude and thanks to hon`ble,

    Deepak khurna (Branch manger) pitampura, for whose

    kindness I had the precious opportunity of attaining training

    at Religare. Under his brilliant untiring guidance I could

    complete the project being undertaken on the A

    project on derivative market in Indiasuccessfully in time. His meticulous attention and

    invaluable suggestions have helped me in simplifying

    the problem involved in the work. I would also like to

    thank the overwhelming support of all the people who

    gave me an opportunity to learn and gain knowledge about

    the various aspects of the industry.

    I would like to thanks for Kapil bansal for his constant

    enthusiastic encouragement and valuable suggestions

    without which this project would not been successfully

    completed.B. JAGADESWAR

    RAO .

    (2005-07)

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    PREFACE

    To maintain and cope up with the growing scope of derivative in India, Religare needs to find potential clients,also the new investors and satisfy there needs.

    The Broad object is to equipped the trainees with all thequality which is essential to face any circumstances whichcan arise while providing service to the clients.

    The project also helps in understanding the trend of thescripts of the particular sector (Banking sector) in differentmarket condition.

    All these steps help me to understand how to cope up withdifferent type of people and there diversified need andsatisfaction.

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    CONTENTS

    1. Acknowledgement.

    2. Preface.

    3. Contents.

    4. Executive Summary.

    5. Objective.

    6. Company Profile.

    7. Introduction to Derivative.

    8. Types of Derivative.

    9. Future & Option.

    10. Future Market Watch.

    11. IT Sector Involvement.

    12. NSE and CNX IT Sector Index.

    13. Findings.

    14. Recommendations.15. Conclusion.

    16. Bibliography.

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    EXECUTIVE SUMMARY

    The research work executed by the team had an object

    oriented realistic approach towards the derivative market in

    India as well as covering the globe by and large, precisely

    speaking economic giants.

    The team did follow market research procedure to get an

    extensive idea about the general perception in the mass when

    derivative market is considered; the exact figures are involved

    in derivative. To acquire customers in favor of Religare was

    also an integral part of the job. The team members coveredDelhi and NCR for this purpose. A brief profile about the

    organization was also intimated to each and every respondent

    in order to increase the popularity of Religare.

    The next phase was all about to have an international look in

    this field of Derivative market. The team examined thoroughly

    areas such as the number of players, technology they areoffering, their customer base, whether this is appealing to the

    common people or not, how they market their services etc.

    In this project report I have made an overview of investment in

    Derivative market of IT sector in India. Here I have explained

    what is Derivative and Derivative market in India with the

    examples of some IT sectors which help to understand the

    investment in Derivative market.

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    OBJECTIVES OF THE PROJECT

    Until or unless we know what we have to do? We cant do

    anything, so we must keep in mind the clear objectives of the

    project. Because in the absence of the objectives one cannot reach

    to the conclusion or goal of the project.

    I, therefore, had the following objectives:-

    1 To understand the growth of Indian Derivative Market

    1 To understand various types of derivative instruments of

    derivative market

    2 To know about various types of investment strategies in

    derivative market

    3 This project helps in selecting market out- performer

    companies in IT sector

    COMPANY PROFILE

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    Religare is driven by ethical and dynamic process for wealth creation. Based

    on this, the company started its endeavor in the financial market.

    Religare Enterprises Limited (A Ranbaxy Promoter Group Company)through Religare Securities Limited, Religare Finevest Limited, Religare

    Commodities Limited and Religare Insurance Advisory Services Limited

    provides integrated financial solutions to its corporate, retail and wealth

    management clients. Today, we provide various financial services which

    include Investment Banking, Corporate Finance, Portfolio Management

    Services, Equity & Commodity Broking, Insurance and Mutual Funds. Plus,theres a lot more to come your way.

    Religare is proud of being a truly professional financial service provider

    managed by a highly skilled team, who have proven track record in their

    respective domains. Religare operations are managed by more than 1500

    highly skilled professionals who subscribe to Religare philosophy and are

    spread across its country wide branches.

    Today, we have a growing network of 150 branches and more than 300

    business partners spread across 180 cities in India and a fully operational

    international office at London. However, our target is to have 350 branches

    and 1000 business partners in 300 cities of India and more than 7

    International offices by the end of 2006.

    Unlike a traditional broking firm, Religare group works on the philosophy of partnering for wealth creation. We not only execute trades for our clients butalso provide them critical and timely investment advice. The growing list of financial institutions with which Religare is empanelled as an approved

    broker is a reflection of the high level service standard maintained by thecompany.

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    MISSION AND VISION

    MISSION

    To be India's first Multinational providing complete financialservices solution across the globe.

    VISION

    Providing integrated financial care driven by the relationship of

    trust & confidence

    GROUP PROFILE

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    Indias largest pharmaceutical Company-Manufactures & marketsGenerics Branded generic pharmaceuticalsActive pharmaceutical ingredients.Amongst the top ten generic companies worldwide.

    -Started by the promoters of Ranbaxy-Vision: To become an integratedCaring partner forHEALTH thruFortis Healthcare Limited&WEALTHFortis Securities Limited.

    -A leading solutions provider in Screening Diagnosis

    Monitoring of every illness and disease in thecommunity.

    -Aim to provide world class services

    MANAGEMENT PROFILE

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    Religare team is led by a very eminent Board of Directors

    who provide policy guidance and work under the active leadership

    of its CEO & Managing Director and support of its Central

    Guidance Team.

    BOARD OF DIRECTORS:-

    Chairman Mr.Harpal Singh

    Managing Director Mr. Sunil Godhwani

    Director Mr.Vinay Kumar Kaul

    Director Mr.Malvinder Mohan Singh

    Director Mr.Shivinder Mohan Singh

    SERVICES PROVIDED

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    11CORE FACILITATOR ADVISORY

    1. EQUITY TRADING 1.MARGINE FINANCING 1.RESEARCH &TECHNICAL

    ANALYSIS2. DERIVATIVE TRADING 2.NRIs DESK Mgt. 2. PORTFOLIO Mgt.

    3. COMMODITIES 3.PROVIDE CLIENT Mgt.TRADING4. DIPOSATORY SERVICES

    BUSINESS & OPERATIONS

    BUSINESS

    Over a period of time RSL has recorded a healthy growth rate both in

    business volumes and profitability as it is one the major players in this line of

    business. The business thrust has been mainly in the development of business

    from Financial Institutions, Mutual Funds and Corporate.

    OPERATIONS

    The operations of the company are broadly organized along the

    following functions.

    Research & Analysis

    This group is focused on doing daily stock picks and periodical scrip \segment specific research. It provides the best of analysis in the industry and

    is valued by both our Institutional and Retail clientele.

    Marketing

    This group is focused on tracking potential business opportunities and

    converting them into business relationships. Evaluating the needs of the

    clients and tailoring products to meet their specific requirements helps the

    company to build lasting relationships.

    Dealing

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    12Enabling the clients to procure the best rates on their transactions is the

    core function of this group.

    Back Office

    This group ensures timely deliveries of securities traded, liaison withstock exchange authorities on operational matters, statutory compliance,

    handling tasks like pay-in, pay-out, etc.

    This section is fully automated to enable the staff to focus on the

    technicalities of securities trading and is manned by professionals having

    long experience in the field.

    INFRASTRUCTURE

    Offices

    The company has offices located at prime locations in Mumbai, New

    Delhi, Kolkatta and Chennai. The offices are centrally located to cater to the

    requirements of institutional and corporate clients and retails clients, and for

    ease of operations due to proximity to stock exchanges and banks.

    Communications

    The company has its disposal, an efficient network of advance

    communication system and intends to install CRM facility; besides this it is

    implementing interactive client information dissemination system which

    enables clients to view their latest client information on web. It has an

    installed multiple WAN to interconnect the branches to communicate on real

    time basis.

    The company is equipped with most advanced systems to facilitate smoothfunctioning of operations. It has installed its major application on IBM

    machines and uses latest state of art financial software.

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    INTRODUCTION TO DERIVATIVES

    The emergence of the market for derivative products, most notablyforwards, futures and options, can be traced back to the willingness of risk-

    averse economic agents to guard themselves against uncertainties arising out

    of fluctuations in asset prices. By their very nature, the financial markets are

    marked by a very high degree of volatility. Through the use of derivative

    products, it is possible to partially or fully transfer price risks by lockingin

    asset prices. As instruments of risk management, these generally do not

    influence the fluctuations in the underlying asset prices. However, by

    locking-in asset prices, derivative products minimize the impact of

    fluctuations in asset prices on the profitability and cash flow situation of risk-

    averse investors.

    DERIVATIVES

    Derivative is a product whose value is derived from the value of one or

    more basic variables, called bases (underlying asset, index, or reference rate),

    in a contractual manner. The underlying asset can be equity, forex,

    commodity or any other asset. For example, Rice farmers

    may wish to sell their harvest at a future date to eliminate the risk of a change

    in prices by that date. Such a transaction is an example of a derivative. The

    price of this derivative is driven by the spot price of Rice which is the

    underlying.

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    EMERGENCE OF DERIVATIVES

    Derivative products initially emerged as hedging devices against

    fluctuations in commodity prices, and commodity-linked derivatives

    remained the sole form of such products for almost three hundred years.

    Financial derivatives came into spotlight in the post-1970 period due to

    growing instability in the financial markets. However, since their emergence,

    these products have become very popular and by 1990s, they accounted for

    about two-thirds of total transactions in derivative products. In recent years,the market for financial derivatives has grown tremendously in terms of

    variety of instruments available, their complexity and also turnover. In the

    class of equity derivatives the world over, futures and options on stock

    indices have gained more popularity than on individual stocks, especially

    among institutional investors, who are major users of index-linked

    derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs

    associated with index derivatives viesavies derivative products based on

    individual securities is another reason for their growing use.

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    HISTORY OF DERIVATIVES

    Early forward contracts in the US addressed merchants concerns about

    ensuring that there were buyers and sellers for commodities. However credit

    risk remained a serious problem. To deal with this problem, a group of

    Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848.

    The primary intention of the CBOT was to provide a centralized location

    known in advance for buyers and sellers to negotiate forward contracts. In

    1865, the CBOT went one step further and listed the first exchange tradedderivatives contract in the US; these contracts were called futures

    contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was

    reorganized to allow futures trading. Its name was changed to Chicago

    Mercantile Exchange (CME). The CBOT and the CME remain the two

    largest organized futures exchanges, indeed the two largest financial

    exchanges of any kind in the world today.The first stock index futures contract was traded at Kansas City

    Board of Trad e. Currently the most popular stock index futures contract in

    the world is based on S&P 500 index, traded on Chicago Mercantile

    Exchange. During the mid eighties, financial futures became the most active

    derivative instruments generating volumes many times more than the

    commodity futures. Index futures, futures on T-bills and Euro-Dollar futures

    are the three most popular futures contracts traded today. Other popular

    international exchanges that trade derivatives are LIFFE in England, DTB in

    Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

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    16GLOBAL DERIVATIVE MARKETS

    The derivatives markets have grown manifold in the last two decades...

    According to the Bank for International Settlements (BIS), the approximate

    size of global derivatives market was US$ 109.5 trillion as at endDecember

    2000. The total estimated notional amount of outstanding overthecounter

    (OTC) contracts stood at US$ 95.2 trillion as at endDecember 2000, an

    increase of 7.9% over endDecember 1999. Growth

    In OTC derivatives market is mainly attributable to the continued rapidexpansion of interest rate contracts, which reflected growing corporate bond

    markets and increased interest rate uncertainty at the end of 2000. The

    amount outstanding in organized exchange markets increased by 5.8% from

    US$ 13.5 trillion as at end December 1999 to US$ 14.3 trillion as at end

    December 2000.

    The turnover data are available only for exchangetraded derivatives

    contracts. The turnover in derivative contracts traded on exchanges has

    increased by 9.8% during 2000 to US$ 384 trillion as compared to US$ 350

    trillion in 1999(Table 1.2). While interest rate futures and options accounted

    for nearly 90% of total turnover during 2000, the popularity of stock market

    index futures and options grew modestly during the year. According to BIS,

    the turnover in exchangetraded derivative markets rose by a record amount

    in the first quarter of 2001, while there was some moderation in the OTC

    volumes.

    DERIVATIVES MARKET IN INDIA

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    The first step towards introduction of derivatives trading in India was

    the promulgation of the Securities Laws (Amendment) Ordinance, 1995,

    which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework

    to govern trading of derivatives. SEBI set up a 24member committee under

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

    appropriate regulatory framework for derivatives trading in India. The

    committee submitted its report on March 17, 1998 prescribing necessary 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, depositrequirement and realtime monitoring requirements.

    The SCRA was amended in December 1999 to include derivatives

    within the ambit of securities and the regulatory framework were developed

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

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

    stock exchange, thus precluding OTC derivatives. The government alsorescinded in March 2000, the threedecade old notification, which prohibited

    forward trading in securities.

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    18Derivatives trading commenced in India in June 2000 after SEBI

    granted the final approval to this effect in May 2000. SEBI permitted the

    derivative segments of two stock

    exchanges, NSE and BSE, and their clearing house/corporation to commence

    trading and settlement in approved derivatives contracts. To begin with, SEBI

    approved trading in index futures contracts based on S&P CNX Nifty and

    BSE30 (Sensex) index. This was followed by approval for trading in options

    based on these two indexes and options on individual securities. The trading

    in index options commenced in June 2001 and the trading in options on

    individual securities commenced in July 2001. Futures contracts onindividual stocks were launched in November 2001. 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.

    The derivatives trading on the exchange commenced with S&P CNX Nifty

    Index futures on June 12, 2000. The trading in index options commenced onJune 4, 2001 and trading in options on individual securities commenced on

    July 2, 2001. Single stockfutures were launched on November 9, 2001. The

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

    Index. Currently, the futures contracts have a maximum of 3-month

    expiration cycles. Three contracts are available for trading, with 1 month, 2

    months and 3 months expiry.

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    PARTICIPANTS

    Derivative contracts have several variants. The most common variants

    are forwards, futures, options and swaps. The following three broad

    categories of participants

    Hedgers : - Hedgers face risk associated with the price of an asset. They use

    futures or options markets to reduce or eliminate this risk

    Speculators : - Speculators wish to bet on future movements in the price of

    an asset. Futures and options contracts can give them an extra leverage; that

    is, they can increase both the potential gains and potential losses in a

    speculative venture.

    Arbitrageurs : - Arbitrageurs are in business to take advantage of a

    discrepancy between prices in two different markets. If, for example, they see

    the futures price of an asset getting out of line with the cash price, they will

    take offsetting positions in the two markets to lock in a profit.

    FUNCTIONS

    The derivatives market performs a number of economic functions.

    1. Prices in an organized derivatives market reflect the perception of

    market participants about the future and lead the prices of underlyingto the perceived future level. The prices of derivatives converge with

    the prices of the underlying at the expiration of the derivative contract.

    Thus derivatives help in discovery of future as well as current prices.

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    202. The derivatives market helps to transfer risks from those who have

    them but may not like them to those who have an appetite for them.

    3. Derivatives, due to their inherent nature, are linked to the underlying

    cash markets. With the introduction of derivatives, the underlying

    market witnesses higher trading volumes because of participation by

    more players who would not otherwise participate for lack of an

    arrangement to transfer risk.

    4. Speculative trades shift to a more controlled environment of

    derivatives market. In the absence of an organized derivatives market,

    speculators trade in the underlying cash markets. Margining,

    monitoring and surveillance of the activities of various participants

    become extremely difficult in these kinds of mixed markets.

    An important incidental benefit that flows from derivatives trading is

    that it acts as a catalyst for new entrepreneurial activity. The

    derivatives have a history of attracting many bright, creative, well-

    educated people with an entrepreneurial attitude. They often energize

    others to create new businesses, new products and new employment

    opportunities, the benefit of which are immense.

    5. Derivatives markets help increase savings and investment in the longrun. Transfer of risk enables market participants to expand their

    volume of activity.

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    TYPES OF DERIVATIVES

    The most commonly used derivatives contracts are forwards, futures

    and options which we shall discuss in detail later. Here we take a brief look at

    various derivatives contracts that have come to be used.

    Forward s: A forward contract is a customized contract between two entities,

    where settlement takes place on a specific date in the future at todays pre-

    agreed price.

    Future s: A futures contract is an agreement between two parties to buy or

    sell an asset at a certain time in the future at a certain price. Futures contracts

    are special types of forward contracts in the sense that the former are

    standardized exchange-traded contracts.

    Options : Options are of two types - calls and puts. Calls give the buyer the

    right but not the obligation to buy a given quantity of the underlying asset, at

    a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a

    given price on or before a given date.

    Warrants : Options generally have lives of upto one year, the majority of

    options traded on options Exchanges having a maximum maturity of nine

    months. Longer-dated options are called warrants and are generally traded

    over-the-counter.

    LEAPS : The acronym LEAPS means Long-Term Equity Anticipation

    Securities. These are options having a maturity of upto three years.

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    Baskets : Basket options are options on portfolios of underlying assets. The

    underlying asset is usually a moving average of a basket of assets. Equity

    index options are a form of basket options.Swaps : Swaps are private agreements between two parties to exchange cash

    flows in the future according 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 swap s: These entail

    swapping only the interest related cash flows between the parties in the same

    currency.

    Currency swap s: 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.

    Swaptions : Swaptions are options to buy or sell a swap that will become

    operative at the expiry of the options. Thus a swaption is an option on a

    forward swap. Rather than have calls and puts, the swaptions market has

    receiver swaptions and payer swaptions. A receiver swaption is an option to

    receive fixed and pay floating. A payer swaption is an option to pay fixed and

    receive floating.

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    SUMMARY

    Derivatives - Derivative is a product whose value is derived from the

    value of one or more basic variables, called bases (underlying asset, index, or

    reference rate), in a contractual manner. The underlying asset can be equity,

    forex, commodity or any other asset. The price of this derivative is driven by

    the spot price of Rice which is the underlying.

    Futures and Options are the most commonly used equity derivative

    instruments. Derivatives market has been in existence for years in anunorganized manner. In India we are yet to see the full-fledged derivatives

    trading. As per the global standards, derivatives trading volumes are

    generally 4-5 times the cash market volumes. Whereas, in India the

    derivatives volumes are 2-3 times the cash market volumes

    Derivatives are used for three categories of participants :-

    Hedgers - Hedgers face risk associated with the price of an asset. They

    use futures or options markets to reduce or eliminate this risk

    Speculators - Speculators wish to bet on future movements in the price

    of an asset. Futures and options contracts can give them an extra leverage;

    that is, they can increase both the potential gains and potential losses in a

    speculative venture

    Arbitragers - Arbitrageurs are in business to take advantage of a

    discrepancy between prices in two different markets. If, for example, they see

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    25the futures price of an asset getting out of line with the cash price, they will

    take offsetting positions in the two markets to lock in a profit.

    Derivatives market reflects the perception of the market player about

    the market. They help in discovery of future as well as current prices. Theytransfer risk from those who have it but may not like to have them to those

    who have an appetite for it. Transfer of risk enables market participants to

    expand their volume of activity .

    FUTURES MARKET WATCH: SPOT THE MISPRICING

    In all the applications so far, we assumed that there was a single futures price.

    In reality when one trades on the futures market, one encounters two prices -

    a bid and an ask. In the following section, we shall discuss two trading

    strategies that can be implemented by an investor following the market watch

    screen.

    Do you sometimes think that a futures contract is mispriced? As per the

    cost-of-carry logic, the futures price must be equal to the spot price plusthe cost of carry. If the futures price is less than the spot price plus cost of

    carry or if the futures price is greater than the spot plus cost of carry,

    arbitrage opportunities exist. If for instance,

    Futures >Spot + Cost of Carry

    Arbitrageurs will borrow funds, buy the spot with these borrowed

    funds, sell the futures contract and carry the asset forward to deliver againstthe futures

    Contract. This is called cash-and-carry arbitrage. If for instance,

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    Futures < Spot + Cost of Carry

    Arbitrageurs will sell the asset, invest the proceeds from this sale and

    buy

    Futures cheap. This is called reverse cash-and-carry. As arbitrageurs enter themarket, buying the cheaper of the two (future and spot) and selling the

    expensive, prices will return to equilibrium where they obey the cost-of-carry

    rule.

    Table 1:Fair values vis--vis market prices for various futures contracts

    Month Quantity Bid Ask Quantity Fair value

    November 1000 1009 1010.5 1000 1009.50

    December 200 1022 1025 400 1019.00

    January 400 1028 1032 200 1028.70

    What we spoke of above were arbitrage opportunities arising out of

    mispricings. However, when futures price is not equal to its fair value,speculators too enter the market, buy the cheaply available contract and sell

    the expensive one, wait till prices return to their fair values and close out

    their positions. Hence identifying mispricings is an essential skill that must

    be developed.

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    28wiped out as soon as traders start exploiting it. The basis and the spread will

    correct it and return close to its fair value. Now is the time to close the

    position, i.e. sell the far month contract and buy the near month.

    Table 4 Mispricings of Basis and Spreads on various futures contracts

    Spot Contract Fair Fair Mkt. Obs. Obs.

    Price Basis Spread Price Basis

    Spread

    1000 F1 1010 10 1012 12

    F2 1020 20 10 1018 18 6

    F3 1030 30 10 1032 32 14

    Refer to Table 4 and similarly observe the spread between F2 and F3.When

    the spread between two futures contracts widens, sell the far month contract

    and buy the near-month one. Why do we sell the far month and buy the near month? Because we know that if the fair spread between two contracts is 10,

    but the one observed on the market watch is 14, the far month contract is

    overpriced and the near month is under priced. There is a mispricings which

    will be wiped out as soon as traders start exploiting it. The basis and the

    spread will correct it and return close to its fair value. Now is the time to

    close the position, i.e. buy the far month contract and sell the near month.

    The table shows the basis and spreads on one-month, two-month and three-

    month futures contracts. Basis is the difference between the spot and the

    futures prices. It is usually negative. The difference between two futures

    contracts is referred to as spreads. The fair spread between F1 and F2 is 10.

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    29However the spread that we observe on the market at the moment is 6. Since

    the spread has narrowed, we can profit by selling the near-month contract,

    i.e.F1 and buying the far-month contract, i.e. F2 Once we do this, we would

    have a position of:

    1. Sell F1@ 1012

    2. Buy F2@ 1018

    After some time, the spread corrects itself and we close our position by

    entering into the following trades:

    1 Buy F1 @ 1010

    2 Sell F2 @ 1020

    We end up making a profit of Rs.4 on the round trip.

    Similarly observe the spread between F2 and F3. The spread has widened

    from an expected value of 10 to an observed value of 14. Hence we sell the

    far month contract and buy the near month one. Once we do this we would

    have a position of:

    1 Sell F3 @ 10322 Buy F2 @ 1018

    After some time, the spread corrects itself and we close our position by

    entering into the following trades:

    1 Buy F3 @ 1030

    2 Sell F2 @ 1020

    We end up making a profit of Rs.4 on the round trip. However a word of

    caution. Although transaction costs on the futures market are less than the

    transactions costs on the cash market, they exist anyway and should be

    factored into these trades. As far as possible, closing out of positions should

    be done using limit orders. The Market by Price (MBP) screen gives a fair

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    30idea of the depth of the market, and should be used while placing the limit

    orders.

    Bid-ask on various futures contracts at time T1 and time T2

    Market watch at time T1

    Spot Contract Bid Ask

    1000 F1 1012 1013

    F2 1014 1016

    F3 1027 1037

    Market watch at time T2

    Spot Contract Bid Ask

    1000 F1 1010 1011

    F2 1019 1022

    F3 1028 1035

    Trading to profit from misaligned spreads seems simple when we look at a

    single futures price, but in the real world we are faced with two prices, a bid

    and an ask. The trick is to get used to detecting misalignment of spreads

    across futures contracts, given three bids and three asks.

    The table shows the bid and asks for various futures contracts as one would

    see them on the market watch at time T1 and T2. If we typically believe that

    the spread between the one-month and two-month futures contracts should be

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    3110 points, we will buy a spread at time T1 when it is less than 10 and sell a

    spread at time T2 when it is greater than 10. Buying a spread basically means

    selling the near month and buying the far month contract. So if we think that

    the spread between F1 and F2 is narrow, what we really need to look at is the bid on F1 and the ask on F2 .If the difference between this is narrower than

    we expect it to be, we sell F1 and buy F2. Once we do this we would have a

    position of:

    1 Sell F1 @ 1012

    2 Buy F2 @ 1016

    We now watch the market to see if the spread corrects itself. To close our

    position at time T2 what we should be watching is the difference between ask

    on F1 and the bid on F2. Once this returns close to our expected spread, 10 in

    this case, we close our position by buying F1 and selling F2 at time T2.

    When we do this we would have a position of:

    1. Buy F1@ 1011

    2. Sell F2 @ 1019

    As we can see, we sold F1 at 1012 and bought it back at 1011 making a profit

    of 1. We bought F2 at 1016 and sold it at 1019 making a profit of 3. Our net

    profit from this set of transactions is 4. The point to note is that when faced

    with a bid and an ask price, one must watch the correct prices to calculate the

    spread. Familiarizing oneself with this set of transactions will enable one to

    quickly detect misaligned spreads on the futures contract and instantly enter

    into trades to profit from them.

    Summary

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    32

    Arbitrage is the practice of taking advantage of a state of imbalance between

    two (or possibly more) markets. A combination of matching deals are struck

    that exploit the imbalance, the profit being the difference between the market

    prices. A person who engages in arbitrage is called an arbitrageur .

    Arbitrage is the safest way to make money in the market. However, the scope

    for making money is diminutive. With the help of the arbitrage strategies

    discussed above, we can exploit the market condition and earn risk-free

    return.

    Arbitrage is game of strategy and also funds. A participant with ample funds

    can easily earn risk-free returns. On the other hand, a strategist can make

    risk-less profits by making use of mispricings in the market.

    Arbitrage could be inter-exchange, NSE and BSE. Arbitrage could also be

    between two segments of the market, Cash and F&O. Borrowing and lending

    is a common practice in arbitrage transaction, therefore, bank and financial

    institution are very active in arbitrage activities.

    The above states strategies cover all the types of arbitrage possibilities using

    equity derivatives.

    SPECULATION STRATEGIES

    1 Bullish Index, long nifty futures

    2 Bearish Index, short nifty futures

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    333 Bullish security, buy futures

    4 Bearish security, sell futures

    5 Bullish index, buy index calls or sell index puts

    6 Bearish index, buy index puts or sell index calls7 Bullish stock, buy calls or sell puts

    8 Bearish stock, buy puts or sell calls

    Speculation: Bullish Index, long nifty futures

    Do you sometimes think that the market index is going to rise? That youcould make a profit by adopting a position on the index? After a good budget,

    or good corporate results, or the onset of a stable government, many people

    feel that the index would go up. How does one implement a trading strategy

    to benefit from an upward movement in the index? Today, you have two

    choices:

    1. Buy selected liquid securities which move with the index, and sell

    them at a later date: or,

    2. Buy the entire index portfolio and then sell it at a later date.

    The first alternative is widely used a lot of the trading volume on liquid

    securities is based on using these liquid securities as an index proxy.

    However, these positions run the risk of making losses owing to company

    specific news; they are not purely focused upon the index. The second

    alternative is cumbersome and expensive in terms of transactions costs.

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    34Taking a position on the index is effortless using the index futures

    market. Using index futures, an investor can buy or sell the entire index

    by trading on one single security. Once a person is LONG NIFTY using the

    futures market, he gains if the index rises and loses if the index falls.How do we actually do this?

    When you think the index will go up, buy the Nifty futures. The minimum

    market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in

    units of Rs.240,000. When the trade takes place, the investor is only required

    to pay up the initial margin, which is something like Rs.20,000. Hence, by

    paying an initial margin of Rs.20,000, the investor gets a claim on the index

    worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a

    claim on Nifty worth Rs.2.4 million.

    Futures are available at several different expirations. The investor can

    choose any of them to implement this position. The choice is basically about

    the horizon of the investor. Longer dated futures go well with longterm

    forecasts about the movement of the index. Shorter dated futures tend to be

    more liquid.

    Example

    1. On 1 July 2001, Milan feels the index will rise.

    2. He buys 200 Nifties with expiration date on 31st July 2001.

    3. At this time, the Nifty July contract costs Rs.960 so his position is

    worth Rs.192,000.

    4. On 14 July 2001, Nifty has risen to 967.35.

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    355. The Nifty July contract has risen to Rs.980.

    6. Milan sells off his position at Rs.980.

    7. His profits from the position are Rs.4000.

    Speculation: Bearish index, short Nifty futures

    Do you sometimes think that the market index is going to fall? That you

    could make a profit by adopting a position on the index? After a bad budget,

    or bad corporate results, or the onset of a coalition government, many people

    feel that the index would go down. How does one implement a trading

    strategy to benefit from a downward movement in the index? Today, you

    have two choices:

    1. Sell selected liquid securities which move with the index, and buy

    them at a later date: or,

    2. Sell the entire index portfolio and then buy it at a later date.

    The first alternative is widely used a lot of the trading volume on liquid

    securities is based on using these securities as an index proxy. However,

    these positions run the risk of making losses owing to companyspecific

    news; they are not purely focused upon the index.

    The second alternative is hard to implement. This strategy is also

    cumbersome and expensive in terms of transactions costs. Taking a positionon the index is effortless using the index futures market. Using index futures,

    an investor can buy or sell the entire index by trading on one single

    security. Once a person is SHORT NIFTY using the futures market, he gains

    if the index falls and loses if the index rises.

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    36

    How do we actually do this?

    When you think the index will go down, sell the Nifty futures. The minimum

    market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done inunits of Rs.240,000. When the trade takes place, the investor is only required

    to pay up the initial margin, which is something like Rs.20,000. Hence, by

    paying an initial margin of Rs.20,000 the investor gets a claim on the index

    worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a

    claim on Nifty worth Rs.2.4 million.

    Futures are available at several different expirations. The investor can choose

    any of them to implement this position. The choice is basically about the

    horizon of the investor. Longer dated futures go well with longterm

    forecasts about the movement of the index. Shorter dated futures tend to be

    more liquid.

    Example

    1. On 1 June 2001, Milan feels the index will fall.

    2. He sells 200 Nifties with a expiration date of 26th June 2001.3. At this time, the Nifty June contract costs Rs.1,060 so his position is

    worth Rs.212,000.

    4. On 10 June 2001, Nifty has fallen to 962.90.

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    375. The Nifty June contract has fallen to Rs.990. Milan squares off his

    position.

    6. His profits from the position work out to be Rs.14,000.

    Speculation: Bullish security, buy futures

    Take the case of a speculator who has a view on the direction of the market.

    He would like to trade based on this view. He believes that a particular

    security that trades at Rs.1000 is undervalued and expects its price to go up in

    the next twothree months. How can he trade based on this belief? In the

    absence of a deferral product, he would have to buy the security and hold on

    to it. Assume he buys a 100 shares which cost him one lakh rupees. His

    hunch proves correct and two months later the security closes at Rs.1010. He

    makes a profit of Rs.1000 on an investment of Rs.1,00,000 for a period of

    two months. This works out to an annual return of 6 percent.

    Today a speculator can take exactly the same position on the security byusing futures contracts. Let us see how this works. The security trades atRs.1000 and the two-month futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 1,00,000. He buys100 security futures for which he pays a margin of Rs.20,000. Two monthslater the security closes at 1010. On the day of expiration, the futures priceconverges to the spot price and he makes a profit of Rs.400 on an investmentof Rs.20,000.

    Speculation: Bearish security, sell futures

    Stock futures can be used by a speculator, who believes that a particular

    security is overvalued and is likely to see a fall in price. How can he trade

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    38 based on his opinion? In the absence of a deferral product, there wasnt much

    he could do to profit from his opinion. Today all he needs to do is sell stock

    futures.

    Let us understand how this works. Simple arbitrage ensures that futures on

    individual securities move correspondingly with the underlying security, as

    long as there is sufficient liquidity in the market for the security. If the

    security price rises, so will the futures price. If the security price falls, so will

    the futures price. Now take the case of the trader who expects to see a fall in

    the price of SBI. He sells one twomonth contract of futures on SBI at

    Rs.240 (each contact for 100 underlying shares). He pays a small margin on

    the same. Two months later, when the futures contract expires, SBI closes at

    220. On the day of expiration, the spot and the futures price converges. He

    has made a clean profit of Rs.20 per share. For the one contract that he

    bought, this works out to be Rs.2000.

    Speculation : Bullish index, buy Nifty calls or sell Nifty puts

    There are times when investors believe that the market is going to rise. For

    instance, after a good budget, or good corporate results, or the onset of a

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    39stable government. How does one implement a trading strategy to benefit

    from an upward movement in the index? Today, using options you have two

    choices:

    1. Buy call options on the index; or,2. Sell put options on the index

    We have already seen the payoff of a call option. The downside to the buyer

    of the call option is limited to the option premium he pays for buying the

    option. His upside however is potentially unlimited. Suppose you have a

    hunch that the market index is going to rise in a months time. Your hunch

    proves correct and the index does indeed rise, it is this upside that you cash in

    on. However, if your hunch proves to be wrong and the market index plunges

    down, what you lose is only the option premium.

    Having decided to buy a call, which one should you buy? Given that

    there are a number of onemonth calls trading, each with a different strike

    price, the obvious question is: which strike should you choose? Let us take a

    look at call options with different strike prices. Assume that the current index

    level is 1250, risk-free rate is 12% per year and index volatility is 30%.

    The following options are available:

    1. A one month calls on the Nifty with a strike of 1200.2. A one month calls on the Nifty with a strike of 1225.

    3. A one month calls on the Nifty with a strike of 1250.

    4. A one month call on the Nifty with a strike of 1275.

    5. A one month call on the Nifty with a strike of 1300.

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    40

    Which of these options you choose largely depends on how strongly you feel

    about the likelihood of the upward movement in the market index, and how

    much you are willing to lose should this upward movement not come about.There are five onemonth calls and five one month puts trading in the

    market. The call with a strike of 1200 is deep in

    themoney and hence trades at a higher premium. The call with a strike of

    1275 is outofthemoney and trades at a low premium. The call with a

    strike of 1300 is deepoutofmoney. Its execution depends on the unlikely

    event that the Nifty will raise by more than 50 points on the expiration date.

    Hence buying this call is basically like buying a lottery. There is a small

    probability that it may be inthemoney by expiration, in which case the

    buyer will make profits. In the more likely event of the call expiring outof

    themoney, the buyer simply loses the small premium amount of Rs.27.50.

    As a person who wants to speculate on the hunch that the market index

    may rise, you can also do so by selling or writing puts. As the writer of puts,

    you face a limited upside and an unlimited downside. If the index does rise,

    the buyer of the put will let the option expire and you will earn the premium.

    If however your hunch about an upward movement in the market proves to

    be wrong and the index actually falls, then your losses directly increase with

    the falling index level. If for instance the index falls to 1230 and youve sold

    a put with an exercise of 1300, the buyer of the put will exercise the optionand youll end up losing Rs.70. Taking into account the premium earned by

    you when you sold the put, the net loss on the trade is Rs.5.20.

    Having decided to write a put, which one should you write? Given that there

    are a number of one-month puts trading, each with a different strike price, the

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    41obvious question is: which strike should you choose? This largely depends on

    how strongly you feel about the likelihood of the upward movement in the

    market index. If you write an atthemoney put, the option premium earned

    by you will be higher than if you write an outofthemoney put. However the chances of an atthemoney put being exercised on you are higher as

    well. In the example, at a Nifty level of 1250, one option is inthemoney

    and one is outofthemoney. As expected, the inthemoney option fetches

    the highest premium of Rs.64.80 whereas the outofthemoney option has

    the lowest premium of Rs.18.15.

    The spot Nifty level is 1250. There are five one-month calls and fiveone-month puts trading in the market. The call with a strike of 1200 is deep

    in-the-money and hence trades at a higher premium. The call with a strike of

    1275 is out-of-the-money and trades at a low premium. The call with a strike

    of 1300 is deep-out-of-money. Its execution depends on the unlikely event

    that the Nifty will raise by more than 50 points on the expiration date. Hence

    buying this call is basically like buying a lottery. There is a small probability

    that it may be in-the-money by expiration in which case the buyer will profit.

    In the more likely event of the call expiring out-of-the-money, the buyer

    simply loses the small premium amount of Rs. 27.50

    Similarly, the put with a strike of 1300 is deep in-the-money and trades

    at a higher premium than the at-the-money put at a strike of 1250. The put

    with a strike of 1200 is deep out-of-the-money and will only be exercised in

    the unlikely event that Nifty falls by 50 points on the expiration date

    Table: one month calls and puts trading at different prices

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    42

    Nifty Strike price of option Call Premium (Rs.) Put Premium

    (Rs.)

    1250 1200 80.10 18.15

    1250 1225 63.65 26.501250 1250 49.45 37.00

    1250 1275 37.50 49.80

    1250 1300 27.50 64.80

    Speculation: Bearish index: sell Nifty calls or buy Nifty puts

    Do you sometimes think that the market index is going to drop? That you

    could make a profit by adopting a position on the index? Due to poor

    corporate results, or the instability of the government, many people feel that

    the index would go down. How does one implement a trading strategy to

    benefit from a downward movement in the index? Today, using options, you

    have two choices:

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    43

    1. Sell call options on the index; or,

    2. Buy put options on the index

    We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for

    writing the option. His downside however is potentially unlimited. Suppose

    you have a hunch that the market index is going to fall in a months time.

    Your hunch proves correct and the index does indeed fall, it is this downside

    that you cash in on. When the index falls, the buyer of the call lets the call

    expire and you get to keep the premium. However, if your hunch proves to be

    wrong and the market index soars up instead, what you lose is directly

    proportional to the rise in the index.

    Having decided to write a call, which one should you write? Given that

    there are a number of one-month calls trading, each with a different strike

    price, the obvious question is: which strike should you choose? Let us take a

    look at call options with different strike prices. Assume that the current index

    level is 1250, risk-free rate is 12% per year and index volatility is 30%. You

    could write the following options:

    1. A one month calls on the Nifty with a strike of 1200.

    2. A one month calls on the Nifty with a strike of 1225.

    3. A one month calls on the Nifty with a strike of 1250.

    4. A one month calls on the Nifty with a strike of 1275.

    5. A one month calls on the Nifty with a strike of 1300.Which of these options you write largely depends on how strongly you feel

    about the likelihood of the downward movement in the market index and how

    much you are willing to lose should this downward movement not come

    about. There are five one-month calls and five one-month puts trading in the

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    44market. The call with a strike of 1200 is deep in-the-money and hence trades

    at a higher premium. The call with a strike of 1275 is out-of-the-money and

    trades at a low premium. The call with a strike of 1300 is deep-out-of-money.

    Its execution depends on the unlikely event that the Nifty will raise by morethan 50 points on the expiration date. Hence writing this call is a fairly safe

    bet. There is a small probability that it may be in-the-money by expiration in

    which case the buyer exercises and the writer suffers losses to the extent that

    the Nifty is above 1300. In the more likely event of the call expiring out-of-

    the-money, the writer earns the premium amount of Rs.27.50.

    As a person who wants to speculate on the hunch that the market index

    may fall, you can also buy puts. As the buyer of puts you face an unlimited

    upside but a limited downside. If the index does fall, you profit to the extent

    the index falls below the strike of the put purchased by you. If however your

    hunch about a downward movement in the market proves to be wrong and

    the index actually rises, all you lose is the option premium. If for instance the

    index rises to 1300 and youve bought a put with an exercise of 1250, you

    simply let the put expire. If however the market index does fall to say 1225

    on expiration date, you make a neat profit of Rs.25.

    Having decided to buy a put, which one should you buy? Given that there are

    a number of one-month puts trading, each with a different strike price, the

    obvious question is: which strike should you choose? This largely depends on

    how strongly you feel about the likelihood of the downward movement in the

    market index. If you buy an at-the-money put, the option premium paid byyou will by higher than if you buy an out-of-the-money put. However the

    chances of an at-the-money put expiring in-the-money are higher as well.

    Speculation: Anticipate volatility; buy a call and a put

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    45Do you sometimes think that the market index is going to go through large

    swings in a given period, but have no opinion on the direction of the swing?

    This could typically happen around budget time, or during times of political

    uncertainty when a change in the government is anticipated. How does oneimplement a trading strategy to benefit from market volatility? Combinations

    of call and put options provide an excellent way to trade on volatility. Here is

    what you would have to do:

    1. Buy call options on the index at a strike K and maturity T, and

    2. Buy put options on the index at the same strike K and of maturity

    T.

    This combination of options is often referred to as a Straddle and is an

    appropriate strategy for an investor who expects a large move in the index

    but does not know in which direction the move will be.

    Consider an investor who feels that the index, which currently stands

    at 1252, could move significantly in three months. The investor could create

    a straddle by buying both a put and a call with a strike close to 1252 and an

    expiration date in three months. Suppose a three-month call at a strike of

    1250 costs Rs.95.00 and a three month put at the same strike cost Rs.57.00.

    To enter into this positions, the investor faces a cost of Rs.152.00. If at the

    end of three months, the index remains at 1252, the strategy costs the investor

    Rs.150. (An up-front payment of Rs.152, the put expires worthless and the

    call expires worth Rs.2). If at expiration the index settles around 1252, theinvestor incurs losses.

    However, if as expected by the investors, the index jumps or falls

    significantly, he profits. For a straddle to be an effective strategy, the

    investors beliefs about the market movement must be different from those of

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    46most other market participants. If the general view is that there will be a large

    jump in the index, this will reflect in the prices of the options.

    SECTOR - INFORMATION TECHNOLOGY OVERVIEW

    Information technology (IT) is a broad field that covers all aspects of

    managing and processing information. IT professionals design, develop,

    support, and manage computer software, hardware, and networks. From the

    exuberant growth of its early years to the uncertainty of recent times, the IT

    industry has stabilizedwith job growth rates now rising steadilyandcontinues to change in order to meet the needs of the business world.

    While the wild optimism that surrounded the IT industry a few years back

    has been deflated, the IT industry is adapting to a changing market. New

    developments such as creating infrastructure for mobile technologies will

    continue to ensure the vitality and viability of the industry. And as the

    industry responds to new business needs, it will continue to evolve into a

    mature profession, a profession versatile enough to adapt to new demands

    and stable enough to support new innovations and developments.

    Market segmentation: Some of the upcoming service lines include higher value

    added services such as Engineering and Design, Knowledge processing,

    logistics, etc. While customer care continues to be the largest service line,

    finance and administration services are expected to grow significantly over the

    next few years. Slowly

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    47

    Gradually Indian BPO industry is moving up the value chain from call

    centers catering to customer care the BPO offerings now include an entire

    gamut of high-end services like equity research, healthcare solutions.

    Focus on emerging areas:

    Annual revenue projections for Indias IT industry in 2008 are US $ 87

    billion and market openings are emerging across four broad sectors, IT

    services, software e-products, IT enabled services, and e-business thuscreating a number of opportunities for Indian companies.

    In addition to the export market, all of these segments have a domestic market

    component as well.

    Software & Services will contribute over 7.5 % of the overall GDP growth

    of India (Source: NASSCOM-McKinsey)

    IT Exports will account for 35% of the total exports from India

    Potential for 2.2 million jobs in IT by 2008

    IT industry will attract Foreign Direct Investment (FDI) of U.S. $ 4-5 billion

    Market capitalization of IT shares will be around U.S. $ 225 billion

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    48

    (Source: Religare securities.com)TRENDS IN INDIAN IT MARKET

    Software product development: Software product development is a market

    that has remained elusive for the Indian software and services players, until

    recently, when companies have begun venturing into this vast and almost

    unexplored arena. During 2002-03, the Indian packaged software market

    totaled Rs. 1,000 crore, accounting for 0.2 percent of the overall global

    software products opportunity. Clearly, a massive untapped potential exists

    for software companies playing on this turf.

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    49

    Offshore product development: Another development that is creating a push for the software products industry among Indian software majors isoffshore outsourcing of software development by large global IT companiesto Indian shores. While some companies including Microsoft, IBM, TexasInstruments, Adobe, Novell, SAP, Intel, and Cisco have taken the direct routeand set up captive development centers in India, others have collaboratedwith Indian companies for these projects. Indian companies outsourcing

    product development activities include large players such as Wipro, TCS,Infosys and smaller niche players with domain expertise in particular verticals such as Sasken, Mindtree, among others.

    Embedded software: The embedded software solutions market touched US$

    21 billion in 2003 and is estimated to grow at 16 percent over the next year.

    Considering the high growth expected from the global embedded software

    solutions market, Indian companies would do well to tap into this rapidly

    expanding opportunity. Indian software companies have started participating

    in this space by developing outsourced embedded solutions for global

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    50Independent Software Vendors (ISVs) such as Samsung, Texas Instruments,

    Delphi and Honeywell Industrial Controls.

    TRENDS IN INDIAN IT HARDWARE MARKETThe growth of the Indian IT hardware sector has traditionally been lagging

    behind the software and services segment, with hardware exports continuing

    to remain low-key. The share of hardware in the overall revenues of the

    Indian ITITES industry has been witnessing a decline over the past few years

    on account of immense competitive pricing pressures and relatively faster

    growth in services segment revenues. Almost 90 percent of the revenues

    generated by the hardware industry came from domestic market in 2003-04.

    PERFORMANCE SUMMARY

    The fourth quarter of FY05 saw Indian software majors reporting a slower

    (relative to previous quarter) sequential growth in the top line and a dip in

    bottom-line, much due to lackluster performance from TCS and the

    appreciation in the value of rupee vis--vis the US dollar. The effect was also

    seen on the operating margins front. In this write up, we analyze the

    performance of the sector (through consolidation of results of the four

    majors) and see what investors in software stocks can expect going forward.

    Indian IT: 4QFY05 performance...

    (Rs m) 3QFY04 4QFY05 Change FY04 FY05 Change

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    52few quarters. The significant growth in offshore traction has been on account

    of increasing offshore penetration, rising adoption, increasing credibility and

    expansion of services by the Indian offshore vendors. The continuation of

    this trend in Q4 FY05 should thereby translate into higher volumes for thecompanies in the sector..

    Pricing remains stable: The overall billing rates have been relatively stable

    in the quarter, which is again in inline with flat prices witnessed in the past

    few quarters. Though most of the Tier I and some of the Tier II companies

    have secured higher than average prices (~4-5%) from new customers, the

    positive impact of the above on the overall pricing scenario is expected to be

    minimal at best, as 90% of their business comes from old customers.

    The adverse impact of Rupee appreciation on topline growth would be

    limited :Though the Rupee/Dollar rate remained stable throughout the quarter

    near the ~Rs43.75 mark, the quarterly average rate of Rs43.71 represents a

    sharp Rupee appreciation of 2.8% on sequential basis. However, the adverse

    impact of this appreciation on the top line growth of the companies is

    expected to be limited (as opposed to that in the previous quarter) due to

    aggressive forex cover taken by majority of the companies before the quarter

    anticipating the Dollar slide. Therefore, the sequential dip in the

    Rupee/Dollar rate realized by the companies in the quarter would be

    relatively lower. Infosys, TCS and Satyam amongst the Tier I companies.

    Operating margins to remain stable overall and improve for selected few: In the absence of any major cost-push factors, we expect the minor adverse

    impact of rupee appreciation to be fully offset by higher fixed cost leverage

    derived from strong volume growth thereby enabling majority of the players

    to maintain operating margins near their Q3 FY05 level. We also expect

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    53marginal margin expansion for companies where traditional levers such as

    lower offshore contribution, higher SG&A cost, lower manpower utilization

    etc are available. We therefore expect TCS, Satyam, Hexaware, Mphasis and

    KPIT to register some margin expansion on sequential basis. Sequential net profit growth to be determined by forex gains/losses of

    previous quarter : With the operating margins expected to remain at similar

    levels as in the previous quarter, the sequential net profit growth should be in

    line with the sequential revenue growth. However, this is not expected, as

    some of the companies recorded extreme net forex gains/losses during the

    previous quarter on the back of sharp Rupee appreciation, both on end of

    quarter rate and average quarter rate basis. Therefore the sequential net profit

    growth would be differentiated and company specific in the absence of such

    extreme forex gains/losses during the quarter. Companies such as TCS,

    Infosys and Patni, which recorded sizeable forex gains in the previous quarter

    are expected to post lower sequential net profit growth whereas companies

    like Satyam, Mphasis, Polaris and Geometric, which witnessed forex losses

    in the pervious quarter are expected to record more than proportional

    sequential net profit growth. HCL Tech is expected to deliver superior profit

    performance as the acquisition of minority stake in DSL Software takes full

    effect in the quarter.

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    54

    Some Interesting Facts

    For Indian software companies, the past two years have marked a shift in

    demand from low-end services to high-end ones, like IT consulting, packageimplementation and systems integration. Now, while Indian software

    companies are increasingly facing competition from global MNCs who are

    replicating the Indian off shoring model, the need of the hour is to rapidly

    move up the software value chain.

    Increasingly, the demand for technology is likely to be more guided by the

    'Return on Investment' factor, i.e., how much of cost saving or return on

    investment can be obtained by clients from their IT spending when quality

    execution capabilities is a given attribute.

    As such, large Indian IT companies that have provide a broad range of

    services and have proven capabilities in executing large and complex projects

    are likely to emerge winners. However, to maintain strong growth in the

    long-term, scalability and quality offerings would be the key.

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    55

    A SURVEY ON THE FINANCIAL PERFORMANCE OF IT

    COMPANIES

    FACTS & FIGURES:

    Aggregate revenue growth below expectation; but mid-caps

    outperform large-caps: The aggregate revenues of the companies under

    review were Rs109.21bn in the quarter, representing a growth of 5.5% on

    sequential basis and 32.8% on yoy basis. On segregation of the aggregate

    revenues between Tier-1 and Tier-2 companies it is apparent that the latter

    outperformed the former. The aggregate revenues of Tier-2 companies grew

    6.1% sequentially higher than the 5.4% sequential growth registered by Tier-

    1 companies. During the quarter, some of the Tier-1 companies recorded

    lower volumes with reasons varying between compliance issues at clients

    end (Infosys), delay in client ramp up and deferment (TCS and Wipro) and

    client restructuring. The topline growth of these companies was also hit by

    the lower Rupee rate realized in the quarter on sequential basis due to Rupee

    appreciation. The second rung top tier companies such as Satyam, HCL and

    Patni registered a rather robust sequential revenue growth in the quarter.

    Amongst the Tier-2 companies, the relatively strong group revenue

    performance (compared to Tier 1 players) was led by Mphasis, Mastek and

    KPIT Cummins.

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    56

    Overall margin decline sequentially; dragged by Teir-1 companies: The

    overall operating margin (OPM) declined by 100bps sequentially to 24.8% in

    the quarter. Though any major cost inflating factors (salary hike, etc) were

    absent in the quarter, OPM of most of the companies deterioratedsequentially reflecting the adverse impact of Rupee appreciation (on average

    quarter rate basis) during the quarter. The margin decline was more

    prominent amongst the Tier-1 companies at 120bps (from 27.6% in Q3 FY05

    to 26.4% in Q4 FY05) on aggregate basis with Infosys (reaffirming its cost

    management efficiency) being the only company to have registered an

    improvement at the operating level. TCS and Wipro recorded the steepest

    margin decline. On aggregate basis, the OPM of Tier-2 companies improved

    by 40bps sequentially to 16.8%. To some extent this was anticipated as most

    of these companies had operating margin levers operating at suboptimal level

    before the start of the quarter. I-flex, Mphasis, Felxtronics and Hexaware

    were the companies that recorded OPM expansion in the segment.

    Other income component determining the profitability of some companies:

    As expected, other income (mainly represented by forex gains/loses) played a

    critical role in the quarter with respect to some companies. We anticipated in

    the preview that while TCS profitability would be capped by the absence of

    forex gains, Satyam and Mphasis would be benefited by normalization of

    lower forex gains and loses recorded in Q3 FY05. Inline with our

    expectation, TCSs profitability was materially affected by a forex loss whilethat of Satyam and Mphasis was enhanced by sizeable forex gains. Overall,

    the other income component in the quarter was sequentially lower by 50.1%

    at Rs1.09bn.

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    57

    Upturn in capex cycle increasing depreciation: The higher depreciation

    during the quarter is attributable to continuation of healthy capital spending

    by sectoral companies. The companies, responding to higher visibility, are

    making huge investments in infrastructure thereby ramping up their deliverycapabilities. These investments have started from second half of FY04 after a

    subdued period witnessed in FY02 and FY03.

    Net profit de-grows on sequential basis; but Tier-2 companies put up

    a better show: The aggregate net profit (pre exceptional items) of our

    coverage universe stood at Rs21.59bn, representing a decline of 4.3% on

    sequential basis and a growth of 31.9% on yoy basis. The Tier-1 companies

    led the dismal profit performance in the quarter with TCS being the

    prominent spoilsport. The aggregate net profit of the Tier-2 companies grew

    1.7% on sequential basis to Rs3.46bn whereas the aggregate net profit of

    Tier-1 companies decreased by 4.6% on sequential basis to Rs20.44bn. The

    companies that recorded stellar profitability growth on sequential basis

    include Satyam amongst the Tier-1 companies and Mphasis, I-flex and

    Flextronics amongst the Tier-2 companies.

    Positive bias for billing rate continues: The fourth quarter witnessed

    the positive bias for billing rates continue as these IT companies increasingly

    saw higher than average billing rates from their existing and new clients. The

    strongest growth in rates came for Infosys, which saw its onsite and offshorerates jump sequentially by around 1% each. On the other hand, while there

    was a slight improvement in offshore rates for Wipro, their onsite rates

    declined by around 3% QoQ. Overall, while the change in billing rates has

    not been significant enough to make a major effect on the top line, volumes

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    58have continued to lead the growth in the same (the top line). For instance,

    offshore and onsite volumes for Infosys grew QoQ by 5% and 7%

    respectively. However, the growth in volumes for all the companies was

    relatively lower than what was seen in the previous quarters. Particularly, themanagements of Infosys and TCS have indicated that certain client specific

    issues have led to this marginal slowdown in off shoring volumes in the

    fourth quarter, something that might have an impact on performance in

    1QFY06 as well. 4QFY05 also saw companies report higher utilization

    levels, which were possible fallout of a lower rate of hiring in the quarter.

    Margins under pressure from rupee appreciation: While Infosys

    reported a margin expansion in the quarter and Satyam reported flat margins,

    those for Wipro and TCS contracted. However, if one were to consider

    margins for the full year, all the four companies have reported improvement

    in the same. Increased proportion of revenues coming from offshore services,

    higher utilisation levels and leverage on the SG&A front have been the key

    factors aiding margin expansion in FY05. We believe that these factors will

    continue to help these companies report muted declines in margins going

    forward. However, uncertainty on account of rupee dollar movement will

    also have an impact on the margins. As a matter of fact, every 1%

    appreciation in the value of rupee negatively affects operating margins by 30

    basis points (this is assuming that, on an average, 30% of costs are in rupeeterms).

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    59

    TCS casts pressure on the bottom line: The graph below clearly indicates

    the kind of pressure exerted by TCS on the net profit growth of the

    consolidated entities during the quarter. The company, on account of poor

    operating performance and some extraordinary expenses during the quarter,reported a 34% sequential decline in net profits. If one were to remove the

    TCS figures and consolidates only for the other three companies, the

    sequential net profit growth stands at 10%, from a negative of 7.3% as shown

    in the table above.

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    60

    OUTLOOK FOR FUTURE: Continued outsourcing momentum is expected

    despite muted earnings guidance by Tier - players. IT companies seems to

    have matured to the next phase where they shall strive to get multi million

    dollar orders. IT spending has been rather stable while it is the market shareof Indian vendors that has been increasing. Given the fact that in FY05, as

    many as 400 out of the global 500 corporations resorted to outsourcing in

    some form or the other, up from 300 in FY04 and more are expected to do so

    in FY06. The long-term direction is towards growth are strong . Offshoring

    will remain core engine of revenue growth. Currently the average P/E of

    these four big companies under consideration (TCS, Infosys, Satyam and

    Wipro ) is around 17.8 times expected EPS for FY07. This seems pretty

    attractive from a long-term basis. As mentioned above, while some

    managements have indicated of a sedate growth in 1QFY06, investors should

    not base their decision on the expected performance of just one quarter.

    Looking further ahead, we expect these software services majors to continue

    on the path of a strong growth as the improvement in Indian offshoring story

    strengthens. However, there is a risk to the assumptions. For the sector as a

    whole, the movement on the currency front is likely to be a strong factor that

    could affect profitability in the coming quarters. As seen in recent times, led

    by pressures of a huge current account deficit, the US dollar has resumed its

    depreciation against the Indian rupee and other major global currencies. If

    this were to continue in the future, and that the rupee were to strengthen

    further, profitability of these companies would be impacted. The strongdemand for Indian IT services is expected to continue in FY06 on the back of

    4-5% growth in global IT spending, increasing outsourcing, rising offshore

    penetration (currently just at 2%), increasing instances of break-down of

    larger deals, expansion of offerings etc. This coupled with anticipated stable

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    61 billing rates should lead to robust revenue growth for the sectoral companies.

    However, the key beneficiaries of the above favorable macro trends are

    expected to be the companies with proven track record, diverse portfolio of

    services and efficient delivery capabilities or companies operating andspecializing in niche areas. Though the operating margin in the year would

    come under pressure from salary inflation, increasing investments in SG&A

    and Rupee appreciation, the sector should be able to deliver decent

    profitability growth. NASSCOM expectation is of 30-32% growth. Tough

    call to go by this but really this is one guiding factor.

    Volume: We expect 6-8% Q/Q volume growth with flat pricing and

    broadly flat margins Q/Q. One of the key detrimental factor for the IT sector

    is the Dollar which was volatile for past 1 year seems to have stabilized at

    around Rs.43.50. While the pound has depreciated by 6% and euro by 7%

    this shall have some marginal impact on the earnings however majority of

    orders are booked in dollar terms. This quarter has 64 billed days in

    comparison to 61 billed days in previous quarter indicating higher billed

    revenues. Moreover the September quarter has the highest billing days.

    Billing Outlook: Industry has witnessed new contracts signing at 5

    10% higher prices. But however the blended rates are still low indicating flat

    billing with positive bias. We expect the billing rates to move up in the

    September quarter. Second half we expect the billing rate to rise by around 4-6%. Though the gap between MNC and Indian vendors rates is shrinking we

    still believe there is some room for some expansion.

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    62

    EBIDTA impact: IT industry continues to face wage inflation in the

    offshore space on account of increased hiring and poaching MNC eventually

    pushing up the wage structure. We expect Offshore salary hike to be increase

    by 15 % and Onsite by 10%. This will impact the operating margins by 300 bps. We foresee the industry to higher more fresher rather than laterals which

    can help reduce average cost per employee. We expect the offshore revenues

    and utilization rates they key levers to enhance the EBITA margins. We also

    expect the vendors to offset wage inflation through SG&A Expenses. As the

    vendors gain scale the incremental SG&A cost will be lower. They hall

    leverage the cost cutting in G&A part, which would help offset margins by

    200-250 ps. 1Q 00506 s all bear the brunt of wage inflation but on annual

    basis the pan out well.

    TAX: Tax rate is another concern as many units of Tier I players are

    nearing the end of tax break under Section 10 A/B. However the percentage

    of revenues booked from that unit may not have a major impact on the

    earnings. As in the case of Geometric Software which witnessed marginal

    increase in average tax rate.

    M&A: Balance sheet continues to boast a strong cash position. This

    makes it an ideal ground for M&A activity. As Indian vendors work on

    diversifying their service offerings, they would be seriously looking at

    acquiring companies with niche capabilities and new geographies. Though

    there is sever challenges from the MNCs we believe the Indian vendors are

    set to poise as a sever challenge to those MNC?s. We note that the Infosysmarket cap is marginally lower than Accenture indicating its capabilities to

    take on the big fight. As there are on par they will mature from youth to

    maturity phase where they shall fight for Multi billion dollar contract. i.e.

    Recently won by Satyam (INVISTA is the world's largest integrated fiber,

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    63resin and intermediates company, serving the Apparel, Interiors,

    Intermediates, Performance Fibers, and Polymer and Resins industries) and

    Infosys and TCS (Deutsche bank). The stocks to look out for being Infosys

    and Satyam, TCS amongst the large companies and Hexaware, KPITCummins and Subex , Geometric amongst the small and mid-sized

    companies.

    NATIONAL STOCK EXCHANGE AND CNX IT SECTOR INDEX

    The National Stock Exchange (NSE) is India's leading stock exchange

    covering various cities and towns across the country. NSE was set up by

    leading institutions to provide a modern, fully automated screen-based

    trading system with national reach. The Exchange has brought about

    unparalleled transparency, speed & efficiency, safety and market integrity. It

    has set up facilities that serve as a model for the securities industry in terms

    of systems, practices and procedures.

    NSE has played a catalytic role in reforming the Indian securities market in

    terms of microstructure, market practices and trading volumes. The market

    today uses state-of-art information technology to provide an efficient and

    transparent trading, clearing and settlement mechanism, and has witnessed

    several innovations in products & services viz. demutualisation of stock

    exchange governance, screen based trading, compression of settlement

    cycles, dematerialisation and electronic transfer of securities, securities

    lending and borrowing, professionalisation of trading members, fine-tunedrisk management systems, emergence of clearing corporations to assume

    counterparty risks, market of debt and derivative instruments and intensive

    use of information

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    64

    The Organization

    The National Stock Exchange of India Limited has genesis in the

    report of the High Powered Study Group on Establishment of New Stock

    Exchanges, which recommended promotion of a National Stock Exchange by

    financial institutions (FIs) to provide access to investors from all across the

    country on an equal footing. Based on the recommendations, NSE was

    promoted by leading Financial Institutions at the behest of the Government of

    India and was incorporated in November 1992 as a tax-paying company

    unlike other stock exchanges in the country.

    On its recognition as a stock exchange under the Securities Contracts

    (Regulation) Act, 1956 in April 1993, NSE commenced operations in the

    Wholesale Debt Market (WDM) segment in June 1994. The Capital Market

    (Equities) segment commenced operations in November 1994 and operations

    in Derivatives segment commenced in June 2000.NSE Group

    India Index Services & Products Ltd. (IISL)

    India Index Services and Products Limited (IISL), a joint venture between

    NSE and CRISIL Ltd. (formerly the Credit Rating Information Services of

    India Limited), was set up in May 1998 to provide a variety of indices and

    index related services and products for the Indian capital markets. It has aconsulting and licensing agreement with Standard and Poor's (S&P), the

    world's leading provider of ingestible equity indices, for co-branding equity

    indices.

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    65

    National Securities Clearing Corporation Ltd.(NSCCL)

    The National Securities Clearing Corporation Ltd. (NSCCL), a wholly owned

    subsidiary of NSE, was incorporated in August 1995. It was set up to bringand sustain confidence in clearing and settlement of securities; to promote

    and maintain, short and consistent settlement cycles; to provide counter-party

    risk guarantee, and to operate a tight risk containment system. NSCCL

    commenced clearing operations in April 1996.

    NSE.IT Ltd.

    NSE.IT, a 100% subsidiary of National Stock Exchange of India Limited

    (NSE), is the information technology arm of the largest stock exchange of the

    country. A leading edge technology user, NSE houses state-of-the-art

    infrastructure and skills. NSE.IT possesses the wealth of expertise acquired in

    the last six years by running the trading and clearing infrastructure of largest

    stock exchange of the country. NSE.IT is uniquely positioned to provide

    products, services and solutions for the securities industry. There has been a

    long felt need for top-of-the-line products, services and solutions in the area

    of trading, broker front-end and back-office, clearing and settlement, web-

    based trading, risk management, treasury management, asset liability

    management, banking, insurance etc. NSE.IT's expertise in these areas is the

    primary focus. The company also plans to provide consultancy and

    implementation services in the areas of Data Warehousing, BusinessContinuity Plans, Stratus Mainframe Facility Management, Site Maintenance

    and Backups, Real Time Market Analysis & Financial News over NSE-Net,

    etc.

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    66

    National Securities Depository Ltd. (NSDL)

    In order to solve the myriad problems associated with trading in physicalsecurities, NSE joined hands with the Industrial Development Bank of India

    (IDBI) and the Unit Trust of India (UTI) to promote dematerialization of

    securities. Together they set up National Securities Depository Limited

    (NSDL), the first depository in India.

    DotEx International Limited

    DotEx was formed to provide a world-class internet trading platform which

    allows members of NSE to offer online trading facilities to their customers.