report on fci

7/27/2019 report on fci

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RESEARCH PROJECT REPORT

ON

TRENDS AND FUTURE OF DERIVATIVES IN INDIA

Submitted in partial fulfillment of the requirementfor the award ofDegree of Master of Business Administration

FromGautam BuddhTechnical University, Lucknow

Submitted by

SURENDRA KUMAR SHUKLARoll no: 1112470148

MBA (Batch 2011-13), 4th Semester

Under the guidance of

Dr. NAMITA SRIVASTAVAAssociate Professor

ICCMRT

INSTITUTE OF CO-OPERATIVE & CORPORATE MANAGEMENT,RESEARCH AND TRAINING

21/467, RING ROAD, INDIRA NAGAR, LUCKNOW-226016


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CERTIFICATE

This is to certify that SURENDRA KUMAR SHUKLA, a student of Master ofBusiness Administration (MBA) Programme (batch 2011-13) at this institute has conducted a

research project titled TRENDS AND FUTURE OF DERIVATIVES IN INDIA. under

my guidance during the 4

th

semester. The report has been prepared towards partial fulfillmentfor the award of MBA degree from Gautam Buddh Technical University. The research project

report is the original contribution of the student.

The research project report is hereby recommended and forwarded for evaluation.

Dr. NAMITA SRIVASTAVA

Associate Professor

ICCMRT

Phone: 2716431, 2716092Fax: (0522) 2716092esy [email protected] www.iccmrt.ac.in

Institute of Co-operative & Corporate Management,

Research and Training

467, Sector-21, Ring Road, Indira Nagar, Lucknow-226 016

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DECLARATION

I, SURENDRA KUMAR SHUKLA, a student of Master of Business Administration (MBA)

Programme from the Institute of Co- operative & Corporate Management Research and

Training, Lucknow hereby declare that all the information, facts and figures used in this

research project titled TRENDS AND FUTURE OF DERIVATIVES IN INDIA. have

been collected by me. I also declare that this project report has been prepared by me and the

same has never been submitted by the undersigned either in part or in full to any other

University or Institute or published earlier.

This information is true to the best of my knowledge and belief.

Date: (SURENDRA KUMAR SHUKLA)

Semester IV

Roll No: 1112470148

ICCMRT


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ACKNOWLEDGEMENT

Perseverance, inspiration and motivation have always played a key role in the success of any

venture, but one ingredient which is also very important than other and at times, more

important that other is corporation and guidance of experts and experienced person. A

successful and satisfactory completion of any research is the outcome of the invaluable

aggregate contribution of different persons fully in radical direction, explicitly or implicitly.

Whereas vast, varied and valuable reading efforts leads to substantial acquisition of knowledge

through books and allied informational sources. True expertise excludes from collateral

practical works and experiences.

Words have never seemed as inadequate as now, when we are endeavoring to express our

heartfelt gratitude at the culmination of the research, to all those made it possible. Even the

best effort is waste without proper guidance and advice. I highly solicit to Dr. Namita

Srivastava (Associate Professor) ICCMRT for her unreserved cooperation, encouragement

and sincere advice throughout the research.

At the outset I would like to thanks Prof. Ajay Prakash (Principal) ICCMRT for his

valuable advice and guidance during my research completion.

Last, but not the least, I would like to express my faith in the Almighty, who has given me

strength at every phase of life to stand and excel.


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PREFACE

MBA is a stepping-stone to the management carrier and to develop good manager it is

necessary that the theoretical must be supplemented with exposure to the real environment.

Theoretical knowledge just provides the base and its not sufficient to produce a good manager

thats why practical knowledge is needed.

Therefore the research product is an essential requirement for the student of MBA. This

research project not only helps the student to utilize his skills properly learn field realities but

also provides a chance to the organization to find out talent among the budding managers in the

very beginning. In accordance with the requirement of MBA course I have prepare research

report on the topic Trends and future of Derivatives in India. The main objective of the

research study is to study the various trends that come in the way of Derivatives market and to

find out the future and market potential of derivative market in India.

For conducting the research project sample size of 60 customers, brokers, dealers and investors

were selected. The information regarding the project research was collected through the

questionnaire formed by me which was filled by customers, brokers, dealers and investors

there.

In my research report, I have studied various trends that come in the way of Derivatives

market. Because impression is usually given that losses arose from derivatives are extremely

complex and difficult to understand financial strategies. So after interviewing with different

brokers, investors and dealers, I have tried to give a solution to these complexities


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TABLE OF CONTENT

PAGE NO.

1. CERTIFICATES

2. DECLARATION (I)

3. ACKNOWLEDGEMENT (II)

4. PREFACE (III)

5. CHAPTER 1

INTRODUCTION 1

6. CHAPTER 2

REVIEW OF LITERATURE 64-68

7. CHAPTER 3

OBJECTIVE & RESEARCH METHODOLOGY 69-73

8. CHAPTER 4

DATA ANALYSIS 74-81

9. CHAPTER 5

FINDINGS & RECOMMENDATION 82-84

10.CONCLUSION 85-86

11. ANNEXURE 89-90

QUESTIONNAIRE


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Chapter 1

Introduction


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INTRODUCTION TO THE STOCK EXCHANGE

A stock exchange is the place where securities, shares, debentures and bonds of joint stockcompanies, central & state govt., semi govt. organizations, local bodies and foreign govt. are

bought and sold. A stock exchange is the nerve center of capital market. Changes in the capital

market are brought about by a complex set of factors, all operating on the market

simultaneously. Such changes are subject to secular trends set by the economic progress of the

nation, and governed by the factors like general economic situation, financial and monetary

policies, tax changes, political environment, international economic and financial development

etc. A stock exchange provides necessary mobility to capital and directs the flow of capital into

profitable and successful enterprises.

The Securities Contract (Regulation) Act 1956 defines stock exchange as:

A body of individuals whether incorporated or not, constituted for the purpose of

assisting, regulating or controlling the business of buying, selling, & dealing in securities.

A stock exchange is a platform for the trade of already issued securities through

primary market. It is the essential pillar of the private sector and corporate economy. It is the

open auction market where buyers and sellers meet and involve a competitive price for the

securities.

It reflects hopes aspiration and fears of people regarding the performance of the economy. It

exerts a powerful and significant influence as a depressant or stimulant of business activity. So,

stock exchange mobilizes savings, canalizes them as securities into those enterprises which are

favored by the investors on the basis of such criteria as

- Future growth prospects.- Good returns.

- Appreciation of capital.

\


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The stock exchange serves the role of barometer, not only of the state of health

of individual companies, but also of the nations economy as a whole (it measures of all the

pull and pressure of securities in the market). The trade in market is through the authorized

members who have duly registered with concerned stock exchange and SEBI.

HISTORY OF STOCK EXCHANGE

The trading of securities in India was started in early 1973. The only stock exchange operating

in the 19th century were those of Bombay set up in 1875 and in Ahemdabad set up in 1894.

These were organized as voluntary non-profit making associations of brokers to regulate and

protect their interests. Before the control on securities trading became a central subject under

the constitution in 1950. It was a state subject and Bombay securities contract (control) act of

1925 used to regulate trading in securities. Under this act, Bombay stock exchange was

recognized in 1927 and Ahemdabad stock exchange were organized at Bombay, Ahemdabad

and other centers but they were not recognized soon after it became a central subject, central

legislation was proposed and a committee headed by sh. A.D.GORWALA went into bill for

security regulation. On the basis securities contract act became law in 1956.

At present there were 23 recognized stock exchanges in India. From these

BSE & NSE are the two major stock exchanges and rest 21 are the regional stock

exchanges. Daily turnover of all the stock exchange is app. 20,000cr. BSE is 129 years old.

NSE is 11 years old and it brought the screen based trading system in India


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FEATURES OF THE STOCK EXCHANGE

It is a place where listed securities are bought and sold.

It is an association of persons known as members.

Trading in securities is allowed under rules and regulations of stock exchange.

Membership is must for transacting business.

Investors and speculators, who want to buy and sell securities, can do so through

members of stock exchange i.e. brokers.

There are mainly three participants in stock exchange i.e.

Issuer of security (company).

Investor of security (Individual, HUF).

Intermediaries and products (broker, merchant bankers and shares, bonds,

warrants, derivatives products etc.).

It is the market as well as source for the capital. Corporate and govt. raise resource

from the market.

FUTURE PLANS OF STOCK EXCHANGE

The current market scenario in the capital market is not very encouraging, however, in the

future; the business model of Indian Stock Exchange would be the most preferred method of

accessing multiple markets with low cost and high credibility of an Exchange. Indian Stock

Exchange is considering several value added services or new products which may help ISE and

ISS in fulfilling the demands of low cost users. We are considering derivative segment through

NSE and DP services initially for the participants and later for clients through CDSL and

NSDL. This futuristic concept of consolidation being pursued by ISE is now being also

explored by the Developed Countries. We think such consolidation enables optimal utilization

of existing resources, enhanced due to economies of scale and permit product innovation, a


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sign o any dynamic market. On account of this philosophy we are proposing to implement

most of the new products centrally on ISE, like, Internet trading, IPO segment, Distribution of

mutual funds units, Information dissemination, etc. We are also planning to provide trading

support to the commodities Exchanges and also consider providing hem entry into the

securities industries. The creation of a national market has provided the brokers of the RSEsand individual investors in the regions and opportunity approach the liquid national level

market. This market is expected to provide liquidity in small capital companies as the other

National Level markets have a higher entry norm and may not cater to this market.

FUNCTIONS OF STOCK EXCHANGE

Stock Exchange Performs The Following Functions:

The stock exchange provides appropriate conditions where by purchase and sale of

securities takes place at reasonable and fair prices.

People having surplus funds invest in the securities and these funds used for

industrialization and economic development of country that leads to capital

formation.

The stock exchange provides a ready market for the conversion of existing securities

into cash and vice-versa.

The stock exchange acts as the center of providing business information relating to

enterprise whose securities are traded as the listed companies are to present their

financial and other statements to it.

Stock exchange protects the interest of the investors through strict enforcement of

rules and regulations with respect to dealings. Punishments (including fine, suspension

or even expulsion of membership) may be there if broker make any malpractice in

dealing with investors like charging high commissions etc.

Stock exchange acts as the barometer of the country as it measures all the pulls and

pressures of the securities in the market.

The stock exchange provides the linkage between the savings in the household

sector and the investment in corporate economy.


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STOCK EXCHANGES OF INDIA

Name of Stock Exchange Year of

Establishme

nt

Type of Organization

1. The Stock Exchange Mumbai 1875 Voluntary Non profit org.

2. Ahmedabad Stock Exchange 1897 Voluntary Non profit org.

3. Calcutta Stock Exchange 1908 Public ltd. Company

4. Madhya Pradesh Stock Exchange 1930 Voluntary Non profit org.

5. Madras Stock Exchange Ltd. 1937 Company ltd. By guarantee

6. Hyderabad Stock Exchange Ltd. 1943 Company ltd. By guarantee7. Delhi Stock Exchange Association

Ltd.

1947 Public ltd. Company

8. Bangalore Stock Exchange 1957 Pvt. Converted into public

ltd. Company

9. Cochin Stock Exchange 1978 Public ltd. Company

10. U.P. Stock Exchange Ltd. 1982 Public ltd. Company

11. Pune Stock Exchange Ltd. 1982 Company ltd. By guarantee12. Ludhiana Stock Exchange 1983 Public ltd. Company

13. Guwahati Stock Exchange 1984 Public ltd. Company

14. Magadh Stock Exchange Ass. (Patna) 1986 Company ltd. By guarantee15. Jaipur Stock Exchange Ltd. 1983 Public ltd. Company

16. Bhubaneshwar Stock Exchange 1989 Company ltd. By guarantee

17. SaurashtraKutch Stock Exchange Ltd. 1989 Company ltd. By guarantee

18. Vadodara Stock Exchange Ltd. 1990 N.D19. National Stock Exchange of India

Ltd.

1994 N.D

20. Coimbatore Stock Exchange Ltd. 1996 N.D

21. OTC Stock Exchange of India N.D

22. Mangalore Stock Exchange Ltd. N.D

23. Interconnected Stock Exchange

(ICSE)

N.D


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WHO BENEFITS FROM STOCK EXCHANGE

1. Investors: -It provides them liquidity, marketability, safety etc. of invstments.

2. Company: - It provides them access to market funds, higher rating and public

interest.

3. Brokers: -They receive commission in lieu of services to investors.

4. Economy and Country: - There is large flow of saving, better growth more

industries and higher income.

INTRODUCTION OF DERIVATIVES

Primary market is used for raising money and secondary market is used for trading in the

securities, which have been used in primary market. But derivative market is quite different

from other markets as the market is used for minimizing risk arising from underlying assets.

The word "derivative" originates from mathematics. It refers to a variable,

which has been derived from another variable.

i.e. X = f (Y)

WHERE X (dependent variable) = DERIVATIVE PRODUCT

Y (independent variable) = UNDERLYING ASSET

A financial derivative is a product that derives value from the market of another

product. Hence derivative market has no independent existence without an underlying asset.

The price of the derivative instrument is contingent on the value of underlying assets.

As a tool of risk management we can define it as, "a financial contract whose

value is derived from the value of an underlying asset/derivative security". All derivatives are

based on some cash product. The underlying assets can be:

a. Any type of agriculture product of grain (not prevailing in India)


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b. Price of precious and metals gold

c. Foreign exchange rates

d. Short term as well as long-term bond of securities of different type issued by govt.

and companies etc.

e. O.T.C. money instruments for example loan & deposits.

Example: Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of

change in price by that date. The price of these derivatives is driven from spot price of wheat.

DEFINITION OF DERIVATIVE-

In the Indian context the Securities contracts (Regulation), Act 1956 defines "Derivative" to

include:

(1) A security derived from a debt instrument, Share, Loan whether secured or unsecured,

Risk instrument or contract for difference or any other form of security.

A contract, which derives its value from the prices of underlying securities.

HISTORICAL ASPECT OF DERIVATIVES:

The need for derivatives as hedging tool was first felt in the commodities market.

Agricultural FUTURE & OPTIONS helped farmers and PROCESSORS hedge againstcommodity price risk. After the fallout of BRITAIN WOOD AGREEMENT, the financial

markets in the world started undergoing radical changes, which give rise to the risk factor. This

situation led to development of derivatives as effective "Risk Management tools".

Derivative trading in financial market started in 1972 when "Chicago Mercantile

Exchange opened its International Monetary Market Division (IIM). The IMM provided an

outlet for currency speculators and for those looking to reduce their currency risks. Trading

took place on currency. Futures, which were contracts for specified quantities of given

currencies, the exchange rate was fixed at time of contract later on commodity future contracts

was introduced then followed by interest rate futures.

Looking at the liquidity market, derivatives allow corporate and institutional investors

to effectively manage their portfolios of assets and liabilities through instruments like stock

index futures and options. An equity fund e.g. can reduce its exposure to the stock market and


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at a relatively low cost without selling of part of its equity assets by using stock index futures

or index options. Therefore the stock index futures first emerged in U.S.A. in 1982.

PRODUCTS, PARTICIPANTS AND FUNCTIONS-

Derivative contracts have several variants. The most common are FORWADS,

FUTURES, and OPTIONS AND SWAPS.

The following three categories of Participants-Hedgers, Speculators, and Arbitrageurs.

(1) HEDGER:-

Hedgers face risk associated with the price of an asset. They use futures or

options markets to reduce the risk. Thus, they are operation who wants to eliminate the risk

composing of their portfolio.

(2) SPECULATORS: -

They wish to be on future movements in the price of an asset. A

speculator may buy securities in anticipation of rise in price. If this expectation comes true

he sells the securities at a higher price and makes a profit. Usually the speculator does not

take delivery of securities sold by him. He only receives and pays the difference between

the purchase and sale prices.

(3) ARBITRAGEURS: -

They are in business to take advantage of discrepancy between prices in

two different markets. If for example, they see the future price of an asset getting out of

line with the cash price, they will take off setting positions in two markets to lock in profit.

TYPES OF DERIVATIVES


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The most commonly used derivative contract is forwards, futures and options:

(1) FORWARDS:-

A forward contract is a customized contract between two

entities, where settlement takes place on a specific date in the futures at today's pre-

agreed price.

(2) FUTURES:-Afuture contract is an agreement between two parties to buy or

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

special types of forward contracts in the sense that are standardized exchange traded

contracts.

(3) OPTIONS:-

It is of two types: call and put options.

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 givendate.

(4) LEAPS:

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years. These

long-term option contracts are popularly known as Leaps or Long term Equity

Anticipation Securities.

(5) BASKETS:

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

Options are most popular form of baskets.

(6) SWAPS: These are private agreements between two parties to exchange cash

flows in the future according to a prearrange formula. They can be regarded as

portfolios of forward's contracts. The two commonly used swaps are:

a) INTEREST RATE SWAPS:


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These entail swapping both Principal and interest

between the parties, with the cash flow in one direction being in a different currency

than those in the opposite direction.

b) CURRENCY SWAPS:

These entail swapping both Principal and

interest between the parties, with the cash flow in one direction being in adifferent currency than those in the opposite direction.

Cash Vs Derivative MarketThe basis differences between these two may be noted as follows.

a) In cash market tangible asset are traded whereas in derivatives market contract based on

tangible assets or intangible like index or rates are traded.

b) The value of derivative contract is always based on and linked to the underlying asset.

Though, this linkage may not be on point-to point basis.

c) Cash market contracts are settled by delivery and payment or through an offsetting

contract. The derivative contracts on tangible may be settled through payment and

delivery, offsetting contract or cash settlement, whereas derivative contracts on

intangibles are necessarily settled in cash or through offsetting contracts.

d) The cash market always has a net long position, whereas the net position in derivative

market is always zero.

e) Cash asset may be meant for consumption or investment. Derivatives are used for

hedging, arbitration or speculation.

f) Derivative markets are highly leveraged and therefore could be much more risky.


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THE DERIVATIVE MARKETS PERFORM A NUMBER OF

ECONOMIC FUNCTIONS:-

(1) Prices in organized derivative markets reflect the perception of market participants

about the future and lead the prices of underlying to 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 current prices.

(2) The derivative market helps to transfer the risks from those who have them but may

like them 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 derivative, the underlying market, witness higher trading

volumes because of participation by more players who would not otherwise participate

for lack of an arrangement to transfer risk.

(4) Derivatives have a history of attracting many bright, creative, well-educated people

with an entrepreneurial attitude. They often energize others to create new business,

new products and new employment opportunities, the benefits of which are immense.

(5) Derivatives market helps increase savings and investments in the long run Transfer of

risk enables market participants to expand their volume of activities.

PARTICIPANTS IN DERIVATIVE MARKET

Exchange, trading members, clearing members.

Hedgers, arbitrageurs, speculators.

Clearing, clearing bank.

Financial institutions.

Stock lenders and borrowers.


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OBJECTIVES OF DERIVATE TRADING

(1) HEDGING:

You own a stock and you are confident about the prospects of the

company. However at the same time you feel that overall market may not perform as goodand therefore price of your stock may also fall in line with overall marked trend.

You expect that some adverse economic or political event might affect the

market sentiments, though fundamentals of the company will remain good, therefore, it is good

to retain the stock.

In both these situations you would like to insure your portfolio against any such market fall.

Such insurance is known as hedging.

Hedging is a tool to reduce the inherent risk in an investment. Various

strategies designed to reduce investment risk using call option, put options, short selling, and

futures are used for hedging. The basic purpose of a hedge is to reduce the risk of loss.

(2) ARBITRAGE:

The future price of an underlying asset is function of spot price and cost of carry adjusted for

any return on investment. However, due to uncertainty about interest rates, distortions in spot

prices, or uncertainty about future income stream, prices in futures market may not truly reflectthe expected spot price in future. This imbalance in future and spot price gives rise to arbitrage

opportunities. Transactions made to take advantage of temporary distortions in the market are

known as arbitrage transactions.

(3) SPECULATION:

You may have very strong opinion about the future market price of a particular asset based on

past trends, current information and future expectation. Likewise you may also have an opinion

about the overall market trend. To take advantage of such opinion, individual asset or the entire

market (index) could be sold or purchased.

Position taken either in cash market of derivative market on the basis of

personal opinion is known as speculation.


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DERIVATIVE TERMINOLOGY

ASSIGNMENT:

It means allocation of an option contract, which is exercised, to a short

position in the same opinion contract, at the same strike price, for fulfillment of the obligation,

in accordance with the procedure specified in by the relevant authority from time to time.

BADLA:

It is an indigenous mechanism of postponing the settlement of trade. This product

is peculiar to India markets. This involves Badla financiers, stock lenders and stock traders.

The long buyers and short sellers may postpone settlement of their trade by making payments

and giving delivery by using the services of Badla financiers and stock lenders who assume

their positions for Badla charges. Counterparty risk, unpredictable charges and high risk due to

inadequate margining are inherent limitations of Badla.

BASIS:

It is difference between spot price and future price of the same asset. In normal

markets this basis is always negative, i.e. spot price is always less than future price. A positive

basis provides for arbitrage opportunity.

BETA

It is a measure of the sensitivity of returns on scrip to return on the market index. It

shows how the price of scrip would move with every percentage point change in the market

index.

CONTRACT VALUE- It is the value arrived at by multiplying the strike price of the

option contract with the regular/market lot size.

EXERCISE:


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It is defined as the number of future or option contracts required be buying or

selling per unit of the spot underlying position to completely hedge against the market risk of

the underlying.

MARGIN:

It is the money collected from parties to trade to insure against the default risk.

Some amount of margins is collected upfront and some are collected shortly after the trade.

Failure to pay margins may result in mandatory closure of position.

OFFSETTING CONTRACT:

New matching contract, which offsets an existing contract, is known as

offsetting contract.

OPTION PREMIUM:

It is consideration paid by the option buyer to option writer. The

premium has two components intrinsic value and time value. Intrinsic value is the difference

between the spot price of the underlying and exercise price of the contract. Time value

represents the cost of carrying the underlying for the option period, adjusted for any dividend

and option premium.

RISK TRANSFER:

It refers to hedging against the price risk through futures. The holder

of an asset, which he intender to sell in near future, may transfer the inherent risk by selling

futures today. The counterparty assumes the risk in anticipation of making gain

REASON FOR STARTING DERIVATIVES


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1. Counter party risk on the part of broker, in case it asks money from us but before giving

delivery of shares goes bankrupt.

2. Liquidity risk in the form that the particular scrip might not be traded on exchange.

3. Unsystematic risk in the form that the price of scrip may go up or down due to Company

Specific Reasons.

4. Mutual funds may find it difficult to invest the funds raised by them properly as the scrip in

which they want to invert might not be available at the right price.

6. Systematic risk in the form that the price of scrip may go up or down due to reason

affecting the sentiment of whole market.

THE REQUIREMENTS FOR SETTING UP FUTURE AND OPTION

TRADING IS OUTLINED BELOW:-

1. Creation of an Options Clearing Corporation (OCC) as the single guarantor of every

traded option. In case of default by a party to a contract, the clearing house has to bear

the cost necessary to carry out the contract.

2. Creation of a strong cash market (secondary market). This is because after the exercise

of an option contract, the investors move to the secondary market to book profits.

3. Creation of paper-less trading and a book-entry transfer system.

4. Careful selection of the securities may be listed on a National securities exchange, have

a wider capital base, be actively traded, and so on.

5. Uniformity of rules and regulation in all the stock exchanges.

6. Standardization of the terms governing the options contracts. This would decrease the

transaction costs, for a given underlying security, all contracts on the options exchange

should have an expiry date, a strike price, and a contract price, only the premium

should be negotiated on the floor of the exchange.

7. Large, financially sound institutions, members and a number of market makers, who

can write the options contracts. Strict capital adequacy norms to be laid out and

followed.


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STRENGTH OF INDIAN CAPITAL MARKET FOR

INTRODUCTION OF DERIVATIVES

1. LARGE MARKET CAPITALIZATION:

India is one of the largest market capitalized country in Asia with amarket capitalization of more than 7,65,000 corers.

2. HIGH LIQUIDITY:

In the underlying securities the daily average traded volume in Indian

capital market today is around 7,500 crores. Which means on an average every month 14%

of the country market capitalization gets traded, shows high liquidity.

3. TRADER GUARANTEE:

The first "clearing corporation" (CCL) guaranteeing trades has

become fully functional from July 1996 in the form of NATIONAL SECURITIES

CLEARING CORPORATION Ltd. for which it does the clearing.

4. STRONG DEPOSITORY:

A strong depository National Securities Depositories Ltd.(NSDL), which

started functioning in the year 1997, has strengthen the securities settlement in our country.

5. A GOOD LEGAL GUARDIAN:SEBI is acting as a good legal guardian for Indian Capital market.

IMPORTANCE OF DERIVATIVE TRADING


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1. Reduction of borrowing cost.

2. Enhancing the yield on assets.

3. Modifying the payment structure of assets to correspond to investor market view.

4. No physical delivery of share certificate so reduction in cost by stamp duty.

5. Increase in hedger, speculator and arbitrageurs.6. It does not totally eliminate speculation, which is basic need of Indian investors.

INSTRUMENTS OF DERIVATIVE TRADING:-

FORWARD

Derivative FUTURE

OPTION

SWAPS

FORWARD CONTRACT:-


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"It is an agreement to buy/sell an asset on a certain future date at an agreed price".

The two parties are:

Who takes a long position agreeing to buy

Who takes a short positionagreeing to sell

The mutually agreed price is known as "delivery price" or "forward price". The

delivery price is chosen in such a way that the value of contract for both parties is zero at the

time of entering the contract, but the contract takes a positive or negative value for parties as

the price of underlying asset moves. It removes the future price risk. If a speculator has

information or analysis, which forecast an upturn in price, and then be can go long on the

forward market instead of cash market.

The speculator would go long on the forward, wait for the price to rise, and then

take a reversing transaction to book profits. Speculator may well be required to deposit amargin upfront. However, this is generally a relatively small proportion of the value of assets

underlying the forward contract.

EFFECT OF CHANGE IN PRICE:

As mentioned above the value of such a contract in zero for both the parties.

But later as the price & the underlying asset changes, it gives positive or negative value for

contract.

PRICE & UNDERLYING

ASSETS

HOLDER & LONG

POSITION

HOLDER & SHORT

POSITION

INCREASE DECREASE POSITIVE VALUE

NEGATIVE VALUE

NEGATIVE VALUE

POSITIVE VALUE

E.g.


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A agrees to deliver 100 equity shares of Reliance to B on Sept. 30, 2002 at a Rate of

Rs. 120 per share. Now if the price of share on that date is Rs. 140 per share, than a who has

short position would stand to loss of Rs. (20*200) = 4000, long position would gain the same

amount or vise versa if price quoted is less than delivery price.

Profit/Loss = ST-E

ST = spot price on maturity dateE = delivery price

LIMITATIONS OF FORWARD CONTRACT:-

1. No standardization.

2. One party can breach its obligation.

3. Lack of centralization of trading.

4. Lack of liquidity.

To overcome this other type of derivation instrument known as "Future Contracts"

were introduced.

VALUATION OF FORWARD CONTRACT-

The forward contract can be put under three categories for the purpose & valuation:

VALUATION OF THOSE SECURITIES PROVIDING NO INCOME-

Shares, which neither expects to do not pay any, dividend in future nor having arbitrage

opportunities.

E.g. Here Price (F) = S0ert

Where F = Future Price

S0 = spot price of asset

R = risk free rate of interest p.a. with continuous compounding

T = time of maturity.

If F>S0ert


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In this case the investor will buy asset and take a short position in the forward contract.

"Short position is not position of investor is of seller means contract sold is greater then

contract bought".

Investor may buy the assets, borrowing an amount equal to * * for "t" period at risk free rate.At the time of maturity, the assets will be delivered for price F and repayment will be equal to

S0ert and there is net profit equal to F- S0e

rt

If F< S0ert

He will long his position in forward contract. When contract matures: the assets

would be purchased for "F" Here profit is S0ert F

E.g.

Consider a forward contract were non-dividend shares available at Rs, 70 mature in 3

months, Risk free rate 8% p.a. compounded continuously.

S0ert = 70 x [e] 0.25x0.08

= 70 x 0202

= Rs. 71.41

If F = 73

Then an arbitrageur will short a contract, borrow an amount of Rs. 70 & buy share at Rs,

Repay the loan of Rs. 70. At maturity sell it as Rs. 73 (forward contract price) and 71.40, thus

profit is (73- 71.40) 1.60

Thus he shorts his forward contract position.


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SECURITIES PROVIDING A CERTAIN CASH INCOME-

If there is certain cash income to be generated on securities in future to the investor, we will

determine present value of income e.g. in case of preference share.

Present Value of Dividend = Rate & Interest (continuously compounded)

~If there is no arbitrage

Then F = (So I) ert

~If F> (So I)ert

Arbitrageur can short a forward contract, borrow money and buy the asset at present

and at maturity asset is sold and earns profit.

Profit = F (So I) ert

If

F


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VALUATION & FORWARD CONTRACT PROVIDING A KNOWN

YIELD:-

In case of share included in portfolio companies the index, as

underlying assets, are expected to give dividend in course of time, which may be percentage 0

their prices. It is assumed to be paid continuously at a rate of "Y" p.a.

F = Soert

E.g.

Stock underlying an under provide a, dividend yield of 4.1% p.a., current value of

index is 520 and risk free rate of interest is 10% p.a.

r=0.10, y = 0.04, * * = 520 T =3/12 =0.25

F = 520xe(0.10-0.40) (0.25)

= 520x01512 = Rs. 527.85

FUTURE CONTRACT

'It is an agreement between buyer and seller for the purchase and sale of a particular assets at a

specific future date; specific size, date of delivery, place and alternative asset. It takes

obligation on both parties to fulfill the contract.

FEATURES OF FUTURE CONTRACT:-

1. Standardized contracts e.g. contract size.

2. Between two parties who do not necessarily know each other.

3. Guarantee for performance by a clearing corporation or clearing house. Clearinghouse

is associated with matching, processing, registering, confirming setting, reconciling and

guaranteeing the trades on the future exchanges. Clearinghouse tries to eliminate risk of

default by either party.

4. It has some features of Badla also.


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FUTURE TERMINOLOGY

SPOT PRICE:

The price at which an asset trades in the spot market.

FUTURES PRICE:

The price at which the futures contract trades in the futures market.

CONTRACT CYCLE:

The period over which the contract trades. The index futures contracts on

the NSE have one month, and three-month expiry Cycles, which expires on the last Thursday

of the month? Thus a January expiration contract expires on the last Thursday of the January.On the Friday following the last Thursday, a new contract having three-month expiry is

introduced of trading.

EXPIRY DATE:

It is date specified in the futures contract. This is the last day on which the

contract will be traded, at the end of which it will cease to exist.

CONTRACT SIZE:

The amount of asset that has to be delivered less than one contract. Forinstance, the contract size on NSE's futures market is Nifties.

BASIS:

In the contract of financial futures, basis can be defined as the futures price minus

the spot price. There will be a different basis for each delivery month for each contract. in a

normal market, basis will be positive. This reflects that futures prices normally exceed spot

prices.

COST OF CARRY:The relation between futures price and spot price can be summarized in

terms of what is known as cost of carry. This measures the storage cost plus the interest that is

paid to finance the assets less the incomes earned on the asset.


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INITIAL MARGIN:

The amount that must be deposited in the margin account at a time a

future contract is first entered into is known as initial margin.

MARKING-TO-MARKET:

In the futures market, at the end of each trading day, the margin

account is adjusted to reflect the investor's margin gain or loss depending upon the future's

closing price.

MAINTENANCE MARGIN:

This is somewhat lower than initial margin. This is set to ensure that

the balance in the margin account never becomes negative. If the balance amount falls below

the maintenance margin, the investor receives a margin call and is expected to top up the

margin account to the initial margin level before trading commences on the next day.

INSTRUMENTS OF FUTURE CONTRACTS

COMMODITY FUTURES-

1. Trader in American Exchanges like CBOT, New York: Commodity Exchange,

Chicago Mercantile Exchange (CLEARING MEMBERSE), New York Mercantile

Exchange Includes: Wheat, Natural Gas, Platinum, Gold, and Cattle etc.

2. Contract Life: Mostly for 90 days or less.

3. Maturity date is mostly non-standardized.

4. Quality specified


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FINANCIAL FUTURES

1. Introduced by IMM (a division of CLEARING MEMBERSE) It Includes: 10 or 5 year

treasury notes (in 1976 by I:M:M), S & P 5000, Nikkie 225, Euro Dollars, British

Pound, Canadian Dollars, Mini Value line Stock Index,

Russell 2000, Russell 3000, etc.

2. Mostly Longer time e.g. US Treasury Bond Futures are of even more than 2 years

3. Maturity date is standardized.

4. There cannot be any quality variations into these assets.

TYPE OF FUTURE CONTRACTS:

INDEX FUTURES & STOCK FUTURES

INDEX FUTURES:

Of the financial futures, Index future contracts are key contracts,

introduced in U.S. A, in 1982 by the "Commodity Futures Trading Commission" (CFTC) by

approving the Kansas Board proposal. Index Futures began trading in India in June 2000 of

Trade (KSBT)'s Futures derive its value from the underlying index-e.g. NSE's futures.

Contracts are based on "S & P CNX NIFTY"

At present it has become the most liquid contract in the country, the arbitrage between

the futures equity market is further expected to reduce impact cost. 80-90% of retail

participation is expected in India because.

1. Brokerage cost is lower.

2. Savings in cost is possible thorough reduced bid-ask spreads where stocks are trade in

package forms.


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3. Impact cost will be much lower than dealing in individual scrip.

4. Institutional and large equity holders need portfolios hedging facility. Index derivatives

are more suited to them and more cost effective than in individual stocks. Pension funds

in the US are known-to use stock index futures for risk hedging purpose.

5. Stock Index is difficult to manipulate as compared to individual stock prices, more so inIndia, and the possibility of cornering is reduced.

6. Stock index, being an average is much less volatile than individual stock prices. This

implies lower capital adequacy and margin requirements.

7. Index derivatives are cash settled, and hence don't suffer from settlement delays and

problems related to bad delivery & forged certificates.

INDIVIDUAL STOCK FUTURES

The high level committee on capital market on 2001 decided to permit FII's to participate in

"Individual Stock Futures" trading e.g. in Reliance SEBI Frame guidelines for its trading stock

futures can be effectively used for hedging: speculation and arbitrage At present there are 31

scrips in which stock derivatives are trading. E.g. the Reliance stock traders at Rs. 1000 and the

two month futures trade at 1006. Assume that the minimum contract value is Rs. 1,00,000. He

buys 100 Individual stock futures for which he buys a margin of Rs. 20,000. 2 months later the

stock closes at Rs. 010. OR expiration date, he makes a profit of Rs. 400 on an investment of

Rs. 20,000 works out annual return of 12%.

VALUATION OF FUTURES CONTRACTS

It can be made possible on following basis:

1. Valuation of financial futures

2. Valuation of commodity futures

I. Carry type commodities

II. Non-Carry type commodities


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VALUATION OF FINANCIAL FUTURES:

Valuation of financial futures is based on following assumptions1. The markets are perfect.

2. There is no transaction cost.

3. All the assets are infinitely divisible.

4. Bid-asks spreads do not exit so that it is assumed that only one price prevails.There is

no restriction on short selling. Also short selling gets to use the full proceeds of the

sales valuations. This includes stock index futures.

The value of futures contract on a stock index may be obtained by using the

"cost of carry model".

In this case Price of the contract is = spot price+ Carry cost-carry returns i.e. (s + C R)

Here: SPOT PRICE:Current Price of One Unit of Deliverable asset in the Market.

CARRY COST: Holding cost i.e. interest Charges etc. + opportunity cost of using

funds.

CARRY RETURNS: Dividends etc.

Valuation of Stock Index futures is F = S0e(r-y) t


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COMMODITY FUTURE'S VALUATION

1) CARRY TYPE OR INVESTRADING MEMBERSENT PURPOSE

COMMODITIES VALUATION-

These types of commodities are held by significant

number. Of investor for futures safety as investment alone.

~If storage cost is zero then F = Soert

~If any storage cost or opportunity cost then it is regarded as negative income. If S is the

present value.

of all the storage costs that may be incurred during the life of a future contract then F = (So +

s)ert

~If the storage cost were proportional to price of commodity then would be the same as in case

of

Providing a negative yield. If S represents the storage costs p.a. proportion of spot

prices, we have

F = Soe(r+s) t E.g. Let us consider a 6 months gold futures contract of 100 gm.

Assume that the spot price is Rs. 480 per gram and that it cost Rs. 3 per gram for the 6 monthly

period to store gold and that the cost is incurred at the end of the period. If the risk free rate of

Interest is 12% p.a. compounded continuously then R=0.12, s=480 x 100= 48000, e = 6/12 =

0.5

S=3 x 100 e-(0.12 x 0.5) = Rs. 282.53

Then F (48000 282.53)e-0.12 = Rs. 54,438.40

2) NON CARRY TYPE COMMODITITES:

Consumable goods like agricultural product's

futures price will not exceed the sum of spot price + Caring Cost-Caring Returns, in these

arbitrage arguments doesn't work investor stores these on because of its consumption value


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only not for investment. Valuation of non-carry commodity futures requires another concept.

i.e. "Convenience return" or "Convenience yield", which is the returns (in terms of money) that

the investor realizes for carrying commodity over his short term needs. The financial assets

have no convenience return. This is different or different investor.

F= (So +s) e (r-c) t

S= P.V.C=convenience cost

So=Spot price

PAY OFF FOR FUTURES:

(a) Payoff for buyers of futures contract-long futures

Its payoff is same as payoff of a person who holds assets.

Result of holding an asset may be unlimited upside or unlimited downside.

Profit

1220

Nifty (underlying)

Assets

Loss

INTERPRETATION-

The figure shows P/L for a long futures position. The investor bought futures when THE

INDEX WAS AT 1220.

If Index His futures position shows profits

If Index His futures position shows losses


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(b) Payoff for seller of futures contract-short futures-

It can be explained by taking an example:

A speculator who sells a 2 months Nifty Index futures contracts when the nifty stands at 1220

(Nifty an underlying assets)

Profit

Nifty (underlying assets)

Loss

INTERPRETATION:

When Index moves Seller start making Profits.

When index movers. Seller starts making Loss.


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FORWARD VS. FUTURES

Features Forward Future

-Operational Traded between Trade onMechanism two parties Exchange

-Contract Differ from Standardized

Specifications traded to trade contracts

-Counter party exists such No such

Risks risk risk

-Liquidity Low High

-Price Not Highly

Discovery Efficient Efficient

-Example Currency Market Future Market

-Settlement At end of period daily


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COBOT WHEAT FUTURES CONTRACT SPECIFICATIONS

Trading Unit

Deliverable Grades

Price Quotation

Tick Size

Daily Price Limit

Contract Months

Contract Year

Last Trading day

Last Delivery Day

Trading Hours

5000 Bushels

No. 1 Northern Spring wheat at par and No. 2

Soft. Red, No. 2 Hard Red Winter, No. 2

Dark Northern Spring and substitution at

different established by the exchange.

Cents and quarter-cents bushel ($12.50 per

contract.)

One-quarter cent per bushel ($12.50 per

contract)20 cent per bushel ($1000 per contract) above

or below the previous day's settlement price

(expandable to 30 cent per bushel) No limit

in the spot month (limit are lifted two

business day before the spot month begins.)

March, May, July, September and December.

Starts in July and ends in May

Seventh business day preceding the last

business day of the delivery month.

Last business day of the delivery month

9.30 to 1.15 p.m (Chicago time!, Monday

through Friday, Only the last trading day of

an expiring contract, trading that contract

closes in noon.

W


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Ticker Symbol

OPTIONS

Options are fundamentally different from forward and futures. An option gives the

holder/buyers of the option the right to do something. The holder does not have committed

himself to doing something. In contrast, in a forward or futures contract, the two parties have

committed them self to doing something. Whereas it nothing (expect margin requirement) to

enter in to a futures he purchases of an option require an up front payment.

HISTORICAL BACKGROUND OF OPTION:

Although options have exercised for a long time, they were traded OTD, without much

knowledge of valuation. Today exchange-traded options are actively traded on stocks, stock

indices, foreign currencies and futures contracts.

The first trading is options began in Europe and U.S. as early

as the century. It was only in early, 1900s that a group of firms set up what is known as the

"put and call brokers and dealers association" with the aim of providing a mechanism for

bringing buyers and sellers together. It someone wanted to buy an option, he or she would

contract one of the member firms. The firm would then attempt to find a seller or writer of

option either from its own client of those of other member firms. If no seller could be found,

the firm would undertake to write the option itself in return of price. The two deficiencies in

above markets were

1. No secondary market

2. No mechanism to guarantee the writer of option would honor it


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In 1973, Black, Marton, Scholes invented the Black-Scholes

formula. In April 1973, CBOE was set up specially for the purpose of trading options. The

market for options develop so rapidly that by early 80's number of share underlying the options

contract sold each day exceed the daily volume of share traded on the NYSE. Since then, therehas been no looking back.

What is option?

An options is the right, but not the obligation to buy or sell a specified amount (and quality) of

a commodity, currency, index or financial instruments a to buy or sell a specified number of

underlying futures contracts, at a specified price on a before a give date in the future.

Thus, option like futures, also provide a mechanism by which one can

acquire a certain commodity on other assets, or take position in order to make profits or cover

risk for a price. In this type of contract as well, there are two parties:

(a) The buyer (or the holder, or owner of options)

(b) The seller (or writer of options)

While the buyer takes "long position" the seller take "short position"

So every option contract can either be "call option" or "put option" options

are created by selling and buying and for every option that is buyer and seller.

OPTION

BUYER SELLER

RIGHT OBLIGATION

TO BUY TO SELL TO SELL TO BUY

(CALL) (PUT) (CALL) (PUT)


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OPTION TERMINOLOGY

Buyer of an option: the buyer of an option is the one who by paying the option

premium buys the right but not the obligation exercise his option on the seller/writer.

Writer of an option: the writer of a call/put option is the one who receives the option

premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Option price: option price is the price, which the option buyer pays to the option seller.

It is also referred as option premium.

Expiration date: the date specified in the options contract is known as expiration date,

the exercise date, the strike date or the maturity.

Strike price: the price specified in the options contract is knows as strike price or the

exercise price.

American options: these are the options that can be exercised at any time up to the

expiration date. Most exchange-traded options are Americans.

European options: these are the options that can be exercised only on the expiration

date itself. These are easier or analyze than American option, and properties of

American options are frequently deducted from those of its European counterpart.

In the money option: an in the money option is an option that would lead to a positive

cash flow to the holder if it will exercise immediately. A call option in the index is setto be in-the-money when the current index stands at a level higher than the strike price

(i.e. spot price>strike price). If the index is much higher than the strike price,

The call is set to deep I TRADING MEMBERS. In the case of a put, the put is

ITRADING MEMBERS if the index is below the strike price.

At-money option: (ATRADING MEMBERS) option is an option that would lead to

zero cash flow if it were exercised immediately. An option on the index is at-the-money

when the current index equals the strike price.

Out-of-the money option :( OTRADING MEMBERS) option is an option that would

lead to a negative cash flow it was exercised immediately. A call option on the index is

OTRADING MEMBERS when the current index stands at a level, which is less than

the strike price (spot price


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the call is set to be deep OTRADING MEMBERS. In the case of a put, the put is

OTRADING MEMBERS if the index is above the strike price.

Intrinsic value of an option: the option premium can be broken into two components-

intrinsic values and time value. The intrinsic value of a call is the amount the option isITRADING MEMBERS, if it is ITRADING MEMBERS. If the call is OTRADING

MEMBERS, its intrinsic value is zero.

Time value of an option: it is a difference between its premium and its intrinsic value.

Both calls and puts have time value. An option that is OTRADING MEMBERS or

ATRADING MEMBERS has only time value. Usually the maximum time value exists

when the options is ATRADING MEMBERS. The longer the time to expiration, the

greater is an option's time value, all else equal. At expiration, an option should have no

time value.

TYPES OF OPTIONS

Thus the options are of two types: CALL OPTION AND PUT OPTION.

CALL OPTION:

It gives an owner the write to buy a specified quantity of the underlingassets at a predetermined price i.e. the exercise price, or the specific date i.e. is the date of

maturity.

EXAMPLE

Suppose it is January now and the investor buys a March option contract on

Reliance Industries (RIL) Share with an exercise price/strike price Rs. 210. With this he get a

right to buy share on a particular date in March, of course he is under no obligation.

Obviously, if at the expiry date the price in market (spot price on expiry

date) is above the exercise price he'll exercise his option and reverse is also true.

PUT OPTION:

It gives the holder the right to sell a specific quantity of underlying assets at an agreed

price on date of maturity he gets the right to sell.


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EXAMPLE

If an investor buys a March Put Option on RIL shares with an

exercise price of Rs. 210 per share the investor get the right to sell 100 share @ 210 per share.The investor would naturally exercise his right if on maturity date price were below 210 and

stand to gain and vice-versa. Buying out options is buying insurance. To buy a put option on

Nifty is to buy insurance: which reimburses the full extent to which-Nifty drops below the

strike price of the put option. This is attractive to many people.

AMERICAN Vs EUROPEAN OPTION:-Its owner can exercise an American option at any time on or before the expiration date. A

European style option gives the owner the right to use the option only on expiration date and

not before.

OPTION PREMIUM:-

A glance at the rights and obligation of buyer and seller reveals that option contracts are

skewed. One way naturally wonders as to why the seller (writer) of an option would always be

obliged to sell/buy an asset whereas the other party gets the right? The answer is that writer of

an option receives, a consideration for

Undertaking the obligation. This is known as the price or premium to the

seller for the option.

The buyer pays the premium for the option to the seller whether he

exercise the option is not exercised, it becomes worthless and the premium becomes the profit

of the seller.

Premium/Price of an option = Intrinsic Value + Time Value

Do Nothing

Option to option holder Close out the position by write a, matching

call option or it in case of writer.

Exercise the option.


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IN-THE-MONEY AND OUT-THE-MONEY OPTIONS:-

Condition Call Put

So>E In the money Out of the money

So


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Option-to-option holder in case ofHe opt for expiry date.

i.e How Option Work:-

CALL OPTION WORK

Spot Nifty: 1100Strike Price: 1150Duration: 3 monthsNo. of option bought=200Premium per option: 10Total premium paid=2000

Day90

Spot Nifty: 1200Buyer exercise the optionProfit: No. of option x priceDifferential-Premium paid=Rs.(200x (1200-1150)-2000=Rs.8000)

Spot Nifty: 1000Buyer foregoes the optionLoss premium paidRs. 2000

Day 1


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PRICING OF OPTION

AT EXPIRATION BEFORE EXPIRATION

Call option Put option Put option Call option

At expiration Before expiration At expiration Before

expiration

1- AT EXPIRATION

(a) Call option pricing at expiration:

If the price of the underlying asset were lower than the exercise

price on the expiration date, the call would expire unexercised. This is because no one would

like to buy an asset, which is available in the market at a lower price. If an out of money call

did actually sell for a certain price, the investor can make an arbitrage profit by selling it and

earning premium.The buyer is unlikely to exercise option, the allowing seller to

retain premium. In even of (irrational) exercise of such a call, writer can purchase asset as S 1

and give it at making a profit of (E+S1) + premium.

On the other hand, if the call happens to be in the money, it'll, be

worth its intrinsic value, equal to excess of asset price over the exercise price. If call price


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VALUE OF CALL OPTION:-

Value

E Price of share

Put option at expiration:

When at the expiration date the price of the underlying asset is

greater than exercised price, the put option will go unexercised. This is because there is no use

of using option to sell at E when If the option were exercised, it would have resulted in a profit

to seller of option of about (E-S1) + premium.

When S1


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2. BEFORE EXPIRATION:

Before expiration, the options call and put are usually sold for at least intrinsic valued

(difference of E & S1).

(a) Call Option Pricing:

A call option will usually sell for at least its intrinsic value,

Minimum value of call is always is equal to its intrinsic value. Intrinsic value = S>E

To this would be added the time value, if any longer the time expiry, greater were time value.

P=f (E, S, T)

Y

Price of Call option

Intrinsic Value

E Stock Price X

In figure intrinsic value is shown, by, a 45 0 line starting at E, equal to the

excess of stock price over the exercise price.

At Stock price S 2, Call Option pence is out- of-the money i.e. zero intrinsic

value then option price=S2B= only time value

450


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(c) Put Option Pricing

It would sell for a price that is at least equal to intrinsic value,

which is excess of exercise price over stock price, when option is in the money.

For in the money Put Option i.e. SE, E,S = 0P=Time Value because intrinsic value = 0

B Time value

Price of put option

Value

Intrinsic B1 Time Value

Stock prices

S1 E S2


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DERIVATIVES TRADING 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 members committee under the Chairmanship of Dr.

L.C. Gupta on 18th November, 96 to develop appropriate regulatory framework for derivatives

trading in India. The committee submitted its report on 17th March, 98 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 SCRA was amended in Dec. 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 derivative shall be legal and valid only it such contract

are traded on a recognized stock exchange, thus precluding OTC derivative.

The government also rescinded in March 2002, 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 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 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 index

options commenced in June 2001. Futures contracts on individual stocks were launched in


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November 2001. Trading and Settlement in derivatives contracts is done in accordance with

the rules, bye-laws, and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI and notified in the official gazette.

Thus, the following five types of Derivatives are now being traded in the India Stock

Market.

* Stock Index Futures* Stock Index Options

* Futures on Individual Stocks

* Options on Individual Stocks

* Interest Rate Derivatives

INDEX FUTURES:

Index futures are financial contracts for which the underlying is the

cash market index like the Sensex, which is the brand index of India. Index futures contract is

an agreement to buy or sell a specified quantity of underlying index for a future date at a price

agreed Upon between the buyer and seller. The contracts have standardized specifications like

market lot, expiry day, tick size and method of settlement.

INDEX OPTIONS:

Index Options are financial contracts whereby the right is given

by the option seller in consideration of a premium to the option buyer to buy or sell the

underlying index at a specific price (strike price) on or before a specific date (expiry date).

STOCK FUTURES:

Stock Futures are financial contracts where the underlying asset is an

individual stock. Stock futures contract is an agreement to buy or sell a specified quantity of

underlying equity share for a

Future date at a price agreed upon between the buyer and seller. Just like Index derivatives, the

specifications are pre-specified.STOCK OPTIONS:

Stock Options are instruments whereby the right of purchase and

sale is given by the option seller in consideration of a premium to the option buyer to buy or


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sell the underlying stock at a specific price (strike price) on or before a specific date (expiry

date).

INTEREST RATE DERIVATIVES:

The derivatives are taken on various rates of interests .

OPERATIONAL MECHANISM FOR DERIVATIVES

TRADING:-

1. REGISTRATION WITH BROKER:

The first step towards trading in the derivatives market is

selection of a proper broker with whom the investor would trade. Investors should

complete all the registration formalities with the broker before commencement of trading inthe derivatives market. The investor should also ensure to deal with a broker (member of

the exchange) who is a SEBI registered broker and possesses a SEBI registration

certificate.

2. CLIENT AGREEMENT:

The investor should sign the Client Agreement with the

broker before the broker can place any order on his behalf. The client agreement includes

provisions specified by SEBI and the derivatives segment.

3. UNIQUE CLIENT IDENTIFICATION NUMBER:

After signing the client agreement, the investor gets a

unique identification number (ID). The broker would key this identification number in the

system at the time of placing the order on behalf of the investor. This ID is broker specific i.e.

if the investor chooses to deal with different brokers, he needs to sign the client agreement with

each one of them and resultantly, he would have different Ids.

4. RISK DISCLOSURE DOCUMENT:


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As stipulated in the Bye-Laws provide his particulars to the

investor. The particulars would include his SEBI registration number, the name of the

employees who would be primarily responsible for the client's affairs, the precise nature of his

liability towards the client in respect of the business done on behalf of the investor. The broker

must also apprise the investor about the risk associated with the business in derivative trading

and the extent of his liability. This information forms part of the Risk Disclosure document,which the broker issues to the client. The investor should carefully read the risk disclosure

document and understand the risks involved in the derivatives trading before committing any

position in the market. The risk disclosure document has to be signed by the client and a copy

of the same is retained by the broker for his records.

5. FREE COPY OF RELEVANT REGULATION:

The client is also entitled to a free copy of the extracts of relevant provisions governing the

rights and obligations of clients, relevant manuals, notifications, circulars and any additions or

amendments etc. of the derivatives segment or of any regulatory authority to the extent it

governs the relationship between the broker and the client.

6. PLACING ORDER WITH THE BROKER:

The investor should place orders only after

understanding the monetary implications in the event of execution of the trade. After the trade

is executed, the investor can request for a copy of the trade confirmation slip generated on the

systems on execution of the trade. The investor should also obtain from the broker, a contract

note for the trade executed within 24 hours. The contract note should be time (order receipt and

order execution) and price stamped. Execution prices, brokerage and other charges, if any,

should be separately mentioned in the contract note. If desired, the investor may change an

order anytime before the same is executed on the exchange.

7. MARGINING SYSTEM IN DERIVATIVES:

The aim of margin money is to minimize the risk of default

by either counter-party. The payment of margin ensures that the risk is limited to the previous

day's price movement on each outstanding position. The different types of margins are:

A) INITIAL MARGIN:


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The basic aim of initial margin is to cover the largest potential

loss in one day. Both buyer and seller have to deposit before the opening of the position in the

futures transaction. This margin is calculated by STANDARD PORTFOLIO ANALYSIS OF

RISK by considering the worst case scenario.

B) MARK TO MARKET MARGIN:

All daily losses must be met by depositing of further collateral-knownas variation margin, which is required by the close of business, the following day. Any profits

on the contract are credited to the client's variation margin account.

7. INVESTOR PROTECTION FUND:

The derivatives segment has established an "Investor

Protection Fund" which is independent of the cash segment to protect the interest of the

investors in the derivatives market.

8. ARBITRATION:

In case of any dispute between the members and the clients

arising out of the trading or in relation to trading/settlement, the party thereto shall resolve

such complaint, dispute by arbitrations procedure as defined in the rules and regulations

and Bye-Laws of the respective exchanges.

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC (R) A, the SEBI

Act, the rules and regulations framed there under and the rules and bye-laws of stock

exchanges.

Securities contracts (Regulation) Act, 1956


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SC(R) A aims at preventing undesirable transactions in

securities by regulating the business of dealing therein and by providing for certain other

matters connected therewith. This is the principal Act, which governs the trading of securities

in India. The term "securities" has been defined in the SC(R)A. As per Section 2(h), the

'Securities' include:

1. Shares, scrips, stock, bonds, debentures, stock or other marketable securities of a likenature in or of any incorporated company or other body corporate.

2. Derivative

3. Units or any other instrument issued by any collective investment scheme to the

investors in such schemes.

4. Government securities.

5. Such other instruments as may be declared by the Central Government to be securities

6. Rights or interests in securities

"Derivative" is defined to include:

A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of security.

A contract which derives its value from the prices, or index of price, of

underlying securities.

Section 18A provides that notwithstanding anything contained in any other law for the

time being in force, contracts in derivative shall be legal and valid if such contracts are:

Traded on a recognized stock exchange.

Settled on the clearinghouse of the recognized stock exchange, in accordance with the rules

and bye-laws of such stock exchanges.

REGULATIONS FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under the Chairmanship of Dr. L.C. Gupta to develop the

appropriate regulatory framework for derivatives trading in India. The committee submitted its

report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee

and approved the phased introduction of derivatives trading in India beginning with stock


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index futures. SEBI also approved the "suggestive bye-laws" recommended by the committee

for regulations and control of trading and settlement of derivatives contracts.

The provisions in the SC(R)A and the regulatory framework developed

there under govern trading in securities. The amendment of the SC(R)A to include derivatives

within the ambit of 'securities' in the SC(R)A made trading in derivatives possible with in the

framework of that Act.1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee

report may apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956

to start trading derivatives. The derivatives exchange/segment should have a separate

governing council and representation of trading/clearing members shall be limited to

maximum of 40% of the total members of the governing council. The exchange shall

regulate the sales practices of its members and will obtain prior approval of SEBI

before start of trading in any derivative contract.

2. The Exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not atomically become the

members of derivative segment. The members of the derivatives segment need to fulfill

the eligibility conditions as laid down by the LC Gupta committee.

4. The clearing and settlement of derivatives traders shall be through a SEBI approved

clearing corporation/house. Clearing corporation/house complying with the eligibility

conditions as laid down by the committee have to apply to SEBI for grant of approval.

5. Derivative brokers/dealers and clearing members are required to seek registration from

SEBI. This is in addition to their registration as brokers of existing stock exchanges.

The minimum net worth for clearing members of the derivatives clearing

corporation/house shall be Rs. 300 Lakh. The net worth of the member shall be

computed as follows:

Capital + Fee reserves

Less non-allowable assets viz.

a. Fixed assetsb. Pledged securities

c. Member's card

d. Non-allowable securities (unlisted securities)

e. Bad deliveries

f. Doubtful debts and advances


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g. Prepaid expenses

h. Intangible assets

i. 30% marketable securities

6. The minimum contract value shall not be less than Rs. 2 Lakh. Exchange should also

submit details of the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy and margindemands related to the risk of loss on the position shall be prescribed by

SEBI/Exchanges from time to time.

8. The L.C. Gupta committee report requires strict enforcement of "Know your customer"

rule and requires that every client shall be registered with the derivatives broker. The

members of the derivatives segment are also required to make their clients aware of the

risks involved in derivatives trading by issuing to the client the Risk Disclosure

Document and obtain a copy of the same duly signed by the client.

9. The trading members are required to have qualified approved user and sales person who

have passed a certification programme approved by SEBI.

DR. L.C.GUPTA COMMITTEE-

The Securities and exchange board of India (SEBI) appointed a committee with Dr. L.C. Gupta

as its chairman in November, 1996 to develop regulatory framework for derivatives trading in

India.

The committee recommended introduction of derivatives market in a phased manner

with the introduction of index futures and SEBI appointed a group with Prof. J.R. Varma as its

Chairman to recommend measures for risk containment in the derivative market in India.

The recommendations of L.C. Gupta Committee at a glance:

a) Stock index futures to be the starting point of equity derivatives.

b) SEBI to approve rules, bye-laws and regulation of the derivatives exchange and the

derivatives contracts.

c) SEBI need not be involved in framing exchange level regulations.

d) SEBI should create a special Derivatives Cell as it involves special knowledge, and a

Derivatives advisory council may be created to tap outside experts for independent.


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e) Legal restrictions on institutions, including mutual funds, on use of derivatives should

be removed.

f) Existing stock exchanges with cash trading to be allowed to trade derivatives if they

meet prescribed eligibility conditionimportantly, a separate Governing Council and

at least 50 members.

g) Two categories of member-clearing members and non-clearing members, with the latterdepending on the former for settlement of trades. This is no bring in more traders.

h) Broker members, dealers and sales persons in the derivatives market must have passed

a certificate programme to be registered with SEBI.

i) Co-ordination between SEBI and the RBI of financial derivatives market must have

passed a certificate programme to be registered with SEBI.

j) Clearing corporation to be the center piece of the derivatives market, both for

implementing the margin system and providing trade guarantee. In the near term,

existing clearing corporation be allowed to participate in derivatives. For the long-term,

a centralized clearing corporation has been recommended.

k) Minimum net worth requirement of Rs. 3 crores for participants, maximum exposure

limits for each broker/dealer on gross basis and capital adequacy requirements to be

prescribed.

l) Mark-to-market to be collected before next day's trading starts.

m) As a conservative measure, margins for derivatives purposes not to take into account

positions in cash and futures market and across all stock exchanges.

n) Margins to be systematically collected and not left to discretion of brokers/dealers.

o) Much stricter regulation for derivatives as compared to cash trading.

p) Strengthen cash market with uniform settlement cycles among all SEs and regulatory

oversight.

Proper supervision of sales practices with registration of every client with the

dealer/broker and risk disclosure as the corner-stone.

J.R. VARMA COMMITTEE-

After the submission of L.C. Gupta committee report and approval of the

introduction of index futures trading by SEBI the board mandated the setting up of a group to

recommend measures for risk containment in the derivative market in India. Prof. J.R. Varma

was the chairman of the group.


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ASSUMPTIONS-

-Volatility in Indian market is high.

-Volatility is not constant & varying.

-There is no data on the volatility on Index futures.

-Even at 99% "Value at Risk" model there could be possibility of default once in six months.

-Not efficient organized arbitrage players.

RECOMMENDATIONS

- Only traders with high net worth are allowed to trade in Derivatives.

- Imposition of Value at Risk margin system.

- Submission of periodic reports by CC and SE to SEBI.

- Continuously refining of Margin system.

- Daily changes in the Margins be calculated and imposed.

- Proper liquid net worth.

-Online position monitoring at customer, Trading Member, Clearing Member and Market

level.

RISK MANAGEMENT:-

NATIONAL SECURITIES CLEARING CORPORATION LTD has developed a

comprehensive risk containment mechanism for the Future & Option segment. The salientfeatures of risk containment mechanism on the Future & Option segment are:

1. The financial soundness of the members is the key to risk management. Therefore, the

requirements for membership in terms of capital adequacy (net worth, security deposits)

are quite stringent.


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2. NATIONAL SECURITIES CLEARING CORPORATION LTD. charges an upfront initial

margin for all the open positions of a Clearing Member. It specifies the initial margin

requirements for each futures/options contract on a daily basis. It also follows value-at-risk

(VAR) based margining through Standard Portfolio Analysis of Risk. The Clearing

Member in turn collects the initial margin from the TRADING MEMBERS and their

respective clients.3. The open positions of the members are marked to market based on contract settlement

price for each contract. The difference is settled in cash on a T + 1 basis.

4. NATIONAL SECURITIES CLEARING CORPORATION LTD.'s on-line position

monitoring system monitors a Clearing Member's open positions on a real-time basis.

Limits are set for each CLEARING MEMBERS based on his capital deposits. The on-line

position monitoring system generates alerts whenever a CLEARING MEMBERS reaches

a position limit set up by NATIONAL SECURITIES CLEARING CORPORATION

LTD.NATIONAL SECURITIES CLEARING CORPORATION LTD. monitors the

CLEARING MEMBERSs for MTRADING MEMBERS value violation, while TRADING

MEMBERSs are monitored for contract-wise position limit violation.

5. CLEARING MEMBERSs are provided a trading terminal for the purpose of monitoring

the open position of all the TRADING MEMBERSs clearing and settling through him. A

CLEARING MEMBERS may set exposure limits for a TRADING MEMBERS clearing

and settling through him. NATIONAL SECURITIES CLEARING CORPORATION

LTD. assists the CLEARING MEMBERS to monitor the intra-day exposure limits set up

by

A CLEARING MEMBERS and whenever a TRADING MEMBERS exceed the limits, it

stops that particular TRADING MEMBERS from further trading.

6. A member is alerted of his position to enable him to adjust his exposure or bring in

additional capital. Position violations result in withdrawal of trading facility for all

TRADING MEMBERSs a CLEARING MEMBERS is case of a violation by the

CLEARING MEMBERS.

7. A separate settlement guarantee fund for this segment has been created out of the capital of

members. The fund had a balance of Rs. 648 crore at the end of March 2002.


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The most critical component of risk containment mechanism for F & O

segment is the margining system and on-line position monitoring. The actual position

monitoring and margining is carried out on-line through Parallel Risk Management System

(PRISM). PRISM uses STANDARD PORTFOLIO ANALYSIS OF RISK (r) (Standard

Portfolio Analysis of Risk) system for the purpose of computation of on-line margins, based on

the parameters defined by SEBI.

MINIMUM BASE CAPITAL

A CLEARING MEMBERS is required to meet with the Base

Minimum Cap

report on fci

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