Risk Management

Derivatives Markets in India

.

A Study on Derivatives Market in India:

Current Scenario and Future Trends.

By

Riddhi Kapadia

2006

A Dissertation in part consideration for the degree of MA Finance and Investment

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“Dedicated to my family for all the sacrifices they have done

For making me who I am.”

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Abstract

The derivative market has become multi-trillion dollar markets over the years.

Derivatives are financial commitments indexed or linked in some capacity to changes in

the value of underlying assets. The bulk of the derivatives trading internationally are

linked to currencies and interest rates, other derivatives are linked to equity or equity

indices. A very small volume of derivatives, compared to the total, is indexed to

traditional commodities. Small by comparison to other derivatives markets, these

commodities-indexed derivatives markets are large compared to the underlying physical

commodity markets.

The Aims and Objectives of this research are to have an in-depth knowledge of the

derivative markets in India and in this report entitled ‘A Study on Derivatives Market in

India – Current Scenario and Future Trends’, I have tried my level best to make it simple

and understandable.

Questionnaires, sampling and personal interviews were conducted for answering the

research questions and achieving aims and objectives of research.

The findings were in favour of derivatives being vital for the stock market and they are

not diminishing in today’s world, but they are at the booming stage; and every

institutional investor would want to use derivative as a tool to maximise its profits.

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The research deals with basics of derivatives and its evolution in India. Also statistics

about the global derivatives market is given and it is heartening to know that India’s NSE

ranked 20th during 2006 in the global derivative market. In the later part of the research

evolution, current scenario and prospects of equity derivatives are discussed. In the

concluding section, the use of derivatives by various financial institutions and obstacles

to derivative market development is debated. In the report it is concluded that the

derivatives market will continue to grow, and there is a need to remove the obstacles in

its way. Also, more products should be introduced in the derivatives market.

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Acknowledgements

I am indebted to my family and friends for the understanding and support they

have given me during the writing of this dissertation.

In particular, I thank my parents, Mr. Nishith and Mrs Ashita Kapadia and my

friends for their inspiration and encouragement to complete my tasks.

I also thank Mr. Vijay Kanchan for remembering who I was , and never let me lose

hope when I was lost , for having faith in me all such times, and encouraging me to

prove my worth.

Finally, I give a million thanks and regards to Dr. Peter Oliver for his constant

support and supervision through out this research. He never let me go out of the

office without a smile and believed that I can do it.

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Table of Contents: Abstract…………………………………………………………………………………..3 Acknowledgements………………………………………………………………………5 Chapter 1 Introduction………………………………………………………………….7 1.0 Context……………………………………………………………………………....7 1.1 Aims and Objectives………………………………………………………………..7 1.2 Background………………………………………………………………………….8 1.2(a) Evolution of Derivatives Trading in India…………………………………..11 1.2(b) A Brief History of Forward Trading………………………………………...15 1.3 Structure of Dissertation…………………………………………………………...20 Chapter 2 Literature Review…………………………………………………………..22 2.0 Forwards……………………………………………………………………………23 2.1 Functions of Derivative Market…………………………………………………...31 2.2 Evolution of Equity Derivatives and its Present Status………………………….41 Chapter 3 Research and Methodology………………………………………………...63 3.0 Introduction………………………………………………………………………...63 3.1 Methods of Collection of Data…………………………………………………….64 3.2 Research Process…………………………………………………………………..72 3.3 Research Design……………………………………………………………………74 3.4 Sampling……………………………………………………………………………74 3.5 Questionnaire Design………………………………………………………………75 3.6 The Interviews……………………………………………………………………...77 Chapter 4 Data Analysis and Findings………………………………………………..79 4.0 Introduction………………………………………………………………………...79 4.1 STEEPLE Analysis………………………………………………………………...97 4.2 Summary of Conclusions…………………………………………………………118 4.3 Recommendations………………………………………………………………...122 References……………………………………………………………………………..125 Appendix……………………………………………………………………………….135

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Chapter 1 Introduction

1.0 Context

After studying the general financial tools, practices and mutual funds and industry trends

this decision was taken to choose the area of research where the author was employed in

the stock market i.e. equity market in India (Mumbai) known as the leader in the ‘Stock

Market in India’. Through preliminary research and examining their methodologies and

tools, worked with company’s management and the stock market was found that India’s

stock exchange i.e. NSE and BSE were one of the earlier markets, which invited

derivatives to enhance their effectiveness in business. The fact that derivatives in any

industry plays a vital role for making profits for the company. It is also one of the

untouched areas in the Nottingham Business School, and so it was decided to do

dissertation on this topic and a written approval from the Management of Mutual Fund

Company i.e. Kabra Mutual Fund Ltd for this project was taken.

1.1 Aims and Objectives

The aim of this research is to study the derivative market in India and its current and

future trends ,which are carried out on the stock (equity) market.

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The objectives of the study are as follows:

• To have an overview of the Indian Derivative Market.

• To assess risk management tools and its strategies.

• To evaluate products of derivatives i.e. Forwards, Futures, Swaps and Options.

• To critically analyse its participants i.e. Hedgers, Speculators and Arbitrageurs.

• To evaluate the functions of derivatives.

• To analyse the trends of working and the future trends of Equity Derivatives.

• To propose conclusion and recommendation based upon the findings.

1.2 Background

Avadhani (2000) opines that the “History of financial markets is replete with crises, such

as the collapse of the fixed exchange rate system in 1971, the Black Monday of October

1987, the steep fall in the Nikkei in 1989, the US bond debacle of 1994, all these events

occur because of very high degree of volatility of financial markets and their

unpredictability. Such disasters have become more frequent with increased global

integration of markets. Innovative financial instruments have emerged to protect against

hazards, these include Future and Options, which are the most dominant forms of

financial derivatives, since such volatility and associated disasters cannot be washed

away. They are called derivatives because their values are derived from an underlying

primary financial instrument, commodity or index, such as interest rates, exchange rates,

commodities and equities. For examples, a commodity future price depends on the value

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of the underlying commodity; the price of a stock option depends on the value of the

underlying stock and so on. A derivative provides a mechanism, which market

participants use to hedge their position against the adverse movement of variables over

which they have no control. Avadhani (2000) continues Financial derivatives came into

the spotlight along with the growing instability in current markets during the post- 1970

period, when the US announced its decision to give up gold- dollar parity, the basic king

pin of the Bretton Wood System of fixed exchange rates. The derivative markets became

an integral part of modern financial system in less than three decades of their emergence.

According to Greenspan (1997) “By far the most significant event in finance during the

past decades has been the extraordinary development and expansion of financial

derivatives…”

Derivatives include a wide range of financial contracts, including forwards, futures,

swaps and options. The International Monetary Fund (2001) defines derivatives as

“financial instruments that are linked to a specific financial instrument or indicator or

commodity and through which specific risks can be traded in financial markets in their

own right. The value of a financial derivative derives from the price of an underlying

item, such as an asset or index. Unlike debt securities, no principal is advanced to be

repaid and no investment income accrues.” While some derivatives may have complex

structures, all of them can be divided into basic building blocks of forward and option

contracts or some combination thereof. For the purpose of hedging, speculating,

arbitraging price differences and adjusting portfolio risks, derivatives allow financial

institution and other participants to identify, isolate and manage separately the market

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risks in financial instruments and commodities. The risks that are associated with

derivatives include credit risk, liquidity risk and market risk (comprising commodity

price risk, currency, interest-rate risk and equity price risk.). The risks of derivatives are

more directly related to size and price volatility of the cash flows they represent than they

are to the size of the notional amounts on which the cash flows are based. In fact the risk

of derivatives and cash flows, which are derived from them are usually only a small

portion of notional amounts. Financial institutions may use derivatives as dealers and

end-users. For example, an institution acts as a end-user when it uses derivatives to take

positions as part of its proprietary trading or for hedging as a part of its asset and liability

management; it acts as a dealer when it quotes bids and offers and commits capital to

satisfying customers’ demand for derivatives. The emergence of the market for derivative

products most notably forwards, futures and options can be traced back to the willingness

of risk-averse economic agents to guard themselves against uncertainties arising out of

fluctuation in asset prices. The financial markets can be subject to a very high degree of

volatility by their very nature. It is possible to partially or fully transfer the price risks by

locking-in assets prices, through the use of derivative products. As instruments of risk

management, derivative products 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 investor.

Sahoo (1997) opines “Derivatives produce initially emerged, as hedging devices against

fluctuation in commodity prices and commodity-linked derivatives remained the sole

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form of such products for many years. The financial derivatives came into spotlight in

post-1970 period due to growing instability in the financial markets. In recent years, the

market for financial derivatives both OTC (CF – Glossary of Terms) as well as exchange

traded has grown both in terms of variety of instruments available, their complexity and

also turnover.” The factors generally attributed as the major driving force behind growth

of financial derivatives are:

• Increased volatility in asset prices in financial markets.

• Increased integration of financial markets with the international markets.

• Market improvement in facilities of communication and a sharp decline in costs.

• Providing economic agents a wider choice of risk management strategies through

development of more sophisticated risk management tools.

• Optimally combining the risks and returns over a large number of financial assets,

leading to higher returns, reduces risk as well as transaction cost as compared to

individual financial assets by innovations in the derivative markets.

1.2 (a) Evolution of Derivatives Trading in India

Shapiro (2000) opines all markets face different kind of risks. The derivative is one of

the categories of risk management tools. As this consciousness about risk management

capacity for derivative grew, the market for derivatives developed. Derivatives markets

are generally an integral part of capital markets in developed as well as in emerging

market economies. These instruments support business growth by disseminating effective

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price signals concerning indices, reference rates or other assets, exchange rates and

thereby render both derivatives and cash markets more efficient. Possible adverse market

movements offer protection through these instruments and can be used to offset or

manage exposure by hedging or shifting risks particularly during the periods of volatility

thereby reducing costs. By allowing the transfer of unwanted risk, derivatives can

promote more efficient allocation of capital across the economy, increasing productivity

in the economy. Though the commodity features trading has been in existence since 1953

and certain OTC derivatives such as Forward Rate Agreements (FRAs) and Interest Rate

Swaps (IRSs) were allowed by RBI through its guidelines in 1999, the trading in

“securities” based derivatives on stock exchange was permitted only in June 2000. The

discussion that follows is mainly focussed on “securities” based derivatives on stock

exchanges.

According to Sahoo (1997) the legal framework for derivatives trading is a critical part of

overall regulatory framework of derivative markets. This will be clear when discussed

later on how the regulation and control of derivatives trading and settlement have been

prescribed through suitable amendment to the bye-laws of the stock exchanges where

derivatives trading were permitted. With the role of state intervention in the functioning

of markets is a matter of considerable debate, it is generally agreed that regulation has a

very important and critical role to ensure the efficient functioning if markets and

avoidance of systemic failures. The purpose of regulation is to promote the efficiency and

competition rather than impeding it.

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According to Hathaway (1998), while there is a perceived similarity of regulatory

objective, there is no single preferred model for regulation of derivative markets. The

major contributory factors for success or failure of derivatives market are market culture,

the underlying market including its depth and liquidity and financial infrastructure

including the regulatory framework. The efficiency of derivatives market can be impaired

through government interventions. For example, governmental trade agreements or price

controls aimed at stabilizing prices, which do not allow derivative market to flourish are

such examples of government intervention. Further, since the financial integrity,

efficiency, market integrity, integrity and customer protection which are the common

regulatory objectives in all jurisdictions, are critical to the success of any financial

market. Anyone responsible for operating such a market would have strong incentives

independent of external regulation to ensure that these conditions are present in the

market place. The incentives for self-regulation can be complemented through the

observation of a successful regulatory system while reducing the incentives and

opportunity for behaviour, which threatens the success and integrity of market

(International Organization of Securities Commission 1996a). The derivatives market

that have emerged will require legislation normally, which addresses issues regarding

legality of derivatives instruments, specially protecting such contracts from anti-gambling

laws, because these involve contracts for differences to be settled by exchange of cash,

prescription of appropriate regulations and power to monitor compliance with regulation

and power to enforce regulations. The type and scope of regulation also change, as the

industry grows. Therefore, regulatory flexibility is critical to the long run success of both

regulation and industry it regulates. It would be interesting to observe the historical

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evolution of development of derivatives market and then examine what needs to be done

to build up these markets.

History of Derivatives: A Time Line

The Ancient: Derivatives

1400s -Japanese rice futures

1500s- Dutch tulip bulb options

1800s- Puts and options

The Recent: Financial Derivatives Listed Markets

1972- Financial currency futures

1973 - Stock options

1977 - Treasury bond futures

1981- Eurodollar futures

1982- Index futures

1983- Stock index options

1990- Foreign index warrants and leaps

1991- Swap futures

1992-Insurance futures

1993- Flex options

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OTC Markets

1981- Currency Swaps

1982 - Interest rate swaps

1983- Currency and bond options

1987- Equity derivatives markets

1988 – Hybrid derivatives

Source: Fortune India, September 16-30, 1993

1.2(b) A Brief History of Forward Trading

Sahoo (1997) opines the precursor to exchange based derivatives in India was kind of

“forward trading” in securities in the form of put option (mandi), call options (teji), and

straddle (fatak) etc. The Securities Contract Regulation Act, 1956(SCRA) was enacted,

inter-alia, to prevent undesirable speculation in securities. The contracts for “clearing

commonly known as “forward trading” were banned by the Central Government through

a notification issued on 27th June 1969 in the exercise of the powers conferred under

Section 16 of the SCRA. As the prohibition of forward trading in securities led to a

decline of trade volumes on stock markets, the Stock Exchange, Mumbai (BSE), evolved

in 1972 an informal system of “forward trading”, which allowed carry forward between

two settlement periods, which resulted in substantial increase in the turnover of the

exchange. However, this has also created several problems, and there were payment crisis

from time to time and frequent closure of the market. During December 1982 – January

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1983, the government reviewed the position and in exercise of its power under Section 10

of the SCRA, amended the bye-laws of the stock exchanges to facilitate performance of

contracts in “specified securities”. In pursuance of this policy the stock exchanges at

Bombay, Ahemdabad and Calcutta introduced a system of trading in “specified shares”

with carry forward facility after amending their bye-laws and regulations.

The Joint Parliamentary Committee on Irregularities in Securities and Banking

Transactions,1992 (JPC of 1992) discussed the issue of “carry forward deals” and

observed that this system was not functioning appropriately as there were a lot of

irregularities in the stock exchanges in the form of non-enforcement of margins, on-

reporting of transactions and illegal trading outside the stock exchange. SEBI was of the

view that carry forward transactions should be disallowed and transactions conducted

strictly on delivery basis and trading in futures and options should be permitted in

separate markets. Consequently SEBI issued a directive in December 1993 prohibiting

the carry forward of transactions. However this was reviewed by SEBI, and pursuant to

the recommendations of the G.S. Patel Committee to review the system, carry forward

transactions in securities were permitted in 1995 subject to certain safeguards. This was

further reviewed by J.R. Varma Committee report in 1997 and the system was further

modified subject to a number of safeguards such as segregation of the carry forward

transactions at the time of execution of trade, daily margin of 10%, 50% of which would

be collected upfront, overall carry forward limit of Rs. 20 crore (CF- Conversion table)

per broker per settlement and other prudential safeguards.

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Sahoo(1997) opines that on the other hand, repo transactions in government securities

and public sector bonds developed during 1980s. Following the discussion of JPC of

1992, which indicated that banks found to have entered into transactions in violation of

RBI circulars, RBI banned all repos except treasury bills since June 1992. The Special

Court, however, declared such transactions null and void in December 1993 as being

violative of the provisions of SCRA and Banking Regulation Act, 1949. The Supreme

Court, however, decided in March 1997 that the ready forward contracts (Repo) were

several into parts, via ready lag and forward lag. The ready lag of transactions have been

completed, the forward lag, which alone was illegal had to be ignored. As repo

transactions violated the Government notification of 27th June 1969 under SCRA, certain

institutions such as banks, cooperative banks and other registered RBI dealers were

permitted to undertake ready forward transactions in government securities through

amendment notifications from time to time during second half of 1990s. The objective

was to enhance liquidity market for government securities and to further develop it. There

were problems with such kind of facility such as no standard documentation, “master

agreement”, non-use of clearing houses to undertake counter party risk and opacity of the

regulatory validity in the view of the pronouncements of the Special Court and the

Supreme Court. As a result the repo market was neither deep nor liquid.

This was an anomalous situation where there was a notification, which prohibited

forward trading while some of forward trading (carry forward/ready forward) was

prevalent. In view of changed circumstances particularly the need to develop derivatives

market the repeal of 1969 notification was considered desirable not only to remove the

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existing anomaly but also as measure of market reforms. Sharpiro (2000) continues with

the issue was the notification to be repealed only after amendment of SCRA so that the

powers could be appropriately delegated to RBI in addition to SEBI. There were complex

regulatory issues relating to repeal of the said notification and delegation of powers to

SEBI and RBI. The issue was what powers in respect of which securities should be

delegated to RBI, since SEBI was already exercising delegated powers under SCRA,

irrespective of type of securities/transactions. The Securities Laws (Amendment) Bill,

1999 was passed (before the legislation sufficient ground work was done as would be

discussed later) by the Parliament permitting a legal framework for derivatives trading in

India in December 1999. Consequently, the Central Government lifted a three- decade-

old prohibition on forward trading in securities on 1st March 2000. Simultaneously, in

order to promote an orderly development of market; the Government issued another

notification on 1st March 2000 delineating the area of responsibility between RBI and

SEBI. In terms of this notification, the contract for sale and purchase of gold related

securities, Government securities, money market securities and securities derived from

these securities and ready forward contracts in debt securities were to be regulated by

RBI. Such contracts, if executed on stock exchanges, would be regulated by SEBI in a

manner that this consistent with the guidelines issued by RBI. On the same date, both

SEBI and RBI issued notifications specifying the regulatory work in their respective

areas. The RBI notification while retaining the general prohibition on forward trading

permitted ready forward contracts by specified entities subject to certain conditions, such

as, maintenance of subsidiary ledger account and a current account and such other

conditions as may be prescribed. SEBI also retained the general prohibition on forward

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trading but permitted derivatives contracts as permissible under the securities law. Since

both the regulators have been made responsible for regulation of debt markets, of course,

with some demarcation issues of coordination become important to prevent the

emergence of regulatory gaps or overlaps.

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1.3 Structure of Dissertation

Chapter 1

Introduces the subject area of the dissertation and scope of it. It places the subject area

into background by briefly mentioning some of the current concerns and history

concerning, derivatives in the equity market sector.

Chapter 2

This chapter looks into the markets of derivatives in detail and introduces the equity

market of India and shows how derivatives revolve around the equity market. It also

shows the companies which made profits through them and disasters, and, finally, why

they are important in today’s world.

Chapter 3

This chapter discusses the methodology of the dissertation. It describes the method of

collecting data, provides an explanation of the thought behind the questions asked in the

questionnaire and highlights the problems encountered.

Chapter 4

This chapter is concerned with data presentation and analysis. It commences with the

presentation of data as put forward in the questionnaire, in order to facilitate in the

analysis process of data. The data presented will be analysed in detail against other

research. The main finding of the research is highlighted. It summarises the conclusions,

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which have been drawn using the available data and analysis of it. It also put forwards

future recommendations, regarding the use of derivatives within organisations.

Chapter 5

This chapter brings out the conclusion based on the research and its findings. Area of

future research has been suggested in this chapter, which has been identified during the

writing of dissertation.

Thus the aims and objectives of research which have been achieved in the later part of the

research and also about the historical background of derivatives market i.e. Evolution of

trading and forward trading in India, has been discussed by the author in this chapter. The

author in the chapter ahead is going to discuss about the in-depth knowledge of

derivatives and equity derivatives.

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Chapter 2 Literature Review

Web 1 opines derivatives as “A derivative is a synthetic construction designed to give the

same profile of returns as some underlying investment or transaction, without requiring

the principal cash outlay. They are called derivatives because they derive their value from

the performance of the underlying instrument. Financial derivatives can be found in debt,

equity, currency and commodity markets”. The examples of derivatives include futures,

forwards, options and swaps. In simple words derivatives is a financial model which

includes a wide range of financial contracts including forwards, futures, options and

swaps which helps corporation to achieve success in the market. Srisha (2001) opines

derivatives allow financial institutions and other participants to identify, isolate and

manage separately the market risks in financial instruments and commodities for the

purpose of hedging, speculating, arbitraging price differences and adjusting portfolios

risks. According to Jiwarajika (2000), “Derivatives are used as a tool of risk

management; the risks are associated with derivatives including market risk, credit risk

and liquidity risks. The risks are directly related to size and price volatility of the cash

flows they represent they are to the size of the notional amounts on which the cash flows

are based.” Volker (2004) defines derivatives as “financial instruments which can be

traded (e.g. options, warrants, rights, futures contract, options on futures, etc.) on various

markets. They are called derivatives because they are “derived” from some real,

underlying item of value (such as company share or other real, tangible commodity.) A

derivative is a tradable “contract”, created by exchangers and dealers. A warrant or

option is the simplest form of derivative. The most common usage relates to the trading

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of commodities futures and options on futures-where pre-defined contracts relating to a

right to buy or sell and underlying commodity or security are traded as opposed to the

actual commodity or security itself.” NPV, APT and CAPM are few such financial

models which are part of derivatives; corporations use these models in addition with

derivatives to achieve success. Thus, as mentioned above by diverse authors, that

derivatives have various products/variants which play a vital role in the market for any

institution; they are Forwards, Futures, Options and Swaps:-

2.0 (a) Forwards

Web 2 suggests that “A forward contract is an agreement between two parties calling for

delivery of, and payment for, a specified quality and quantity of a commodity at a

specified future date. The price may be agreed upon in advance, or determined by

formula at the time of delivery or other point in time”. Beside other instruments, such as

Options or Futures, it is used to control and hedge risk, for example currency exposure

risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts

on oil). The forward price usually gives a good estimation of the market price in the

future. D.C. Patwari and Anshul Bhargava explains in simple words that a forward

contract is an agreement between two persons for the purchase and sale of a commodity

or financial asset at a specified price to be delivered at a specified future date. One of the

parties to a forward contract assumes a long position and agrees to buy the underlying

asset at a certain future date for a certain price. The specified price is referred to as the

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delivery price. The parties to the contract mutually agree upon the contract terms like

delivery price and quantity.

CF – Appendix A

2.0 (b) Futures

Web3 opines “A Futures Contract is is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a

pre-set price. The future date is called the delivery date or final settlement date. The

pre-set price is called the futures price. The price of the underlying asset on the delivery

date is called the settlement price. The futures price, naturally, converges towards the

settlement price on the delivery date”. In simple words, Web 4 opines a “futures contratct

as a standardized, transferable, exchange-traded contract that requires delivery of a

commodity, bond, currency, or stock index, at a specified price, on a specified future

date. Unlike options, futures convey an obligation to buy. The risk to the holder is

unlimited, and because the payoff pattern is symmetrical, the risk to the seller is

unlimited as well. Dollars lost and gained by each party on a futures contract are equal

and opposite. In other words, a future trading is a zero-sum game. Futures contracts are

forward contracts, meaning they represent a pledge to make a certain transaction at a

future date. The exchange of assets occurs on the date specified in the contract. Futures

are distinguished from generic forward contracts in that they contain standardized terms,

trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by

clearing houses. Also, in order to insure that payment will occur, futures have a margin

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http://en.wikipedia.org/wiki/Contract

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http://en.wikipedia.org/wiki/Futures_exchange

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requirement that must be settled daily. Finally, by making an offsetting trade, taking

delivery of goods, or arranging for an exchange of goods, futures contracts can be closed.

Hedgers often trade futures for the purpose of keeping price risk in check also called

futures”. Sirisha (2001) continues explaining the Types of Futures which are as follows:

Foreign Exchange Futures

Currency Futures

Stock Index Futures

Commodity Futures

Interest Rate Futures

CF- Appendix B

2.0 (c) Options

Web 5 opines “An Options Contract is the right, but not the obligation, to buy (for a

call option) or sell (for a put option) a specific amount of a given stock, commodity,

currency, index, or debt, at a specified price (the strike price) during a specified period of

time. For stock options, the amount is usually 100 shares. Each option contract has a

buyer, called the holder, and a seller, known as the writer. If the option contract is

exercised, the writer is responsible for fulfilling the terms of the contract by delivering

the shares to the appropriate party. In the case of a security that cannot be delivered such

as an index, the contract is settled in cash. For the holder, the potential loss is limited to

the price paid to acquire the option. When an option is not exercised, it expires. No shares

change hands and the money spent to purchase the option is lost. For the buyer, the

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upside is unlimited. Option contracts, like stocks, are therefore said to have an

asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the

contract is covered, meaning that the writer already owns the security underlying the

option. Option contracts are most frequently as either leverage or protection. As leverage,

options allow the holder to control equity in a limited capacity for a fraction of what the

shares would cost. The difference can be invested elsewhere until the option is exercised.

As protection, options can guard against price fluctuations in the near term because they

provide the right acquire the underlying stock at a fixed price for a limited time risk is

limited to the option premium (except when writing options for a security that is not

already owned). However, the costs of trading options (including both commissions and

the bid/ask spread) is higher on a percentage basis than trading the underlying stock. In

addition, options are very complex and require a great deal of observation and

maintenance also called option”.

CF – Appendix C.

Hull (1995) opines that there are two different types of options which are as follows:

Call Option

Put Option

(CF- Glossary of Terms)

Edwards (2000) critically evaluates “Asian Options are different and are average rate

options. At the end of the contract period, the strike rate is compared with the average

rate observed for the currency exchange. If the strike price is favorable to the holder of

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the Asian Options, the option is exercised by the way of cash settlement. Asian options

are useful for hedging currency exposure where management accounts are translated on

an average rate for the accounting period and are misleading cheaper that American or

European options. They simply cost less because of the statistical fact that an average of a

price series is more stable than any particular price series. Asian options are cash settled

automatically”.

2.0 (d) Swaps

Web 6 opines “A swap is a derivative, where two counterparties exchange one stream of

cash flows against another stream. These streams are called the legs of the swap. The

cash flows are calculated over a notional principal amount. The notional amount

typically does not change hands and it is simply used to calculate payments Swaps are

often used to hedge certain risks, for instance interest rate risk. Another use is

speculation”.

The notional amount typically does not change hands and it is simply used to calculate

payments.

Types of Swaps

There are two basic kinds of swaps:

Currency Swaps

27

http://en.wikipedia.org/wiki/Derivative_%28finance%29

http://en.wikipedia.org/wiki/Counterparty

http://en.wikipedia.org/wiki/Hedge_%28finance%29

http://en.wikipedia.org/wiki/Interest_rate_risk

http://en.wikipedia.org/wiki/Speculation


Interest Rate Swaps

Edward (2000) argues that Currency Swaps involve exchange of currencies at specified

exchage rates and to make a series of interest payments for the currency that is received

at specified intervals.Today, interest rate swaps account for the majority of banks’swap

activity and the fixed for floating rate swap is the most common interest rate swap. In

such a swap one party agrees to make a floating rate interest payment in return for fixed

rate interest payments from the counterparty, with the interest rate calculations based on

hypothetical amouny of principal called the notional amount.

CF- Appendix D

Marlowe (2000) opines that the emergence of the derivative market products most

notably forwards, 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. Financial markets, by the very nature can be subject to a very high degree of

volatility. Through the use of the products of derivatives it is possible to fully or partially

transfer risk of price by looking-in the price of assets. As instruments of risk

management, derivative products generally do not influence the fluctuations in the

underlying asset prices. However by locking –in the price of assets, the products of

derivatives minimize the impact of fluctuation in the price of assets on the profitability

and cash flow situation of risk-averse investor.

28


D.C. Patwari and Anshul Bhargava state that there are three broad categories of

participants-hedgers, speculators and arbitrageurs, trade in the derivative market they are:

2.0 (e) Hedgers

Hedgers are attracted to the derivative market to reduce a risk they already face. A hedge

is a position in order to offset the associated risk with the movement of price of an asset

and to reduce the risk with the use of derivatives. A hedger is a trader who enters the

future market to reduce a pre- existing risk.

CF- Appendix E

2.0 (f) Speculators

In contrast to hedgers who want to reduce or eliminate their risk, speculators take a

position in the market, thereby increasing their own risk. Speculators buy and sell

derivatives to make profit and not to reduce their risk. Speculators wish to take a position

in the market by betting on future movement of price of an asset. Futures and options

both increase the potential gain and losses in a speculative venture. Speculators are

attracted to exchange traded derivative products because of their high leverage, high

liquidity, low impact cost, low transaction cost and default risk behavior. It is the

speculators who keep the market going because the bear the risks, which no one else is

willing to bear.

CF- Appendix F

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2.0(g) Arbitrageurs

An arbitrageur is basically risk-averse and enters into those contracts where he can earn

riskless profits. It is possible to make riskless profits by buying one market and

simultaneously selling in another, when markets are imperfect (long in one market and

short in one market). Arbitrageurs always look out on such price differences.

Arbitrageurs fetch enormous liquidity to the products, which are traded on exchanges.

The liquidity in-turn results in better price discovery, lesser market manipulation and

lesser cost of transaction.

CF- Appendix G

As mentioned by D.C. Patwari and Anshul Bhargava, these participants are very

essential for the market in derivatives. According to Murti 2000, “the hedgers, the

speculators and the arbitrageurs all three must co-exist. A hedger is always risk-

averse. Typically in India he may be a treasurer in a public sector company who certainly

wants to know the cost of interest for the year 2002, therefore based on the current

information, he would enter into a future contract and lock up the rate of interest four

years hence. But he consciously ignores what is called the upside potential (here the

possibility that the interest rate may be lower in 2002 that what he had contracted for four

years earlier. A hedger therefore plays it safe. To complete the hedging transaction, there

must be another person willing to take advantage of the movement of price that is the

30


speculator. The speculator thrives on uncertainties while the hedger avoids them. The

speculator stands to gain enormously if he is proved correct but if the speculator forecast

wrong then he may lose plenty of money. An integral part of derivative market is the risk

taking associated with speculation. The arbitrageur is the third category of participant,

who looks at riskless profit by buying and selling simultaneously, the same or similar

financial products in various markets. There is a possibility to take advantage of space or

time differentials that exist, as markets are seldom perfect. Arbitrage evens out the price

variations.

In simple words, for healthy functioning of the derivative market, all the three types of

participants are required. The market would become mere tools of gambling if without

hedgers, as they provide economic substance to this market. Speculators provide depth

and liquidity to the market. Arbitrageurs help in bring price discovery and price

uniformity. The presence of the three participants not only enables the smooth

functioning of the market in derivatives but also helps in increasing the market liquidity

as well.

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2.1 Functions of Derivative Market

According to N D Vohra & B R Bagri the derivative market performs a number of

useful economic functions:

1. Price Discovery: The futures and options market serve an all important function

of price discovery. To take advantage of such information in these markets, the

individuals with better information and judgment are inclined to participate. The

actions of the speculator swiftly feed their information into the derivative markets

causing changes in the prices of derivatives, when some new information arrives,

perhaps some good news about the economy. As indicated earlier, these markets

are usually the first ones to react because the cost of transaction is much lower in

these markets than in the spot markets. Therefore, these markets indicate what is

likely to happen and thus assist in better price discovery.

2. Risk Transfer: The derivative instruments do not themselves involve risk, by the

very nature. Rather, they merely distribute the risk between market participants.

In this sense, the whole derivative market may be compared to a gigantic

insurance company – providing means to hedge against adversities of

unfavourable market movements in return for a premium, providing means and

opportunities to those who are prepared to take risks and make money in the

process.

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3. Market Completion: The existence of derivative market adds to the degree of

completeness of the market. When the number of independent securities or

instruments is equal to the number of all possible alternative future states of

economy, it implies a complete market. To understand the idea, let us recall that

the derivative instruments of futures and options are instruments that provide the

investor the ability to hedge against possible odds or events in the economy. If

instruments may be created which can, solely or jointly, provide a cover against

all the possible adverse outcomes, then a market would be said to be complete. It

is held that a complete markets can be achieved only when , firstly , there is a

consensus among all investors in the economy can land up with, secondly, there

should exist an ‘efficient fund’ on which simple options can be traded. Here an

efficient fund implies a portfolio of basic securities that exist in the market with

the property of having a unique return that exist in the market with property of

having a unique return for every possible outcome, while a simple options is one

whose payoffs depends on underlying return. Evidently, since the requiring

condition identification and listing of all possible states of the economy can never

be obtained in practice, and it is also not possible to design financial contracts that

are enforceable, which can cover an endless range of contingencies, a complete

market remains a theoretical concept. Thus leads to a great degree of market

completeness due to the presence of futures and options.

Dhingra (2004) believes if one views that past stock exchanges and the effect of blue

chip companies like IBM, Coca- Cola, Microsoft or Intel on the stock index, there is a

33


clear sign to the rise of stocks to substantial amounts. History shows the phenomenal

growth characteristic of the above stocks is related to that of the fundamentals on which

the companies have been operating under and not related to speculators. The current

market capitalization of Microsoft Corporation is approximately $225 billion compared

to the group turnover of mere $22 million, and looking back at the BP case study (1998),

the answer indicates the advantage derivatives provide against various risk involving

commodities, fixed assets or interest rate transaction and planning.

Now the question remains -Do derivatives always aid every corporation or organization

to yield profits? Industry Week (July 1998) mentions that derivatives have been

plagued, which have led to media’s criticism and subsequent users and accounting

board’s cautious attitude towards derivatives. In the past most derivatives problems are

related to the uncontrolled speculation by various individuals primarily in the highly

susceptible futures, forwards and swaps.

Web 7 opines the difficulties with today’s worldwide derivatives are as follows:

It is not an investment, but a “side bet”, usually very short term at that. The

money is “not” put into productive use to generate an economic profit i.e. if loss it

would affect the entire world and if profit, creates for the entire world.

We are giving out profits not yet created to speculators who then use those profits

to chase even larger amounts of future profits. We’ve often referred to our

national debts as “hocking the futures of our children”. But that is peanuts

compared to the claims that the global financial bubble already has upon

34


mankind’s future economy i.e. the profits given by the companies to the

speculators are not given accurately, they are then who does the gamble in the

market.

The monetary profits are not being made through construction but “destruction”.

Stability in the markets is what is needed for development. But only through

instability can the speculator make any gain i.e. Stability is derivatives’ enemy.

And most immediately damning to our present system is the crisis the growth in

derivatives poses for the liquidity of our monetary system. In order to maintain a

growing system of “robbing Peter to pay Paul”, we have to have more available

instruments of cash to accommodate the robbers. Far from hedging against risk as

they claimed to do, “derivatives ARE the risk.”

Once this process gets too far along, you are trapped into keeping the deception growing

like the fellow who gets so far behind at the casino; he keeps upping the ante way beyond

his means as his only hope to get back to even with the house.

Web 7 continues arguing “derivatives are the risk”. This statement can be wrong at a

certain point, and at the same time it can be right as well. Derivatives involving disasters

have confined the notice of the global financial sector. Names like Orange County,

Barings, and Proctor&Gamble have come to symbolize the “danger of derivatives”.

Since derivatives grow to have an increasingly significant impact in the economy of

India, what does this mean for us? Barings Bank was brought down by a single trader is

State Bank similarly vulnerable? Specifically in the equity market, where the first

35


exchange-traded derivatives are likely to start trading in early 1998, what new pitfalls lie

in store for us? Thus it shows that derivatives do not always give way to profits, but it

also sometimes gives ways to losses.

Web 8 opines in fundamental nature, these examples suggest that the scandals are not

only in the market of derivatives-related instruments, but also in foreign exchange

trading, commodity trading and in bonds. ‘Over-the-counter’ (OTC) deals with most of

the failures which have taken place, except with the Barings’ case where it was a case of

internal fraud, as also with the case of Daiwa Bank, where there was a loss of $1 billion

in debt portfolio. ‘Over-the-Counter deals lack a well laid out regulatory framework,

transparency and sophisticated margin system. Due to the complex nature of transactions,

most of the failure happens, while exchange-traded derivatives are simple and easy to

understand. In that sense, these derivatives have been found to be more useful in allowing

participants to transfer their risk, without the problems associated with the OTC deals.

For normal equity or debt trading as much as derivative trading, internal control would be

important in any case; and the participants need to be more cautious in implementing and

operating superior back-office and control system to stay away from any internal control

failures. Indian investors will have difficulties in understanding, as derivatives are

complex and exotic instruments. Trading in standard derivatives such as forwards, futures

and options is already established in India and has a long history. Forward-trading in

rupee-dollar forward contracts, which has become a liquid market and also cross currency

options trading are allowed by the Reserve Bank of India (RBI).

36


The derivatives have existed in the equity market for long. In fact, the history of the

Native Share and Stock Brokers Association, which is now known as the Bombay Stock

Exchange (BSE), suggests that the concept of options existed early as in 1898. A quote

ascribed to Mr. James P. McAllen, MP, at the time of the inaugural ceremony of BSE’s

new Brokers Hall in 1898, is: “….India being the original home of options, a native

broker would give a few points to the brokers of the other nations in the manipulation of

puts and calls.”

This implies that the concept of futures and options is well-ingrained in the Indian

equities market and not as alien as it is made out to be. Even today, options are traded

with complex strategies, which are called jota-phatak, bhav-bhav and teji-manda (CF-

Glossary of terms) at various places. In that sense, derivatives are not new to India and

are current in various markets including the equity markets.

Web 8 states that the market of India is not ready for derivatives trading and capital

markets are safer than derivatives and are correct to some extent because there are no

risks such as Investment, Liquidity, Credit, Exchange, Management and Market risks.

This was the situation when they were just introduced to the market, and people playing

with it didn’t know what exactly it means but now derivatives are used as a tool of risk

management and there are no more conflicts in using derivatives in equity markets and

other markets, because people today have the exact knowledge that derivatives is not just

an underlying value, because they are derived from any asset or commodity but now they

37


know derivative is a financial model and know what derivatives can do to help their

corporation and is far more better than capital market.

Web 9 Shah 2000 opines that ever since the first financial futures started trading in 1972,

the global industry of derivatives has seen massive growth rates, with trading volumes

doubling every three years for the following twenty years. The outstanding derivative

position that exist today typically run into many trillion of dollars. In this situation, in the

early nineties, we have seen disasters involving a few billion dollars. This is not a large

“failure rate”. It is useful to demarcate two categories of derivatives contracts: those

which are traded at exchange and those which are traded on OTC. OTC derivatives

involve many complexities: the price that is negotiated might not be fair price, there is a

counter party risk, the transactions are not publicly visible and the complexity of

contracts often generates unsavory sales practices and high fees for intermediaries. In

contrast, exchange-traded derivatives are safer in many directions: they ensure that users

get a fair price on all trades; there is zero risk of default through the role of clearing

corporation and high degree of transparency. A lot of famous disasters have taken place

with the OTC derivatives.

In India, on the equity market, SEBI has made it clear that the development of the

derivatives industry should focus on exchange- traded derivatives. In the commodities

area also, the development of the last three years in India have centered on exchanges. It

is in interest rates and currencies, where OTC derivatives presently dominate in India that

38


concerns about fairplay and credit risk are more serious. India’s equity market has been

the centre of better debates. One argument which is often heard runs as follows:

“Derivatives are highly leveraged instruments; hence the proposal to create index futures

and options should be viewed with great caution.” This is inconsistent with a remarkable

fact about exchange-traded index derivatives in India: they involve less danger than

existing spot market.

Market Manipulation

The index, with a market capitalisation of Rs.2.2 trillion (CF – Conversion table), is

much harder to manipulate that individual securities. Hence the dangers of market

manipulation are smaller on an index derivatives market as compared with the existing

cash market i.e. the market manipulation is much smaller on an index of market of

derivatives as compared to the cash market.

Insider Trading

Individual companies are typified by sharp information of asymmetry, between external

traders/investors and company insiders. In contrast, the index is about India’s

macroeconomy, where there is less information of asymmetry i.e. in this sense , there is a

less scope for malpractice on a market which trades the index.

Shah 2000 continues with the India’s dollar-rupee forward market experience, the largest

market of derivatives in existence in India today- is an example of how this might

39


proceed. When this market first came about, it had a fairly restricted usage. Today, the

use of forward market is routine and commonplace amongst hundreds of importers and

exporters. These are firms with core competences such as importing crude oil or

exporting garments; they are faced with currency risk and do not view trading in the

rupee as being a core competence. The forward market enables them to proceed with

their core competences while using the forward market to eliminate currency risk. The

dollar-rupee forward market has typical daily trading volumes of $1.5 billion, which

makes it one of the biggest financial markets in India today. Even though it is an OTC

market, it is known as a serious disaster.

Dhingra 2004 opines that over the years the market of derivatives have become multi-

trillion dollar markets .Derivatives are financial commitments indexed or linked in some

capacity on the value of underlying assets. The bulk of the derivatives traded

internationally are linked to currencies and interest rates. Other derivatives are linked to

equity or equity indices. A very small volume of derivatives, compared to the total is

indexed to traditional commodities. Small by comparison to other derivatives markets,

these commodities-indexed derivatives markets are large compared to the underlying

physical commodities markets. It has been a gradual march to glory for derivatives

trading in India with current average daily trading volume at more than 10000 crores

(CF-Conversion table). Thanks to the market’s growing fancy for stock futures,

derivatives trading have finally been able to underline its presence in the Indian capital

market. From a meager Rs. 35 crores worth of turnover in June 2000, when derivatives

where introduced in phase to Rs. 572,403 crores in December 2003 and reached Rs

40


600,000 crore in March 2006. There has been a phenomenal rise in the growth of futures

and options market. Gradually more derivatives products are being offered with the

underlying as diverse as commodities, credit, interest rate, currency etc.

In simple words, derivatives have come along from 1970 till today, it had helped

corporations to make immense profit, and sometimes it had corporations going down the

drain with all the losses on their head. As explained earlier, derivatives have four main

variants/products which are Forwards, Options, Swaps and Options and also have three

main participants which are Hedgers, Speculators and Arbitrageurs and the scenario of

the Indian derivative market. Now let us see how derivatives revolve around equity i.e.

stock market and foreign markets in India.

2.2 Evolution of Equity derivatives and its Present Status

Shah (2000) opines equity derivatives trading started in India in June 2000, after a

regulatory process which stretched over more than four years. In July 2001, the equity

spot market move to rolling settlement. Thus, in 2000 and 2001 the Indian Equity market

reached the logical conclusion of the reform program, which began in 1994. It is, hence,

important to learn about the behaviour of the equity market in this new regime.

India’s experience with the launch of equity derivatives market has been extremely

positive, by world standards. Amongst all emerging markets, in terms of equity

derivatives turnover, NSE is now one of the prominent exchanges. There is an increasing

sense that the market of equity derivatives is playing a major role in shaping price

41


discovery. The goal of this section is to convey a detailed sense of the functioning of the

equity derivative market. I seek to convey some insights into what is going on with the

equity derivative market, and summarise broad empirical regularities about pricing and

liquidity. Equity derivatives are traded only on two exchanges (CF- Glossary of Terms).

NSE

BSE

Chart 1 shows the time-series of NSE and BSE turnover. This graph is in log scale.

Straight line segments in such graphs correspond to periods of constant percentage

compound growth rate. This suggests that NSE has had a phase of meteoric and steady

growth from May 2001 onwards. As taken place with competing derivatives markets

elsewhere in the world, there was substantial competition in the early days of market.

However, NSE has become the clearly dominant market trading equity derivatives in

India.

Chart 1: Derivative Markets Volume at NSE and BSE

42


Source: NSE and BSE

The details of derivatives traded in India only on exchanges via, the BSE and NSE

(Table 6). The total exchange traded derivative volume shows an increase (19.69%) to

Rs.25, 641,269 million during 2004- 2005 as against Rs.21, 422,690 million during the

previous year. NSE emerged as a market leader in the Indian Market by accounting for

about 99.3% of the total turnover. Since more that 99% of volumes came from NSE, the

further detail is based on the NSE data.

Table 6: Trade Details of Derivative Market

NSE BSE TOTAL

Month/

Year

No of

Contracts

Traded

Turnover

(Rs. mn.)

No of

Contracts

Traded

Turnover

(Rs. mn.)

No of

Contracts

Traded

Turnover

(Rs. mn.)

Apr-02 804,602 216,736 1,079 238 805,681 216,974

Apr-03 2,205,470 500,196 5,280 873 2,210,750 501,069

May-03 2,252050 534,233 1,155 229 2,253,205 534,462

Jun-03 2,750,294 730,173 423 92 2,750,717 730,265

Jul -03 3,720,563 1098,495 4,718 1,031 3,725,281 1,099,526

Aug-03 4,314,098 1,403,625 23,634 5,090 4,337,732 1,408,715

Sep-03 5,481,939 1,851,509 34,274 8,509 5,516,213 1,860,018

Oct-03 5,989,205 2,303,645 30,668 8,574 6,019,873 2,312,219

Nov- 03 4,769,938 1,921,714 31,337 9,287 4,801,580 1,931,001

Dec-03 5,724,035 2,389,067 107,545 36,840 5,831,580 2,425,907

43


Jan -04 6,976,023 3,240,630 103,573 37,869 7,079,596 3,278,499

Feb-04 5,696,541 2,728,392 22,212 7,299 5,718,753 2,753,691

Mar-04 7,006,620 2,604,813 17,439 505 7,024,059 2,605,318

2003-04 56,886,776 21,306,492 382,258 116,198 57,269,034 21,422,690

April-04 6,568,668 2,202,995 2,892 850 6,571,560 2,203,845

May-04 6,481,198 1,947,629 1,1416 390 6,482,344 1,948,019

Jun-04 5,822,819 1,583,055 0 0 5,822,819 1,583,055

Jul-04 6,314,513 1,753,454 10 3 6,314,523 1,753,457

Aug-04 5,931,706 1,760,057 0 0 5,978,503 1,706,057

Sept-04 5,931,706 1,783,796 39,788 20,560 5,971,494 1,804,356

Oct -04 5,666,914 1,822,327 115,298 32,900 5,782,212 1,855,137

Nov-04 5,314,655 1,758,045 157,458 46,950 5,472,113 1,804,995

Dec-04 7,515,469 2,652,899 43,942 14,150 7,290,857 2,667,049

Jan-05 7,246,915 2,652,899 43,942 14,150 7,290,371 2,731,745

Feb-05 6,661,661 2,535,514 9,213 3,040 6,670,874 2,538,554

Mar-05 7,694,164 2,988,571 7,070 2,430 7,701,234 2,991,001

2004-05 77,017,185 25,470,526 531,719 170,743 77,548,904 25,641,269

Source: NSE and BSE Bulletin

Futures and Options Segment

Web10 opines that on June 12, 2000, the Future and Options segment commenced on

NSE with S&P CNX Nifty Index Futures. Trading in options based on S&P CNX Nifty,

44


options on securities and futures commenced on Jun 2001, July 2001 and November 2001

respectively.

Trading Mechanism

Web10 states that the trading system of derivatives at NSE is known as NEAT-F&O

trading system, which provides a fully automated screen-based trading for all kinds of

products of derivatives available on NSE on a national wide basis. It supports an

anonymous order driven market, which operates on a time priority/strict price. It offers

great flexibility to users in terms of kinds of orders that can be placed on the system.

Various time and price-related conditions like Immediate or Cancel, Limit/Market Price,

Stop Loss, etc. can be built into an order. The trading in derivatives is essentially similar

to that of trading of securities in the CM segment.

There are four entities in the trading system:

1. Trading members: Trading members can either trade either on their own account

or on behalf of their clients including participants. They are registered as

members with NSE and are assigned an exclusive trading member ID.

2. Clearing members: Clearing members are members of NSCCL. They carry out

risk management activities and confirmation/inquiry of trades through the trading

system. These clearing members are also trading members and clear trade for

themselves or/and others.

45


3. Professional clearing members: A professional clearing member (PCM) is a

clearing member who is not a trading member. Typically, banks and custodian

become PCMs and clear and settle for their trading members.

4. Participants: A participant is a client of trading members like financial

institutions. These clients may trade through multiple trading members, but settle

their trades through a single clearing member only.

The terminals of trading of F&O Segment are available in 298 cities at the end of March

2006. Besides trading terminals, it can also be accessed through the internet by investors

from anywhere.

Contract Specification

Web 10 Shah (2000) states that index options and index futures contracts traded on NSE

are based on S&P CNX Nifty Index, CNX IT Index and the CNX Bank Index, while

stock futures and options are based on individual securities. Presently stock futures and

options are available on 119 securities. While stock options are American Style, Index

options are European Style. There are a minimum seven strike prices, three ‘out-of-the-

money’, and one ‘at-the-money’ and three ‘in -the -money’. The price at which the buyer

has a right to buy or sell the underlying is the strike price. The number of strikes provided

in options on Nifty index is related to the range in which previous day’s closing value if

Nifty index falls as per the following table:

46


In respect of equity derivatives, at any point the numbers of available contracts with 1

month, 2 months and 3 months to expiry are available for trading. These contracts expire

on last Thursday of the expiry month. A new contract is introduced on the next trading

day following expiry of the near month contract. All derivatives are never settled on

credit but are presently cash settled.

Trading Value

Web 10 states that F&O segment reported a total trading value (notional) of Rs. 4824250

crores (CF- conversion table) in the previous year 2004-2005. The business growth of

F&O segment is presented in Table and Chart. The trading volumes in the F&O segment

indicate that futures are more popular than options; contracts on securities are more

popular than those on indexes; and call options are more popular than put options. The

F&O segment provides a nationwide market. Mumbai accounts for 50% of the total

turnover. The share of Mumbai in total turnover has been declining over the years

reinforcing nationwide presence of NSE i.e. Mumbai in India plays a major role as the

turnover in November 2001 was an immense rise for the market of India.

47


Transaction Changes

Web 10 Dhingra (2000) states that the maximum brokerage chargeable by a trading

member for the trades effected in the contracts entered on F&O segment is fixed at 2.5%

of the contract value in case of index futures and stock futures. In case of index options

and stock options, it is 2.5% of the notional value of the contract [(Strike Price +

Premium) * Quantity)], exclusive of statutory levies. The transaction charges payable to

the exchange by the trading member for the trades executed by him on the F&O segment

are fixed at the rate of Rs. 2 per lakh of turnover (0.002%) subject to a minimum of

Rs.1,00,000 per year. The trading members contribute to Investor Protection Fund of

F&O segment at the rate of Rs. 10 per crore of turnover (0.0001%) i.e. to get the contract

of NSE, the value is fixed; and the transactional charges are also fixed. The trading

members are also required to pay securities transaction tax (STT) on non-delivery

transactions at the rate of 0.0133% (payable by the seller) for derivatives w.e.f 1 June

2006.

Clearing and Settlement

Web10 states that NSCCL undertakes clearing and settlement of all trades executed on

the F&O segment of the NSE. It also acts as legal counterpart to all trades on this

segment and guarantees their financial settlement. The clearing and settlement process

comprises of three main activities, viz., Clearing, Settlement and Risk Management.

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Settlement Mechanism

According to Web10 Srikant and Melon (2003) “All futures and options contracts are

cash settled i.e. through exchange of cash. The underlying for index futures/options of the

Nifty index cannot be delivered. The settlement amount for a CM is netted across all their

TMs/clients, across various settlements. For the purpose of settlement, all CMs are

required to open a separate bank account with NSCCL designated clearing banks for

F&O segment”.

Settlement of Futures Contracts

The future contracts settlements are of two types, the final settlement, which happens on

the trading day of the futures contract and the MTM settlement, which happens on

continuous basis at the end of each day.

Final Settlement for Futures

Shah (2000) states that on the day of expiry of the futures contracts, after the hours of

closing of the respective futures contract on such day, NSCCL marks all positions of a

CM to the final settlement price and the resulting loss/profit is cash settled. Final

settlement loss/profit amount is debited/credited to the relevant CM’s clearing bank

account on the day following expiry day of the contract.

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MTM Settlement of Futures Contracts

For each member, all contracts for futures are marked-to-market (MTM) to the daily

settlement price of the relevant futures contract at the end of each day. The losses/profits

are computed as the difference between:

a) The trade price and the day’s settlement price in respect of contracts executed

during the day but not squared up.

b) The previous day’s settlement price and the current day’ settlement price in

respect of brought forward contracts.

c) The selling and the buying price in respect of the contracts executed during the

day are squared up.

Srikant and Menon (2003) further continues that the daily settlement price on a

trading day is the closing day of the respective futures contracts on such day. The

closing price for a future contract is calculated currently as the last half hour weighted

average price of the contract in the F&O segment of NSE. Final settlement price is

the closing price of the relevant underlying index/security in the Capital Market

segment of NSE, on the last trading day of the contract. The closing price of the

underlying index/security is currently its last half an hour weighted average value in

the Capital Market Segment of NSE.

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Settlement of Option Contracts

The option contracts settlements are of three types: daily premium settlement, interim

exercise settlement in the case of option contracts on securities and final settlement.

Daily Premium Settlement for Options

Web 10 Jhadav (2000) opines the seller of the option is entitled to receive the premium

for the option sold by him. Similarly, the buyer of an option is obligated to pay the

premium towards the options purchased by him. The premium payable amount and the

premium receivable amount are netted to compute the net premium payable or receivable

amount for each client for each option contract. The pay-in and pay-out of the premium

settlement is on T+1 day. Then premium payable amount and premium receivable

amount are directly credited/debited to the CMs clearing bank account.

Interim Exercise Settlement

Web10 states that Interim exercise settlement takes place only for option contracts on

individual securities. An investor can exercise his in-the-money options at any time

during trading hours, through his trading member. Interim exercise settlement is effected

for such options at the close of the trading hours, on the day of exercise. Valid exercised

option contracts are assigned to short positions in the option contract with the same series

(i.e. having the same underlying, same expiry date and same strike price), on a random

basis, at the client level. The CM who has exercised the option receives the exercise

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settlement value per unit of the option from the CM who has been assigned the option

contract. The interim exercise value is the difference between the strike price and the

settlement price of the relevant option contract. Exercise settlement value is

credited/debited to the relevant CM’s clearing bank account on T+2 day (T=exercise

date).

Final Exercise Settlement

Web 10 Jhadav (2000) states that final exercise settlement is effected for option

positions at in-the-money strike prices existing at the close of trading hours, on the

expiration day of an option contract. All long positions at in-the-money strike prices are

automatically assigned to short positions in option contracts with the same series, on a

random basis. Final settlement loss/profit amount for option contracts on Index is

debited/credited to the relevant CM’s clearing bank account on T+1 day. Final settlement

loss/profit amount for option contracts on Individual Securities is debited/credited to the

relevant CM’s clearing bank account on T+2 day. Open positions, in option contracts,

cease to exist after their expiration day.

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Risk Management System

NSCCL has developed a comprehensive risk containment mechanism for future and

options (F&O) segment. The salient features of risk containment measures on F&O

segment as stated by Jhadav( 2003) in his book are:

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.

NSCCL charges an upfront initial margin for all the open positions of a CM. It

specifies the initial margin requirements for each future/options contract on a

daily basis. It follows Var-based margining computed through SPAN. The CM in

turn collects the initial margin from the TM’s and their respective clients.

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.

The exposure of a CM cannot exceed 33.3 times the liquid net worth for index

options/futures and 20 times the liquid net worth for stock options/futures.

NSCCL’s online position monitoring system monitors a CMs open positions on a

real-time basis. Limits are set for each CM based on his base capital. The on-line

position monitoring system generates alerts whenever a CM reaches a position

limit set up by NSCCL. NSCCL monitors the CMs for MTM value violation,

while TMs are monitored for contract-wise position limit violation.

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CMs are provided a trading terminal for the purpose of monitoring the open

positions of all TM’s clearing and settling through him. A CM may set exposure

limits for a TM clearing and settling through him. NSCCL assists the CM to

monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds

the limits, it stops the particular TM from further trading.

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

in additional capital. Position violations result in disablement of trading facility

for all TMs of a CM in case of violation by the CM.

A separate Settlement Guarantee Fund for this segment has been created out if the

base capital of members. The fund had a balance of Rs 2500 crore (CF-

Conversion Table) at the end of March 2006.

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

margining system and on-line positioning monitoring. The actual position monitoring

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

(PRISM) using SPAN(R) (Standard Portfolio Analysis of Risk) (CF – Glossary of

terms) system for the purpose of computation of online margins, based on the

parameters defined by SEBI.

NSE – SPAN

According to Web 11 Srithar (2000) “The objective of SPAN is to identify overall

risk in a portfolio of futures and options contracts for each member. The system treats

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futures and options contracts uniformly, while at the same time recognizing the

unique exposures associated with options portfolios like extremely deep out-of-the-

money short positions, inter-month risk and inter-commodity risk.

Because SPAN is used to determine performance bond requirements (margin

requirements), its overriding objective is to determine the largest loss that a portfolio

might reasonably be expected to suffer from one day to the next day based on 99%

VAR methodology.

SPAN considers uniqueness of option portfolios. The following factors affect the

value of an option:

Underlying market price.

Volatility (variability) of underlying instrument.

Time to expiration.

Interest rate

Strike Price

(CF – Glossary of Terms)

As these factors change, the value of futures and options maintained within a portfolio

also changes. Thus SPAN constructs scenarios of probable changes in underlying prices

and volatilities in order to identify the largest loss a portfolio might suffer from one day

to the next. Then it sets the margin requirement at a level sufficient to cover this one-day

loss”.

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Web 11 states that “The complex calculations (e.g. the pricing of options) in SPAN are

executed by the Clearing Corporation. The results of these calculations are called Risk

arrays. risk arrays, and other necessary data inputs for margin calculation are then

provided to members in a file called the SPAN Risk Parameter file. This file will be

provided to members on a daily basis. Members can apply the data contained in the Risk

parameter files, to their specific portfolios of futures and options contracts, to determine

their SPAN margin requirements. Hence members need not execute complex option

pricing calculations, which would be performed by NSCCL. SPAN has the ability to

estimate risk for combined futures and options portfolios, and re-value the same under

various scenarios of changing market conditions”.

Trading Volume and Open Interest

Web 10 states another study conducted under the NSE Research Initiative entitled

“Informational Content of Trading Volume and Open Interest – An empirical study of

Stock Market in India” examines the role of certain non-price variables namely open

interest and trading volume from the stock option market in determining the price of

underlying shares in the cash market. The study reveals that the open interest for stock

options is one of the significant variables in determination of the future spot price of

underlying share. The result clearly indicates that open interest predictions are

statistically more significant than volume-based predictors in Indian context too. The

results in this study show that the option markets, more specifically the net open interest,

are likely to be informative about the future movement of stock prices. Investors who do

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not possess the specific information about the future price movement can use these

predictors for deciding upon their trading strategies. The study reveals difference in

results in US context and India maybe because firstly, the exchange traded stock

derivative market in India is of recent origin; and it takes time for the investors to realise

the true potential of these instruments. Secondly, the participation of institutional

investors in Indian stock derivative market is extremely limited. It can be attributed to the

regulatory restrictions where in such investors are allowed to use derivative securities for

the purpose of hedging only. The story of mutual funds is not significantly different from

this. Therefore, the investors who have better access to information and can be classified

in the category of informed investors are constrained to deal in the derivative securities.

Though there are some positive developments taking place in this direction, these

securities are yet to gain significance in the portfolio of institutional investors in India.

Settlement

All derivatives are currently cash settled. During 2004-2005, the cash settled amounted to

Rs.145,4816.15 million. The futures and options settlement involved Rs.132,516.81

million and Rs.13,969.34 million, respectively. The settlement details on F&O segment

are presented below.

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Table 7: Settlement Statistics in F&O Segment

( In

Rs.mn)

Month / Year Index / Stock Futures Index / Stock Options Total

MTM Final Premium Exercise

Settlement Settlement Settlement Settlement

2000-01 840.84 19.29 860.13

Apr-01 80.43 0.88 81.31

May-01 37.76 1.13 38.89

Jun-01 48.52 0.1 14.69 2.75 66.06

Jul-01 66.95 1.35 58.76 14.28 141.34

Aug-01 45.94 1.36 98.31 50.62 196.23

Sep-01 336.87 5 156.22 139.09 637.18

Oct-01 112.69 1.01 179.61 114.22 407.53

Nov-01 283.75 7.09 245.55 202.14 738.53

Dec-01 789.41 37.62 174.67 82.14 1083.84

Jan-02 1125.28 21.69 305.71 177.55 1630.23

Feb-02 1088.7 122.14 244 88.57 1543.41

Mar-02 1036.18 19.88 170.08 68.1 1294.24

2001-02 5052.48 219.25 1647.6 939.46 7858.79

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Apr-02 1065.6 41.5 173 86.5 1366.6

May-02 1665.4 18.4 215.3 143.5 2042.6

Jun-02 1240.5 34.4 197 103.5 1575.4

Jul-02 1608.8 17 236 106.7 1968.5

Aug-02 1021 28.8 204.6 138.9 1393.3

Sep-02 1198.3 14.4 233.1 134.6 1580.4

Oct-02 1282.4 77.9 258 166.4 1784.7

Nov-02 1109.3 86.8 337.1 353.4 1886.6

Dec-02 1640.4 53.3 446.4 168.2 2308.3

Jan-03 2184.19 29.92 383.92 229.38 2827.41

Feb-03 1484.2 16.8 289.3 131.4 1921.7

Mar-03 1878.93 38.38 338.39 196.35 2452.05

2002-03 17379.02 457.6 3312.11 1958.83 23107.56

Apr-03 2058.06 47.93 459.95 300.07 2866.01

May-03 1635.92 57.42 380.39 304.3 2378.03

Jun-03 2202.33 38.58 487.81 464.99 3193.71

Jul-03 3897.88 80.24 694.32 447.68 5120.12

Aug-03 5696.01 85.82 773.16 588.14 7143.13

Sep-03 10318.74 92.38 781.23 304.09 11496.44

Oct-03 11880.49 141.09 991.48 603.07 13616.13

Nov-03 9393.49 238.6 634 221.13 10487.22

Dec-03 9054.58 178.99 699.91 410.95 10344.43

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Jan-04 26682.05 128.24 1074.58 426.73 28311.6

Feb-04 13296.98 164 682.56 244.2 14387.74

Mar-04 12103.23 136.18 930 445.84 13615.25

2003-04 108219.76 1389.47 8589.39 4761.19 122959.8

Apr-04 8372.79 156.72 647.04 252.9 9429.45

May-04 25561.3 134.7 912.9 358.2 26967.1

Jun-04 5352.5 200.5 468.1 98.5 6119.6

Jul-04 4511.5 151.4 721.3 427.7 5811.9

Aug-04 5480.1 86.8 509 146.5 6222.4

Sep-04 4801.2 126.3 562.1 397.4 5887

Oct-04 8378.2 231.8 685 310 9605

Nov-04 6911.7 102.1 768.2 419.5 8201.5

Dec-04 12385.8 223.1 1040.9 565.4 14215.2

Jan-05 23176.9 317.4 963.6 423.7 24881.6

Feb-05 9916.3 106.2 963.5 393 11379

Mar-05 15393.5 438.2 1169 765.9 17766.6

2004-05 130241.79 2275.22 9410.64 4558.7 146486.4

Source: NSE (CF- Conversion Table)

Member Concentration

In recent months, there had been a great deal of concern about the sharp concentration of

the market turnover in derivatives and positions amongst a very small set of brokerage

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firms. The trading patterns of members in the Derivative Segment are shown in the Table

3. The top ten members are vital in the case of options which perhaps reflect the greater

demands upon IT system, and human capital of the preceding years was more usable

directly.

Many brokerage firms made a business decision that the derivative market was unlikely

to succeed when the market was young. This gave huge success to the brokerage firms

who were equipped with the vision to anticipate the success of this market and invest in

IT and human capital. These pioneering firms are perhaps expected to have the first

dominant market share. Over time, as other brokerage start building activities of

derivatives, it is expected that these numbers will be substantially transformed.

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Table 3: Member Trading Pattern in the Derivative Segment

Month No Of Members

May 06 Jun 06

Upto to Rs. 100 mn 32 43

Rs. 100 mn. Up to Rs. 500mn. 58 85

Rs. 500 mn. Up to Rs. 2500mn. 175 181

Rs. 2500 mn. Up to Rs. 5000mn. 96 97

Rs.5000mn Upto Rs.10000mn 101 103

Rs. 10000mn and more 252 208

Source: NSE

From this section we have known what exactly derivatives means i.e. its products,

participants, functions and disasters which it had caused to some MNCs and at the same

time were used by Coca Cola, etc to make profits for their organisation. Derivatives is a

risk for every organisations as mentioned earlier; because, if not used in the right manner

it would cause tremendous losses to companies using it. The evolution of equity

derivatives is also mentioned in this section, showing how derivatives are essentially

important in the equity market. In the chapter ahead the author will discuss the

methodology i.e. how the data was collected and what hindrances were there while

collecting the data for this research.

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Chapter 3 Research Methodology

Web12 defines research as “a systematic investigation, including research development,

testing and evaluation, designed to develop or contribute to generalizable knowledge.

Activities which meet this definition constitute research for purposes of this policy,

whether or not they are conducted or supported under a program which is considered

research for other purposes. For example, some demonstration and service programs may

include research activities”

3.0 Introduction

According to Cassel, C. & Symon, G., (2004), all research involves data collection and

analysis, whether through observation, reading, measurement, asking question or a

combination of these or other strategies. The collection of the data and for research may,

however vary considerably in its characteristics. In simple words research can be primary

or secondary. In primary research the collection of data is specifically for study at hand.

It can be obtained by communicating directly or indirectly with the subject or directly by

the investigator. Qualitative research and quantitative research are included in the direct

communication techniques. For the purpose of this research, a combination of primary

and secondary data have been used; and, under primary, although largely quantitative

data was collected, room for qualitative data was made available whenever thought

necessary.

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3.1 Methods of Collection of Data

Flower (1985) opines the choice of collection of data mode-mail, personal interview,

group administration, or telephone is directly related to the sample frame, research topic,

characteristics of sample and the resources available; it has implication of rates of

response, question form, and survey costs. As mentioned earlier, that there are two main

researches which are primary and secondary research:

3.1 (a) Primary Research

Web 13 suggests that primary research is conducting original research to obtain a variety

of social indicators that can help to determine the risk of community and protective

factors identify community resources, and determine community readiness for prevention

efforts. For instance primary research can involve researching community laws and

surveys to determine norms, gaps, attitudes or social services. Some methods of

conducting primary research are as follows:

Questionnaires

Experimentation

Observation

Documentary Sources

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3.1 (a) (I) Questionnaires

According to Cassel, C. & Symon, G., (2004), questionnaires are as a low-priced way to

gather information from a potentially large number of respondents. They are often the

only feasible way to reach a number of reviewers large enough to statistically allow

analysis of results. It can gather information on both the information on specific

components of the system as well on the overall performance of the test system, if a well-

designed questionnaire is used effectively. They can be used to correlate performance and

satisfaction with the test system among different group of users, if the questionnaire

includes demographic questions on the participants. In simple words questionnaires are

an economic way of collecting data from a large number of participants. Questionnaires

are the most important research techniques and ways of collecting data. When a

questionnaire is administered, the researcher control over the environment is somewhat

limited.

Web 14 opines the steps which are required to design and administer a questionnaire

include:

Defining the Objective of the Survey

Determining the Sampling Group

Writing the Questionnaire

Administering the Questionnaire

Interpretation of the Results

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Questions may be designed to collect either quantitative or qualitative data. Quantitative

questions are more precise then qualitative, by the very nature. The qualitative questions

may cause the participant to become bored with the questionnaire sooner as it requires

more thought on the part of the participant. In general it can be said that questionnaires

can measure both quantitative and qualitative data well but that qualitative questions

require more care in design, administration and interpretation. Denzin, N.K. & Lincoln,

Y.S. (2000) opines that questionnaire can be open-ended and close-ended i.e. coded, the

former does not restrict the participant’s answers and the later provides a number of

coded options. Their respective merit depends on the aims of the study and the needs of

the analysis. If desired, the results of open ended questions can be coded into different

categories so that an account of various response is available, though qualitative

information might be lost in doing so.

Web 14 continues by stating that a design of a questionnaire should take into

consideration the present beliefs, depth of knowledge for the product, attitudes and

perceptions, of the respondents. It should be free of bias, use simple languages to

understand and the questions asked should not lead the respondent to a particular answer.

There are some key features to design a questionnaire, although there is no perfect way to

do it. According to Oppenheim (2000), there are 5 basic types of questionnaires.

In- House Survey

Telephone

Mail Questionnaire

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Computer Questionnaire

Mall Intercept

In this particular instance a simple questionnaire method was adopted to collect data for

analysis because of several reasons. Questionnaires are an inexpensive way of gathering

data from a potentially large number of respondents who are spread out. It was an

appropriate way to reach a number of reviewers large enough to allow the result analysis.

The questionnaire is designed to gather quantitative data largely; however, it does have

questions that require qualitative answers. This is done with an intention to gather reliable

data as much, as possible, incorporating qualitative question only when thought to be

essential. More importantly, under this instance, an all qualitative questionnaire would

lead to excessive indulgence in thought thereby leading to waste of time and boredom

and therefore inaccurate answers. At the same time various casual discussions were

conducted on the subject to generally get a vibe on their experience and opinions before

designing the questionnaire.

3.1 (a) (II) Experimentation

Donald S.Tull and Deli. I .Hawkins (1993) define as “A controlled situation in which

the experimenter systematically changes the values of one or more variable (independent

variables) to measure the impact of these variables (the dependant variables)”. Those

items that are affected by the experimental treatment are the dependant variables.

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3.1 (a) (III) Interviews

Denzin, N.K. & Lincoln, Y.S. (2000) opines that the method of interview involves

discussing or questioning issues with people. For the collection of data, it is a useful

technique which would be unlikely to be accessible using techniques such as observation

or questionnaires. An interview normally tends to have a social character. Interviews

may, however, be time consuming as the right respondent might not always be available

and can also be costly. An important contribution of interviews perhaps stems from its

flexibility. It, in most cases, helps in building a relationship; thereby allowing for better

collection of data.

3.1 (a) (IV) Documentary Sources

It is possible to gain information from other sources for special use or to complement

questionnaires, although a great deal of data on individual is confidential. At the

commencement of research, it can prove valuable to look at documentary sources. It is

basically a review of papers and this can involve:

Articles from previous publications

Sites on internet

Documents on audio, video or a computer supported mechanism

Advisors with a particular expertise

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The purpose of reviewing the documents is to allow for a better idea about what has been

said and written on the subject under study.

3.1 (b) Secondary Research

Web15 defines secondary research as “data which already exist in some form, having

been collected for a different purpose, perhaps even by a different organization, and

which might be useful in solving a current problem”. Although secondary research less

expensive than primary research, it is not always accurate, useful, as specific, custom-

made research. There are various sources available to the marketer, and the following list

is by no means conclusive:

Census data

Public records

Business libraries

Trade directories

Trade Associations

Websites

Omnibus surveys

Published company accounts

Previously gathered marketing research

Informal contracts

National/ International governments

Professional institutes and organizations

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National and local press Industry magazines

Types of Secondary data include:

There are basically two types of research of research methods, qualitative and

quantitative. Silverman (2000) opines that the danger in the title, however, is it seems to

assume a fixed preference or pre-defined evaluation of what is good (i.e. qualitative) and

bad (i.e. quantitative) research.

3.1 (b) (I) Qualitative Research

Web 16 defines “Qualitative research is a generic term for investigative methodologies

described as ethnographic, naturalistic, anthropological, field, or participant observer

research. It emphasizes the importance of looking at variables in the natural setting in

which they are found. Interaction between variables is important. Detailed data is

gathered through open-ended questions that provide direct quotations. The interviewer is

an integral part of the investigation (Jacob, 1988)”.

Silverman (2000) states that the reason for these differences lies in the purpose of the

research. Qualitative research is designed to predict and control the topic of study.

Therefore, the quantitative researcher must be able to predict and control the data they are

gathering.

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3.1 (b) (II) Quantitative Research

(Web 17) defines “Quantitative research is the systematic scientific investigation of

quantitative properties and phenomena and their relationships. Quantitative research is

widely used in both the natural and social sciences, including physics, biology,

psychology, sociology, geology, education, and journalism. The objective of quantitative

research is to develop and employ mathematical models, theories and hypotheses

pertaining to natural phenomena. The process of measurement is central to quantitative

research because it provides the fundamental connection between empirical observation

and mathematical expression of quantitative relationships.The term quantitative research

is most often used in the social sciences in contrast to qualitative research”.

Motley (1986) citicises studies for lacking a strong theoritical basis from which to

operate. However, quantitative researchers fail to acknowledge is the position they put

themselves in when they do this. Silverman (2000) opines that much quantitative

research leads to the use of a set of adhoc procedure to define, count and analyse its

variable. The main advantage of quantitative research method is that it gives out

quantifiable data sometimes, which needs to be generalised. The great weakness of this

approach is that it does not take account of human behaviour, but it is important to find

out the actual objectives of the reseach.

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http://en.wikipedia.org/wiki/Science

http://en.wikipedia.org/wiki/Quantitative

http://en.wikipedia.org/wiki/Measurement

http://en.wikipedia.org/wiki/Qualitative_research


According to Hathaway (1995), another major difference between that the two is the

underlying assumptions about the researcher’s role. In qualitative research, it is the

thought that the researcher can learn about situtation mostly by participating or/and being

immersed in it. In quantitative research, however, the research is ideally an objective

observer that neither influeces or participates in what is being studied. The basic

underlying assumptions of both methodologies guide and sequence the types of data

collected methods employed. The primary research in this instance was largely based on

quantitative analysis.

3.2 Research Process

Web 18 states that “The research process is the step-by-step procedure of developing

one's research — and research paper. However, one can seldom progress in a step-by-step

fashion as such. It is often necessary to revise an initial research plan. The research

process involves identifying, locating, assessing, analyzing, and then developing and

expressing your ideas. These are the same skills that will be needed in the post-university

"real world" when you produce reports, proposals, or other research for your employer.

All of these activities will be based on primary and secondary sources from which

recommendations or plans are formulated”. There is no fixed number of stages to be

followed since it varies from research to research. At the same time every research

process does in reality follow a common trend in its completion. This includes

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formulating and clarifying a topic, reviewing the literature, choosing a strategy, collecting

the data, analysing the data collected and finally writing up.

Naresh K. Malhotra (2004) opines the different steps in which research should be done.

Problem Definition.

Development of an Approach to the Problem.

Research Design Formulation

Field Work or Data Collection

Data Preparation and Analysis

Report Preparation and Presentation.

Web19 states the different steps in research in a more simple understandable way in

which research should be done.

Define the Problem

How is the collection of data done to analyze problem to be solved?

Select the method of sampling

How will be analyzing any collection of data.

The decision about the budget and time frame is to be done.

Go back and speak with the clients or managers requesting the research. Make

sure that you agree on the problem. If you gain approval, then move on to the next

step.

Go ahead for the collection of data.

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Conduct data analysis.

Check for the errors. It is not uncommon to find errors in sampling, method of

collecting data, or analytic mistakes.

Write your final report.

3.3 Research Design

Naresh K. Malhotra (2004) opines that research design is a blueprint or framework for

conducting the research project. It is in simple words, a plan for study that guides the

collection and analysis of data. It, in fact, is the central part of any activity involving any

work of research. It serves as a guide to the investigation methods, the instruments in

research used, nature of data with the sampling frame and plan. One of its key features

should be to hold the parts and phases of the enquiry together. It should be

comprehensive in its coverage of the work i.e. it should allow for logic, tight-ness,

precision, and effective use of resources. A research design lays the foundation for

conducting the project. A good research design will ensure that the research plan is

conducted efficiently and effectively.

3.4 Sampling

Four companies were chosen for having Comparative Analysis of Current and Future

trends with the help of Equity (stock) market in India.

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The companies which have been chosen for the comparative study are:

NSE

BSE

ShreeKrishna Mutual Funds Ltd

Kabra Mutual Funds Ltd.

These above mentioned companies do represent a part of Mutual Fund’s

Associations companies, so data collected is valid and reliable to all extent.

The author in his Research will be carefully studying, analysing, and would make

conclusions on the overall performance of three kinds of funds of the above

chosen Mutual Fund Companies.

In addition to these the author would conduct interview with the Director of Kabra

Mutual Funds Ltd, ShreeKrishna Mutual Funds Ltd, Mr. Nikunj Shah - Dealer

Institutional Derivatives, Mr. Chirag Mehta - Dealer Institutional Derivatives on how an

investor would choose the right kind of equity and a brief view of working of the market

of derivatives in India.

3.5 Questionnaire Design

A Mixed Method Approach was used by the author to segment the questionnaires.

Quantitative data was supposed to be used; but to get certain definite answers to

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certain questions, qualitative data analysis was used. The questionnaire was designed

largely to gather quantitative data, although it does have questions that require

qualitative answers. This is done with an intention of collecting as much reliable data

as possible incorporating qualitative questions only when thought necessary. As

mentioned earlier, to generate ‘Important Questions’, the research will use qualitative

research methods. Since the range of responses were not tightly defined in coded

questions, open format questions have here felt good for soliciting subjective data. An

obvious advantage is that the variety of responses should be wider and more truly

reflect the opinions of the respondents. Therefore, an open-ended question with a

coded system was used to collect data so that while a definitive answer is gauged,

room for personal expression is not lost in the process. A logical sequence was

followed allowing for test of bias mechanism in it, while designing the questionnaire.

The length of the questions was of paramount importance, because it was tempting to

ask long, explanatory questions to the interviewee; but since that could lead them on

to the answer, a right balance needed to be struck. So most of the questions were kept

short and brief, but an odd question was allowed to be long if required as it was felt

useful to give the respondents time to marshal their thoughts if that meant a more

certain answer. Finally, having taken into consideration the most essential feature was

to ensure that the questions were simple, clear, avoiding hypothetical questions, were

not leading, and uses correct language and phrasing.

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3.6 The Interviews

The data that is collected is valid and reliable as mentioned earlier as these companies

represent a part of Mutual Fund’s Association of the companies. Therefore, same set

of questionnaires were used but subsidiaries’ questions were used depending on the

responses. Therefore, various interview will be conducted i.e. interviewing the

Managing Director of Kabra Mutual Funds Ltd, ShreeKrishna Mutual Funds Ltd, Mr.

Nikunj Shah - Dealer Institutional Derivatives, Mr. Chirag Mehta - Dealer

Institutional Derivatives Ltd and some interviews with the employee working for the

above mentioned firms and the employees of NSE and BSE markets. The sample size

of interview will be 15- 30 which would be analysed by quantitative methods. To

collect the data from the four major mutual fund companies under study, the

researcher has used semi-structured interviews. The data that is collected is recorded

as written note and shown in chart form analysis. The real motives and feelings were

obtained from the respondents with the help of interviews. The bias information is

removed through this process and tries to probe deeply into real ideas of the

respondents. The questionnaire was easily understood by the respondents and the

answers were given readily. Generally, the researcher found that the questions

followed from the answers provided the interviewees leading too much in-depth

discussion later.

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3.7 Conclusion

For this research, the purpose is to analyse quantifying behaviour, for which a

questionnaire model of collecting data will be the most suitable. For gathering responses

from a carefully crafted cross section of the general public via the internet using email for

delivering and receiving responses, a self-administered questionnaire was used. The data

gathered will help in ascertaining the main reasons for difficulty faced by major

entertainment companies in breaking into some consumer markets. Provision for

qualitative responses will be made by the questionnaire, for respondents to express their

views on issues directly related to the study which will in the end be used to come to a

conclusion on the over all hypothesis of the research which is to say that there seems to

be a strong cultural resistance in some regions faced by major organisations in the

industry when trying to win over audience. The validity and reliability of the collection of

data helps in better quality research.

Thus, in this chapter the author has discussed the meaning of research and classification

of primary and secondary research i.e. Qualitative and Quantitative research, the process

of research and the design in which the author has structured i.e. Sampling ,

Questionnaires and Interviews. In the chapter ahead author has discussed the analysis of

data and its findings.

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Chapter 4 Data Analysis and Findings

Derivatives are key parts of the financial system. They are financial instruments which

are derived from underlying items of values and it does play a vital role in the equity

markets in many forms such as Forwards, Futures, Swaps and Options. Derivatives do

revolve around these above-mentioned variants/products with the help of its participants

which are Hedgers, Speculators and Arbitrageurs.

Chart 1: Awareness of Derivatives in Equity Market.

95

4 10

20

40

60

80

100

Yes No N/A

The chart above clearly shows that 95% of the people have knowledge about what

derivatives are and how they revolve around the equity market. 4% of the people thinks

that derivatives are no longer to be used in the equity market, and 1% of the people has

knowledge of what derivatives are but do not know what difference it makes to the equity

market.

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The NSE reported a total turnover of Rs.25, 470,526 million (CF- Conversion Table)

during 2004-2005 as against Rs.21,306,492 million during the preceding year, about 770

lakhs contracts were traded during the same period. The daily turnover average also

increased from 110,150 million in April 2004 to 135,844 million in March 2005.

The product-wise distribution of turnover for NSE segment for the period 2004-2005 is

presented in Chart 2. It seems that near month contracts are most popular than not so

near month contracts, futures are more well-liked than options, contracts on securities are

more well-liked than on indices and call options are more well-liked than put options.

Chart 2 Product-wise Distribution of Turnover of NSE, 2004-2005

Thus from the above chart we can see clearly that Stock Futures (58.27%) have

dominated the market in 2004-2005 and have the highest product-wise distribution of

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turnover of the NSE in compared to Stock Options(6.63%), Index Futures (30.32%) and

Index Options(4.79%).

One of the puzzles in India’s experience with the equity derivatives has been domination

of individual stock derivatives. This partly reflects a problem with human capital, where

the thought processes of speculation and market making on individual stocks, which have

prevailed for many decades, were carried forward into equity derivatives market from

2001, onwards. In contrast, trading in index derivatives requires new kinds of thinking

like the portfolio concept diversification.

As experience with derivative grows, we shall expect a greater shift away from individual

stocks to index derivatives. In addition, the importance of index volatility is greater when

faced with situations like budget announcement, or the Gulf War, as opposed to months

where macroeconomic news appears to be unimportant.

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Chart 3: Business Growth of NSE Segment

Source: NSE

The business growth of NSE segment is shown in the chart above. The daily average

turnover is also shown during the period. It is seen that the average daily turnover was

more than 250000 million (conversion table) during Jan-Mar 2006 quarter whereas it has

been increasing from Jan- Mar 02 quarter which was approximate 1000 million, it does

not mean that people didn’t know what was the equity market at that time but they were

getting much more knowledge about the stock market and thus as we can see in the chart

above the business growth have not been stagnant but it has been increasing with a quick

speed and thus have reached the turnover above 250,000million during the quarter Jan –

March 2006.

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Intermediation

The key element of a successful derivatives market is a nationwide network of brokerage

firms. These role play a important role in terms of giving direct market access to firms

and individuals located across the country , by doing credit risk management about the

failure of customers, and by performing knowledge functions in terms of training,

technical support and consulting. This network of firms has been a key element in the

nationwide outreach of the modern securities industry, as opposed to the traditional south

Bombay focus which prevailed prior to 1994.

Geographical Distribution

The F&O segment of NSE (CF- Glossary of terms) provides a nation-wide market. In the

chart below the city-wise turnover of the F&O segment is presented in the Table. During

the month Jan 2005, Mumbai contributed nearly 43.54% of the total turnover. The

contribution from Delhi was 21.54% and Kolkata was 12.15%.

Table1 shows the distribution of and the turnover of derivatives by various urban centres

as of Jan 2005. This shows that equity derivatives trading is more concentrated in the top

five urban centres. Turnover from outside the top five centres amounts to 18.2% only.

This difference is likely to be largely owing to gaps in knowledge on the part of

employees of brokerage firms, and their customers, in location outside the major urban

centres.

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Member trading Pattern in the Derivative Segment

Source: NSE

Open Interest

Open Interest is the total number of outstanding contracts that are held by market

participants at the end of each day. Putting it simply, open interest is a measure of how

much interest is there is a particular option or future. Increasing open interest means that

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fresh funds are flowing in the market, while declining open interest means that the market

is liquidating.

Chart 4: Awareness of the Open Interest Rate

97%

2% 1%0%

20%

40%

60%

80%

100%

120%

Yes No N/A

YesNoN/A

Chart 4 clearly shows that 97% of the people are aware of what is open interest and have

knowledge about how important is it for the equity market., where as 2% of the people do

not know what is implied by open interest rate and 1% are aware and have knowledge

about how important is open interest rate but they don’t know what difference does it

make to the equity market.

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Chart 5: Daily Open Interest for Near Month Nifty Futures for 2004 - 2005

Source: NSE

Chart 5 clearly shows that the daily open interest rate have been tremendously going up

from 1- 15 April 2002 which is a very good sign for market, because the more the open

interest goes up, the more the market is flowing in with fresh funds and by any chance if

the daily open interest rate goes declines/down, then the market will have to pay debts.

So, the above chart clearly shows that the market is flowing in with fresh funds and the

daily open interest rate is as high approximate Rs.20000 million.

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Implied Interest Rate

Avadhani (2000) believes in the ideal efficient market, the cost of transaction should be

zero, and there should be a generous supply of sophisticated arbitrageurs. This should

yield a cost of carry on the futures market which exactly reflects the zero coupon yield

curve for government bonds, with a slight risk premium to reflect the failure probability

of clearing corporation.

The implied interest rate or futures market or cost of carry is often used inter-changeably.

Cost of carry is more appropriately used for commodity futures, as by definition it means

that the total costs required carrying a commodity or any other good forward in time. The

costs involved are insurance cost, transportation cost, storage cost and the financing cost.

In case of equity, the carry cost is the cost of financing less the dividend returns.

Assuming zero dividends the only relevant factor is the cost of financing. One could

work out the implied interest rate incorporated in future prices, which is the percentage

difference between the future value of an index and the spot value annualised on the basis

of the number of days before the expiry of the contract. Carry cost or implied interest rate

plays an important role in determining the price differential between the spot and the

futures market. By comparing the implied interest rate and the existing interest rate level,

one can determine the relative cost of futures’ market price. Implied interest rate is also a

measure of profitability of an arbitrage position. Theoretically, if futures price is less that

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

cost of carry, arbitrage opportunities exist.

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Chart 6 shows the awareness of people in subject to Implied Interest Rate. The futures

prices are available for different contracts at different points of time. Chart 7 presents

Nifty futures close prices for the near month contracts, which are most liquid and the spot

Nifty close values from April 2003 to March 2004. The difference between the future

price and spot price is called basis. As the time to expiration of a contract reduces, the

basis reduces. Daily implied interest rate for Nifty futures from April 2003 to March

2004 is presented in Chart 8. The implied interest rate for near month Nifty Futures as

on the last trading of the month is presented in Table 2. It is observed that index futures

market suffers from mispricing in the sense that futures trade at discount to underlying.

This may be due to restriction on short sales and lack of maturity.

Chart 6: Awareness of Implied Interest rate

96%

3% 1%0%

20%

40%

60%

80%

100%

Yes No N/A

YesNoN/A

Chart 6 above shows that 96% of the people are aware of what implied interest is and

have the knowledge about how important it is to the equity market, where as 3%of the

people have no clue about what is known by implied interest rate and 1% of the people

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are aware of it and have knowledge about how important is Implied interest for the equity

market but they don’t know what differences does it make to equity market.

Chart 7: Nifty Futures and Spot Price (2004 -2005)

Source: NSE

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Chart 8: Implied Interest Rate for Near Month Nifty Futures (April 2004-March

2005)

Source: NSE

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Table 2: Implied Interest Rate for Near Month Nifty Future

Source: NSE

Implied Volatility

Web 10 opines that volatility is one of the important factors, which is taken into account

while pricing options. It is a measure of the amount and the speed of price change. To

estimate future volatility, a time series analysis of historical volatility may be carried out

to know the future movements of the underlying. Alternatively, one could work out

implied volatility by entering all parameters into an option pricing model and then

solving it for volatility. For example, the Black Scholes model solves for the fair price of

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the option by using the following parameters-days to expiry, strike price, spot price, and

volatility of underlying, interest rate, and dividend. This model could be used in reverse

to arrive at implied volatility by putting the current price of the option prevailing in the

market. Putting it simply implied volatility is the estimate of how volatile the underlying

will be from the present until the currency of option. If volatility is high, then the options

premiums are relatively expensive and vice-versa. However, implied volatility estimate

can be biased, especially if they are based upon options that are thinly traded samples.

Chart 9: Awareness of Implied Volatility

95%

3% 2%0%

20%

40%

60%

80%

100%

Yes No N/A

YesNoN/a

Chart 9 above shows that 95% of the people are aware of what Implied Volatility is and

have the knowledge about how important it is to the equity market, where as 3%of the

people have no clue about what is known by implied volatility and 1% of the people are

aware of it and have knowledge about how important is Implied Volatility for the equity

market but they don’t know what differences does it make to equity market.

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Chart 10: Intra-day evolution of Implied Volatility

Chart 10 shows the time-series of implied volatility on the two most traded underlying –

Satyam Computer and Nifty – on 9 December 2002. The upper curve in the graph is

obviously that for Satyam, and the lower one is for Nifty. This graph plots the implied

volatility associated with the price observed on every trade for ATM call or put options.

The range of values seen in this graph, even at a single point in time, reflect (1) the

bid/offer spread on both call and put option markets, i.e. the “bid ask bounce”, and (2) the

lack of put-call parity arbitrage, through which call and put options do not trade at

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identical implied volatilities. A casual perusal of the graph seems to suggest that there is a

good deal of potential for intra-day trading on the options market. The derivatives market

is producing new information in the Indian economy, by making available these market-

based volatility forecasts (Bodie & Merton 1995). As option liquidity builds up, we will

be able to obtain a term structure of volatility, showing market forecasts of volatility

between the trading day and various different expiration dates. Such interpretations, and

uses of implied volatility, will be much more justifiable after put-call parity is established

by arbitrageurs, whereby put and call options will show near-identical implied

volatilities. Prof. J. R. Varma (“Mispricing of Volatility in the India Index Options

Market”, Working Paper 2002-04-01, April 2002, IIM, Ahmedabad) has estimated the

option prices and implied volatility from the Black formula. It was found that for about

6.5% of all calls and about 7.5% of all puts, implied volatility was undefined, because the

option traded below its intrinsic value. This is an indication of mispricing of options.

A study conducted under the NSE Research Institute titled “Futures Trading, Information

and Spot Volatility of NSE -50 Index Contract,” Working Paper No. 18; November 2002

in particular addressed the impact of introduction of futures trading on volatility of spot

market by separating the possible effects of market wide information. The changes in the

volatility of spot price may be due to other factors apart from futures. The study reveals

that there is a fall in volatility since the commencement of futures trading which may be

attributed to increase trading in the cash markets due to faster dissemination of

information making cash markets more liquid and therefore less volatile. It could be also

due to shift of speculation from cash market to futures market due to low transaction

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costs and high leveraging in the futures market. This shift can be attributed to low

margins, low transaction cost and standardised contracts and trading conditions prevalent

in the futures market.

Volatility Smile

Avadhani (2000) proposes that volatility smile is the relation between implied volatility

and the strike price of the same maturity. Normally the smiles for equity options have a

downward sloping curve and they look alike for both put and call option. However, in

Prof Varma’s “Mispricing of Volatility in the Index Options Market” working paper

2002-04-01, April 2002, IIM, Ahemdabad found V shaped smiles and the smiles are

markedly different for puts and calls. He estimated volatility smiles separately for puts

and call options and established that the smiles are sharply different for calls and puts.

The implied probability distribution is more highly peaked and has (expect for deep-in-

the money calls) thinner tails than normal distribution or historical distribution. The

market thus appears to be underestimating the probability of market movements in either

direction. Prof. Varma also noticed some over pricing of deep-in the-money calls and

some inconclusive evidence of violation of put-call parity. However, it was observed that

the observed prices are rather close to the average of the intrinsic value of the option and

its Black-Scholes value disregarding the smiles. In an ideal Black/Scholes world, the

market should use a single implied volatility in pricing options for a given maturity, with

various different strikes. However, in the real world, the phenomenon of the ‘the

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volatility smile’ has been repeatedly observed. This is depicted pictorially in a graph

where option strikes are placed on the x-axis, and implied volatilities placed on the y

axis. The figure often looks like a “smile”, with higher implied volatility for strikes which

are far away from the spot price. The smile is generally interpreted as evidence that the

simple Black/Scholes model does not fully capture the behaviour of the market.

Chart 11: Volatility Smile for Nifty at 3 PM on 9th Dec 2002

Chart 11, above shows a typical smile diagram for Nifty and Figure 1 shows the diagram

for a few stocks. We do see significant variation of the implied volatility depending on

the stock price. However, there is no simple, ‘smile pattern’. It is striking to see a greater

flatness of the smile when the bid/offer spread is tight, i.e. when there is a greater

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liquidity. There may be an underlying phenomenon where higher implied volatilities and

high bid/offer spreads are both reflecting underlying uncertainty in the market.

Figure 1: Volatility Smile for four underlying at 3 PM on 9th Dec 2002.

From the above Figure 1, it can be seen clearly from the above findings that derivatives

are important tool for the equity market and they do play an important role in the up-

bringing of the market as well. But how these analyses/findings ahead are compared to

see their relevancy with the help of STEEPLE analysis previously called as PESTEL

Analysis. It is however, useful to begin with the process with a checklist – Political

Future, Environmental Future, Economic Future, and Social-Cultural Future,

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Technological Future, Legal Future and Educational Future. In the STEEPLE Analysis

the only factor which will not be compared to check the relevancy of the equity market in

Environmental Future. The chart below presents some of the main item that might be

considered when undertaking a STEEPLE Analysis to compare the relevancy of equity

market in any country.

Political Future

Relation between the organisation and government

The distribution of income is directly related to GDP of a country, as mentioned above

and since the GDP is directly related to each and every consumer’s income, therefore

more than 79% of the people are employed by the equity market and thus it concludes

that India is a tertiary economy and no more an agrarian economy. Nowdays, the

government is playing a major role in each and every country and giving out investment

policies not only related to stock market but also related to power sector industries, tea

industries etc.

Government ownership of industry and attitude to monopolies and

competition

Government ownership of industry and attitude to monopolies and competition over

certain firm shares i.e. stocks and in certain firm’s government have got up to 25%

stack in their annual earnings to support the infrastructure of the country.

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Education Future

Today there is an awareness made to the people by the government that the fact that

derivatives do play an important role in the equity market by making them more and

more educated not in general manners but also in the stock market, to know how vital

the stock market is, there are courses conducted. And how our economic is directly

related to it, which is very vital for all the individuals to know, because the total GDP

for our country depends on the equity market.

Economic Future

Interest Rate

Interest rate depend on the equity market because if the interest rates are set high by

any firm for their shares then buyers would not buy their shares and would opt for

some other good firm’s shares i.e. stocks. So the interest rate for each and every

firm’s shares should be set to standard rate.

Investment, by the state, private enterprise and foreign companies.

There is investment made by foreign companies, state, people and private enterprise

into this equity market. For instance in India, Reliance, Dell, Satyams, Wipro and

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many other big names are examples of people, foreign companies and private

enterprise investing into them to make them recognised worldwide.

Currency fluctuations and exchange rates.

Currency fluctuations and exchange rates of each and every country depends upon its

GDP. As mentioned above that equity markets do play a vital role to set up or to

decline a country’s GDP, because people do invest in this market to get high returns.

Total GDP and GDP per head.

The distribution of income is directly related to GDP of a country. As mentioned

above and since the GDP is directly related to each and every consumer’s income,

more than 79% of the people are employed by the equity market, and thus it

concludes that India is a tertiary economy and no more an agrarian economy.

Disposable Income and Consumer expenditure.

Disposal income is an income where an individual keep it aside for investment or

any other activity. As there are higher returns in the stock market and people are

aware of these, individuals are investing more and more of their disposable

income into stock market to obtain high returns.

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Social-Cultural Future

Distribution of Income

Distribution of Income does relate with Equity and Derivatives market, because in

countries like India for, the total GDP relates to the above mentioned market, because

it employs more than 79%.

Education

One of the vital aspects related to Equity and Derivatives market in India is

education. This is because people day by day are more aware of the importance and

the role of derivatives in the stock market .i.e. equity market.

Technological Future

Level of expenditure on R&D by organisation’s rivals

The level of expenditure on R&D by organisation rivals are on a very high scale;

because each and every firm want to be best and earn the most profit i.e. sellers

should sell and buyers should buy it shares, therefore, the rivals expenditure is on a

higher scale.

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Government investment policy

Government is playing a most important role in each and every country and giving

out investment policies not only related to stock market but also relates to power

sector industries, tea industries and etc.

New patterns and products

There are new up-coming products in the stock market i.e. newly listed firms sell

their shares i.e. stocks on NSE.

Legal Future

Competition law and government policy

Government have put certain policies for each and every organisation to introduce its

shares i.e. stocks into the market and also certain policies for sellers and buyers who

play a vital role in making a sale for the companies.

Hence it clearly shows that with the help of the STEEPLE analysis, the equity market

does have its own relevancy/importance in each and every country.

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Chapter 5: Conclusion and Recommendation

Derivatives are a key part of the financial system. To conclude the significance of

derivative market in India, in this chapter the author has firstly taken the findings and

directly has related its importance with the institutional investors of India. Thus, the

findings are summarised below:

The Sellers and Buyers have knowledge and are aware of derivatives and its

importance in equity market i.e. NSE, BSE.

The best product-wise distribution has been made by NSE for equity market in

India.

The Business growth of NSE started from a mere Rs.1000 million and has reached

to 250,000 million during Jan- Mar 2006 quarter and is at the booming stage at the

moment possible itself.

The brokers who are the intermediates play an important role for up-keeping the

interest rate in the equity market.

The business capital of India which is Mumbai has shown the highest Member

trading i.e. business of equity market.

The Sellers and Buyers are alert to the open interest rate which is calculated by the

end of day to know the business growth.

Today we can see that the Open Interest rates for NSE Segment for Near Month

Nifty Futures have risen to 25000 million, which is quite remarkable; because it

states that the sellers and buyers of the stock/shares are aware of the broker’s

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holding their contracts and making equity market more reliable so that more and

more users/people/clients do put in money.

Sellers and Buyers have the knowledge and aware of the implied interest rate which

is used to calculate the efficiency of the equity market.

Sellers and Buyers also have the knowledge and aware of the implied volatility

which is used to calculate to know the pricing options.

Intra-day evolution of implied volatility has estimated the prices of options and

found that for about 7.5% for all puts and about 6.5% for all calls was undefined,

because of the intrinsic value, this was a dreadful sign for the market of equity,

because it was clearly a signal of mispricing the options and the sellers and buyers

had no clue about it. This shift can be attributed to low cost of transactions, low

margins, etc for the equity market.

The market has a much automated borrowing and lending market which is not upto

the market.

In India, derivatives and equity markets hold 79% (approximately) population

towards it. Sellers and Buyers who sell and buy the stock listed on the BSE and NSE

(Glossary of Terms) are alert that NSE has the highest product-wise distribution for

India. In the earlier chapters, we have seen that derivative to an extent, are a disaster

for companies’, but at the same time it has been proved wrong by Companies like

IBM, Intel, Coca-cola, by making remarkable profits for themselves and making each

and every individual aware that derivatives are extremely important for stock market,

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therefore the business growth of NSE has started from mere Rs.1000 million to Rs.

200,000 million (CF- Conversion Table) in a mere span of 2 – 3 years.

Dhingra (2000) opines that there is a clear indication to rise of these stocks to

considerable amounts, if one observes the history of stock exchanges and the outcome of

blue chip companies like Microsoft, IBM, Intel or Coca- Cola on the stock index; there is

a clear signal of the rise of these stocks to considerable amounts. History shows that an

extraordinary growth characteristic of the above stocks is related to the fundamental on

which the companies have been operating under and not speculation. The current market

capitalisation of Microsoft Corporation is approximately $225 billion compared to the

group turnover of mere $22 million and looking back at the BP case study (1998) the

answer indicates the advantage derivatives provide against various risk involving

commodities, fixed assets or interest rate transaction and planning. Now the question

remains that do derivatives always aid every corporation or organisation to yield profits?

Industry Week (July 1998) mentions that derivatives have been plagued, which have led

to media’s criticism and subsequent users and accounting board’s cautious attitude

towards derivatives. In the past most derivatives problems are related to the uncontrolled

speculation by various individuals primarily in the highly susceptible futures, forwards

and swaps.

In terms of a vibrant market for exchange-traded derivatives, India is one of the most

booming developing countries. This chapter recaps the strength of the modern

development of India’s securities market and conclusion i.e. suggestions on to how the

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institutional investors in India i.e. mutual funds companies, banks, FDI,etc play an

important role in the market which are based on nationwide market access, anonymous

electronics trading, and a predominantly retail market. Web 21opines that the derivative

market of India had a flat line in the early 1950s, but since the new turn of millennium

have gone strength to strength, doubling the turnover and outdoing expectations. Not

even on the radar of the global business futures of 1990s, India has recently rocketed up

to become Asia’s fourth largest exchange traded derivative market, behind Korea, Japan

and China. The bulk of trading is in equity products including single stocks (SSF’s) and

options offered by National Stock Exchange of India, with transactional values equivalent

to 200% of the underlying cash market, which is not bad for a market which is five years

old i.e. Indian Equity Market.

There is a lot of risk in investment in Equity Funds and is appropriate for those individual

who can afford to take high risk but this high risk may either leave the investor to lose all

their money with no returns as they are not safe investments or pay them high returns in

the long run. Therefore, from the point of view of the investment in such type of equity

funds would be safer, and investments would be secure. Thus, we can conclude by saying

that the entire derivatives market and the future trends in India would be essential to

compare and see how these derivatives in the equity market are used by institutional

investors.

Thus it follows that Institutional Investors in India could be meaningfully classified into:

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All India Financial Institutions (FIs)

Mutual Funds(MFs)

Banks

Foreign Institutional Investors(FIIs)

Life and General Insurers

In the ensuing sections, the issues and impediments in the use of the following types

of derivatives by the institutional investors in India:

Equity Derivatives

The intensity of derivatives usage by any institutional investor is a function of its

ability and willingness to use derivatives for one or more of the following purposes:

Risk/Trading/Market Making: Running derivatives trading book for profits

and arbitrage.

Risk Containment: Using derivative for risk containment purposes and

hedging.

Covered Intermediation: On-balance-sheet derivatives intermediation for

client transactions, without retaining any net-risk on the balance sheet (except

credit risk).

These perspectives are considered in examining issues and impediments in use of

derivatives in the ensuring paragraphs.

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BANKS

Types of Banks

Based on the differences in business practices, organisational ethos, and governance

structure, it is meaningful to classify the banking sector of India into the following:

Private Sector Banks (Old Generation).

Private Sector Banks (New Generation).

Public Sector Banks (PSBs).

Foreign Banks (with banking and authorised dealer license).

Types of Risks

The two core risks are Interest Rate Risk and Credit Risk and all banks accept and wish

to profit from .Foreign Currency (Price) Risk accepted by banks varies widely across the

four categories. Commodity (Price) Risk accepted by bank under their scheme framed

under respect of gold deposits accepted by various banks under their schemes framed

under RBI Guidelines on the Gold Deposit Scheme 1999 announced in the union budget

for the year 1999-2000. Equity (Price) Risk accepted by bank again is limited to their

direct or indirect (through Mutual Funds) exposure to equities under the RBI prescribed

5% capital market instruments limit (of total outstanding advances as at previous year-

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end). Some banks may have further equity exposure on account of equities collaterals

held against loans in default.

Equity Derivatives in Banks

Banks play an important role in the equity market, as mentioned earlier. Given the highly

leveraged nature of banking business, and the attendant regulatory concerns of their

investments in equities, banks in India can, at best, be termed as marginal investors in

equities. Use of equity derivatives by banks ought to be inherently limited to hedging and

arbitrage trading between cash market and options and futures market. However, for the

following reasons, banks with direct or indirect equity market exposure are yet to use

exchange trading equity derivatives (via, index futures, security-specific futures, index

options or security-specific options) currently available on the Bombay Stock Exchange

(BSE) and National Stock Exchange (NSE):

RBI’s guiding principle by banks in the capital market instruments does not

authorise banks to use equity derivatives for any purpose. RBI’s guiding principle

also do not authorise banks to undertake securities borrowing and/or lending of

equities. This also disables also banks processing institutionalized risk

management process and arbitrage trading skills for running an arbitrage book to

capture risk free pricing mismatch spreads between the equity cash and options

and futures market – and activity banks currently undertake in the fixed income

and FX cash and forward markets.

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Indirect or direct equity exposure of banks is negligible and does not warrant

serious management attention and resources for hedging purposes.

To manage the risk of equity market exposure, and monitor use of equity

derivatives, the internal resources and processes in most bank treasuries are

inadequate.

Inadequate technological and business process readings of their treasuries to run

an equity arbitrage trading book, and manage related risks.

All India Financial Institutions

The All India FI Universe

With the merger of ICCI into ICCI Bank, the universe of all- India FIs comprises IFCI,

SIDBI, IDBI, IIBI, NABARD, IDFC and EXIM. In the context of use of financial

derivatives, the universe of FIs should perhaps be extended to include a few other

financially significant players such as HDFC and NHB.

Equity Derivatives in FIs

The risk exposure in equity of most FIs is rather not important, and often restricted to

equity devolved on them under underwriting commitments they made in the era upto

mid-1990s. FIs could use equity derivatives for hedging (risk containment) purposes and

110


for arbitrage trading purposes between the cash market and options and futures market.

FIs too are not users for equity derivatives, for the same reason to those outlined earlier

concerning with banks. FIs are not disabled by the RBI guideline from running an

equities arbitrage trading book to capture risk free pricing mismatch spreads between

cash and options and futures market. Yet, it can be seen that most FIs do not run an

equities arbitrage trading book. This could be the possible reason because for the

inadequate readiness on terms of possessing arbitrage trading skills and institutionalized

risk management process for running an arbitrage book.

Mutual Funds

Equity Derivative in Mutual Funds

In the equity derivatives market, mutual funds ought to be natural players. SEBI (Mutual

Funds) Regulations also authorise use of exchange traded equity derivatives by mutual

funds for hedging and portfolio rebalancing purposes. And, being tax exempt, there are

also no tax issues relating to use of equity derivatives by them. However, most mutual

funds, whenever managed by Indian or foreign owned asset management companies are

not yet active using the equity derivatives that are available on NSE or BSE.

The following impediments seem to hinder use of exchange trade equity derivatives by

mutual funds:

111


SEBI (Mutual Funds) Regulations restrict use of exchange traded equity

derivatives to ‘hedging and portfolio rebalancing purposes’. The popular view in

the mutual fund industry is very open to interpretation; and the trustees if mutual

funds do not wish to be caught on the wrong foot. The mutual fund industry

therefore wants SEBI to clarify the scope of this regulatory provision.

Inadequate technological and business process readiness of several players in the

mutual fund industry to use equity derivatives and manage related risks.

The regulatory prohibition on use of equity derivatives for portfolio optimization

return enhancement strategies, and arbitrage strategies constricts their ability to

use equity derivatives.

Relatively insignificant investor interest in equity funds ever since exchange

traded options and futures were launched in June 2000 (on NSE, later on BSE).

Foreign Institutional Investors (FIIs)

Equity Derivatives in FIIs

Applicable SEBI and RBI guidelines, till Jan 2002, permitted FIIs to trade only in index

futures contracts on BSE and NSE. RBI, only since 4 Feb 2002 permits (as a sequel to

SEBI permission in Dec 2001) FIIs to trade in all exchange traded derivative contracts

within the position limits for trading of FIIs and their sub-accounts.(These open position

limits have been spelt out in SEBI circular dated 12 Feb 2002.) With the enabling

regulatory framework available to FIIs from February 2002, their activity in the exchange

112


traded equity derivatives market in India should increase noticeably in the emerging

future. Evidently, several FIIs are still in the process of completing the process of their

internal approvals for use of exchange traded equity derivatives on the NSE or BSE.

Perhaps, the two years of successful track record of the NSE in managing the systemic

risk associated with its futures and options (F&O) segment would also pave way for

greater FII activity in the equity derivatives market in India in the emerging future.

Tax Issues in Equity Derivatives for FIIs:

Two crucial tax issues arise in use of equity derivatives by FIIs:

Tax character of profit or gain from equity derivatives contract − is it business

income or capital gains, and if business income, is it speculative business income

or non-speculative business income.

Applicability or otherwise of withholding tax on profits from equity derivatives

contracts.

In absence of a specific finding ruling either from the CBDT or a competent Court, the

income tax law on these issues remains wide open to interpretation. Technically, given

the short tenure of equity derivative contracts, the better view seems to be that the profit

or loss from equity derivative contracts would be business profit or /loss rather than a

capital gain/loss. Interestingly, the CBDT circular dating back to 12 September 1960

interprets very generously hedging transactions in commodities, stocks and shares, to

113


include portfolio and strategic hedging, and does not confine hedging transactions to a

position hedge. And, any profit or loss from a hedging transaction in stocks and shares is

treated as a non-speculative business profit or loss. This is significant because losses from

speculative transactions are ‘ring fenced’ and cannot be offset against capital gains or

other business profits. Given that all FIIs are non-residents for tax purposes, whether any

part of the profit or loss from equity derivatives transactions is liable to tax in India or

not, requires technical termination about applicability of the relevant double tax

avoidance treaties between India and country of tax residence of the recipient FII, the

business presence (‘permanent establishment’) of the recipient FII in India etc. The

applicability or otherwise of holding with tax on profits from equity derivatives

transactions by FIIs would also have to be based on foregoing determination. Resolution

of these tax issues at the policy level is perhaps crucial for the long-term development of

the equity derivatives market in India

LIFE & GENERAL INSURERS

Equity Derivatives in Life & General Insurers

The Insurance Act as well as the IRDA (Investment) Regulations 2000 are silent about

use of equity (or other) derivatives by life or general insurance companies. It is the view

of the Insurance Regulatory and Development Authority (IRDA) that life and general

insurers are not permitted to use equity (or other financial) derivatives until IRDA frames

114


guidelines/regulations relating to their use. And, IRDA is yet to frame these

guidelines/regulations, though it is seized of the urgent need to frame them. Life or

general insurers would have to wait for these guidelines/regulations to fall in place before

they can use equity (or other financial) derivatives. Assuming this happens sooner than

later, most new life and general insurers have been established only in the past two years

or so, and they currently have little or no equity investments at all. Given the nascent

stage at which they are, it will take at least a few years before they become active

investors in the equity market. Till then, use of equity derivatives would be of relevance

primarily to the incumbent public sector insurance majors, namely, Life Insurance

Corporation of India (LIC), General Insurance Corporation of India (GIC), New India

Assurance Company Limited (NIA), United India Insurance Company Limited, National

Insurance Company Limited, and Oriental Insurance Company Limited. And, these

incumbents would have to overcome the following key impediments before they actively

use equity (or other financial) derivatives:

Inadequate technological and business process readiness of their investment

management function to run a derivatives trading book and manage related risks.

Inadequate readiness of human resources/talent in their investment management

function to run a derivatives trading book and manage related risks; and

Inadequate willingness of insurer management to risks being accountable for

bonafide losses in the derivative trading book (assuming regulations permitting

115


use of equity derivatives for purposes other than hedging), and be exposed to

subsequent onerous investigative reviews.

Thus, Derivative markets in equities, are at their nascent stage of evolution in India, but

have significant growth potential. For this potential to be realised, as discussed in the

various sections, one or more of the following issues or impediments would have to be

overcome and resolved:

The regulatory framework applicable to the respective market of derivative

and participants would need to evolve further.

The business process framework and technology of several key participants in

these markets needs to be readied to manage the risks relating to their activity

in the derivative market.

The human resources/talent of several key participants in these markets needs

to be vastly upgraded and readied to manage the exposure and risk relating

their activity in the derivative market.

A framework which relieves management of public sector banks and FIs of the risk of

being held accountable for the bonafide trading losses in the derivatives book and being

exposed to subsequent onerous investigative reviews.

But concomitantly holds management of public sector and FIs accountable for

lost opportunity profits needs to be ushered in.

116


The top and senior management of several key participants need to undergo an

orientation phase to familiarise themselves with the conceptual underpinnings and

microstructure of these derivatives markets to help them establish an appropriate

governance framework for the derivatives market activity of the participant.

The tax treatment applicable to the participants in relation to the derivative

contracts would need to be clarified to provide certainty about it to market

participants.

117


Summary of Conclusion:

Derivatives play a very important role in the up-bringing of an organization; it

plays a major role in the equity market.

Today, with the help of derivatives, the Indian stock exchange market has

recently rocketed up to become Asia’s fourth largest exchange traded

derivatives market.

In terms of growth of derivative markets and a variety of derivatives users, the

Indian market has exceeded or equaled many other Indian markets.

The variety of instruments in derivatives instruments available for trading is

also expanding.

Corporations, private sectors institutions, state-owned and smaller companies

are gradually getting into the act.

The business growth of NSE started from a mere Rs.1000 million and has

reached to 2,50,000 million (conversion table) during Jan- Mar 2006 quarter

and is at the booming stage at the moment possible itself. This shows that the

stock market with the help of derivatives have taken for a very good progress

in the Indian economy.

There exist large gaps in the range of derivative products that are actively

traded. In equity derivatives, NSE figures show that 90% of activity is due to

index futures or stock futures, whereas trading in options is limited to few

stocks, partly they are cash settled and not the underlying stocks. Exchange-

traded derivatives on interest rates and currencies are virtually absent

118


Although from the past experience of stock exchanges, we have seen that

derivatives have yielded losses to MNC’s like BP , Proctor & Gamble and etc

but at the same time it has also yielded profits to MNC’s like Coca-Cola, Intel

etc for their organisation, thus we can see clearly that derivatives do not

involve risk all the time.

The institutional investors are major players in the derivatives market as

mentioned earlier.

According to NSE, retail investors (including small brokerages trading for

themselves) are the major participants in equity derivatives, accounting for

65% of turnover in August 2006.

The success of single stock futures in India is unique, as it has failed in most

other countries. One reason for this success may be retail investors’ prior

familiarity with “badla” trades which shared some features of trading in

derivatives. Another reason may be small size of future contracts, as

compared to similar contracts in other countries.

There is a lot of risk in investment in Equity Funds and is appropriate for

those individual who can afford to take high risk, but this high risk may either

leave the investor to loose all their money with no returns as they are not safe

investments or pay them high returns in the long run. Therefore, from the

point of view of the investment in such type of equity funds would be safer

and investments would be secure.

119


Equity derivatives of Banks are highly leveraged nature of banking business

and the investment in the equities, banks in India are the best and termed as

marginal investors in equity.

Equity derivatives in FIs do not run an equities arbitrage trading book, yet it

appears that there is no RBI guideline disabling FIs from running an equities

arbitrage trading book to capture risk free pricing stocks.

Equity derivatives in Mutual Funds are ought to be natural players in the

equity derivatives market and SEBI have also authorised use of exchange

traded equity derivatives for mutual fund plc.

The activities in the FII in the equity derivatives market in India are in the

emerging future.

Equity derivatives in Life and General Insurers are silent about the use of

equity or other derivatives.

The market has a very automatic borrowing and lending market which is not

upto the market.

Put-Call issues are very good indicators of the derivative market.

The second key factor where the equity derivatives market has as yet not made

substantial progress is the large-scale utilisation of IT systems in trading,

arbitrage, market marking, etc. When a few dozen underlying generate thousands

of derivative securities, it is essential to have computer systems primarily driving

the actual implementation of trading strategies. They will have a profound impact

upon the nature of pricing and liquidity on this market, when these systems fall

120


into place. The government, although aware of the equity derivative market, has

not yet made any substantial progress in the IT systems but derivatives markets

earlier had its own declined stage and now have its flourishing stage in India.

Thus, to conclude the whole scenario of the derivatives importance in the equity

market as mentioned earlier that derivatives had made tremendous losses to

companies like Proctor and Gamble, etc but at the same time it has helped

companies like Intel, IBM, and etc to make tremendous profits to them and also

have international recognition. Thus, from above, we can see that derivatives are

vital and how they are important for each and every institutional investors such as

Mutual Funds, Banks, Foreign Institutional Investors (FIIS), All Financial

Institutions (FIs), Life and General Insurers. We have seen from above that

derivatives on its own and in the equity market have pulled almost 79% of India’s

population towards it, and now the booming period has come and everyone is

aware that derivatives are making the country’s GDP and are directly linked with

the disposable income of each and every entity. One major question, as looking

forward is concerning institutional participation on the equity derivative market.

As with most of the financial sector innovations of the last decade, individuals

have displayed intellectual capacity and a speed of exploiting new ideas which

has just not been found with finance companies. Globally, mutual funds and

banks are key players on the equity derivative market. In India, owing to variety

of government and regulatory problems, this has just not materialised. Web19

states that 0.79% of the NSE derivatives turnover in December 2005 came from

institutional users. Most of the legitimate difficulties of mutual funds in terms of

121


regulatory restrictions have been eased out through SEBI governing the mutual

funds. Rules governing insurance companies and FIIs have been partly eased.

Banks, however, continue to face stringent regulatory hurdles. We can see an

enormous increase in liquidity .Hence we say that institutional investors do play a

major role for derivatives and equity market which in turn enhance the country’s

GDP.

122


Recommendations

Further Research in this area after a span of year’s time would be worthwhile to

do because the derivatives market and equity market are not stable.

A research based on strategic alliances between BSE (Bombay Stock Exchange),

NSE (National Stock Exchange) and NADAQ could be seen in the upcoming

years.

Since derivative and equity market depend on exchange rate on a large scale and

they are of a very fluctuating nature, further research on exchange rate would be

prudent.

At the same time, research on the interest rate would be sensible; because, as

exchange rate have a fluctuating nature, interest rate depends upon the exchange

rate of any country for its progress and on the whole interest rate are co-related

with the derivatives and equity market.

In the derivative market more scripts are required in the F&O segment.

The lots size need to be reduced from Rs.2,00,000 to Rs.1,00,000.

Markets should be stock settled instead of cash settlement.

Since the equity market depends on any individual’s disposable income, further

research should also be looked into disposable income.

To have a consistent method of accounting for losses and gains from the

derivatives trading, a proper framework to account for derivatives needs to be

developed.

123


Research on the institutional investors in India i.e. FIs, Mutual Funds, Banks, Life

and general insurers would be meaningful to do on a large scale, because these are

the major players who use derivatives and invest in equity market.

Harmonisation of regulations is required.

Strengthening of SROs is critical for safeguarding the derivative market.

124


Books Referred :-

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market.

Kabra Committee on Forward Markets.

127


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Appendices

Appendix A:

Illustration of Forward Contract

Two parties C and D enter into a forward contract on 1st March. C agrees to purchase

2000 shares of ‘F Ltd’. For a pre-determined price of $1 three month forward. On the

fixed future date here on, C will get the 2000 shares and will pay the price i.e. $2000.00

and D will deliver the shares and shall receive the money.

Figure 1: Forward Contracts

D

Specified Price

C

Specified Asset

135


At the maturity date the contract is settled. The holder of the short position delivers the

asset to the holder of the long position in return for cash amount equivalent to the deliver

price. Forward contracts are not dealt on exchange but traded over the counter. These

have certain flexibility and self- regulatory. There is privacy in the forward market that is

not there in the exchange trading. Counter party default risks and lack of liquidity are the

main draw backs of a forward contract. Forward contracts are being used in India on a

large scale in the foreign exchange market to hedge currency risk.

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Appendix B:

Illustration of Future Contract

Centres into a futures contract on 1st September to purchase 100 equity shares of ‘F Ltd’

at a price agreed of $1 in December. If on the maturity date (as determined the rules of

the exchange for the month of December) the price of equity stock falls to $0.50, C will

have to pay $0.50 per share or otherwise if the price of equity stock rises to $2, C will

receive $1 per share.

Figure 2: Futures Contracts

Future contracts are normally settled as compared to forward contract only through the

difference between the strike price and market price as on the date of maturity.

D

If the market price falls to $0.50 $0.50 per share

C

If the market price rises to $2 $1 per share

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Appendix C:

Illustration of Option Contract

C pays $ 4000 to buy a ‘December 103’ call option on a $ 100,000 US Treasury bond at

an exercise price of $103. If the price falls below $103, the maximum amount that C

would lose is the premium paid and if the price rises above $103, C will gain from the

difference.

Figure 3: Options Contracts

C

Pay on the at maturity date

D

Premium $ 2,000

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Appendix D:

Illustration of a Swap Contract

According to Avadhani (2000) if Mr ‘A’ has borrowed from Mr. ‘X’ at LIBOR + 2%.

Mr ‘A’ to cover the transaction from unanticipated fluctuations in the interest rate agrees

to pay a fixed rate of 9% to Mr. ‘B’ and in return Mr. ‘B’ agrees to pay a floating rate i.e.

LIBOR +2% to Mr. ‘A’ although the actual payments between Mr. ‘A’ and Mr. ‘B’ will

take place only on net basis. The net result of the transaction for each parties will be as

follows:

Mr. ‘X’ will receive the amount at LIBOR + 2%

Mr. ‘A’s liability is fixed at 9%

Mr. ‘B’ liability depends on the fluctuating rate i.e. LIBOR.

Let us take two cases

1. LIBOR = 10%

In this case Mr. ‘A’ will pay to Mr. ‘X’ at the rate of 12%. Mr. ‘B’ will pay Mr. ‘A’ at the

rate pf 3%. Hence the net liability of Mr. ‘A’ is 9%

2. LIBOR = 5%

In this case Mr. ‘A’ will pay to Mr. ‘X’ at the rate of 7% and Mr. ‘A’ will pay to Mr. ‘B’

at the rate of 2% . Hence the net liability of Mr. ‘A’ remains the same at 9%.

139


Figure 4: Swaps X

Floating LIBOR + 2%

Floating LIBOR + 2%

A A

Fixed 9%

Swaps have an informal market among dealers as they are not traded on organized

exchanges. As distinguished from futures and options swaps market affords privacy that

may not be there in exchange trading. The inherent limitations of a swap market may be

summarised as follows:

A party has to find a counter party willing to take the opposite side of the

transaction.

A swap agreement being between two counter parties cannot be altered or

terminated early without the agreement of both the parties.

Parties to the swap must be certain of the creditworthiness of the counter party as

the risk of counter party default is always there.

140


Appendix E:

Illustration of a Hedge

According to D.C. Patwari and Anshul Bhargava for example, in February 1996, an

importer had to make a payment for a contract entered in December 1995. In December

1995, the rate of exchange was Rs. 32.20 for a US Dollar, which shot up by 6th February

1996 to Rs.38.60. This indicates that the value of the US Dollar against the rupee rose by

almost 20 %. If the importer has imported good worth $1 crore, then his cost increased by

Rs. 6.40 crore. In businesses where margins are not even 5%, one can afford a loss of 20

%. The unhedged imports spelt doom for the importer. Similarly, a firm exported goods

on 6th February 1996, expecting to realize Rs 38.60 per dollar, but could only get

Rs.34.80 per dollar in March 1996. Its sale proceeds thus went down by Rs.3.80 per

dollar- a 10% loss in sale value. Fluctuations of 4-5% over a month’s time are quite

normal. Considering this, currency futures and options are necessary to hedge this kind of

risk.

141


Appendix F:

Illustration of a Speculator

According to D.C. Patwari and Anshul Bhargava for example take the case of Shyam

who is a Commodity Exchange member. He thinks in December 2004, that the March

2005 cotton futures contracts are underpriced, so he buys in March 2005 cotton futures

contracts. Till January 2005 he holds his long position. When the price of future contracts

in March 2005 increases over a period of time, he sells them and makes profits. He can

deal in commodities worth lakhs of rupees without investing in them. His investment is

the margin money, which is required to be paid to the clearing house.

142


Appendix G:

Illustration of a Arbitrageur

According to D.C. Patwari and Anshul Bhargava for example, suppose ITC quoted in

the spot market at Rs.1000 per share and its 3 months futures at 1,030. Then one can

purchase ITC shares at Rs.1000 each in the spot market by borrowing 8% p.a. for 3

months and selling ITC futures for 3 months at Rs.1030. While the cost is Rs. 1,020

(1000+20), the futures are sold at Rs. 1,030, providing the trader with an arbitrage profit

of Rs. 10 per share before brokerage.

143


Appendix H:

Global Derivative Market

The Global Derivative Market has been remarkable for the calendar year 2005. The

National Stock Exchange of India making huge strides and moved upward in global

ranking. The recent data (covering exchange traded derivatives, including futures, options

on futures and options on securities) published by Futures Industry Association has stated

that the total number of contracts traded increased by 8.92% during year 2004 – futures

contracts rising by 16.27% and option rising by 4.60% during the year 2004. As shown in

the Table 1, volume rose in all sectors of the market but the category with the greatest

was trading in equity index derivatives such as index options, index futures and options

on index futures.

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Table 1: Volume by Category

(In million)

Global Jan-Feb

2006

Jan- Feb

2005

%

Change

Equity Index 787.11 521.33 51.0%

Interest Rate 461.41 396.78 16.3%

Individual Equity 457.95 360.28 27.1%

Agricultural 64.51 44.08 46.4%

Energy 54.29 39.35 37.9%

Foreign Currency 31.57 20.66 52.8 %

Non- Precious Metals 19.28 15.06 28.0%

Precious Metals 12.03 8.15 47.7%

Other 0.36 0.21 74.4%

TOTAL 1,888.51 1,405.89 34.3%

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(In million)

Global 2004 2003 %

Change

Equity Indices 3,775.43 3,959.17 -4.64

Interest Rate 2,271.25 1,881.27 20.73

Individual Equities 2002.43 1,560.17 28.53

Energy Products 243.46 217.56 11.90

Agricultural Commodities 326.15 311.01 4.87

Non- Precious Metals 105.23 90.39 16.42

Foreign Currency/Index 105.37 77.85 35.35

Precious Metals 60.56 64.46 -6.05

Other 0.86 0.66 -6.50

Total Volume 8,890.74 8,162.54 8.92

In Table 2 are the details of the Top 20 contracts for the year 2004. Kospi 200 options of

Kofex led the table with more than 2.5 billion contracts in 2004 followed by Euro –

Dollar Futures of CME. Kospi 200 is still maintained its position of number 1, though

witnessed a huge decline of 11.14%.

NSE too, has been making huge strides by moving upwards in the global ranking. NSEIL

ranked (1st) in the single stock future category (Table 3) in the year. NSE has been ranked

17th in the global futures and options volume in 2004 against its rank of 21st in the

146


previous year (Table 4). In the Top 40 Futures and Exchanges of the World, NSE stands

10th position in 2004 against 15th in the year 2003. (Table 5).

147


Table 2: Top 20 Contracts for the year 2004 (in millions- net of Individual equities)

Rank Contract Exchange 2004 2003 %Change

1 Kospi 200 Options Kofex 2,521.56 2,837.72 -11.14

2 3 Month Euro- bond Futures CME 297.58 208.77 42.54

3 Euro- Bond Futures Eurex 239.79 244.41 -1.89

4 TIIE 28 Futures MexDer 206.03 162.08 27.12

5 10 Year T-Note Futures CBOT 196.12 146.45 33.92

6 E- Mini S&P 500 Index CME 167.2 161.18 3.73

7 Euro-Bobl Futures Eurex 159.17 150.09 6.05

8 3- Month Euribor Futures Euronext.liffe 157.75 137.69 14.57

9 3 Month Eurodollar Options CME 130.6 100.82 29.54

10 Euro-Schatz Futures Eurex 122.93 117.37 4.74

11 DJ Euro Stoxx 50 Futures Eurex 121.93 117.37 4.84

12 5 year T- note Futures CBOT 105.47 73.75 43.01

13 Interest rate Futures BM&F 100.29 57.64 73.99

14 E-mini NASDAQ 100 futures CME 77.17 67.89 13.67

15 30 – Year T- bond Futures CBOT 72.95 56.08 13.27

16 DJ Euro Stoxx 50 Options Eurex 71.41 61.79 15.57

17 CAC 40 Index Option Euro next 63.15 73.67 -14.28

18 No 1 Soya bean Futures DCE 57.34 60.00 -4.43

19 10 – Year T- Note Options CBOT 56.88 41.17 38.16

20 Kospi 200 Futures Kofex 55.61 62.20 -10.59

Source: FI Futures Industry, March/April 2004. The monthly magazine of the FIA.

148


Table 3: Futures on Individual Securities (Stock Futures)

Exchange 2003 2004

National Stock Exchange of India 25,572,505 44,020,670

RTS Stock Exchange 31,782,174 39,061,704

Euronext 7,004,235 13,491,781

Spanish Exchange( BME) 12,492,568 12,054,799

Stockholm 1,424,890 4,533,805

Borsa Italiana 4,68,083 1,734,356

Athens Derivatives Exchange 477,464 919,679

JSE South Africa 4,85,919 883,587

Budapest 618,261 706,386

Australian 267,630 459,801

Warsaw 93,005 87,888

Mumbai 103,939 38,383

SFE Corporation 47,822 29,986

Hong Kong 18,654 17,274

Copenhagen 310 1,685

Source: WFE 2004 Annual Report and Statistics

149


Table 4: Global Futures and Options Volume

Rank

2004 2003

Exchange Volume

2004 2003

%

Change

49 51 Wiener Borse 2,242,475 1,392,529 61.04

50 49 Winnipeg Commodity Exchange 2,054,296 1,842,776 11.48

51 50 One Chicago 1,922,726 1,619,194 18.75

52 53 Minneapolis Grain Exchange 1,416,282 1,133,731 24,92

53 42 Bupapest Commodity Exchange 1,300,726 3,673,978 -64.60

54 48 Yokohama Commodity Exchange 1,164,811 1,852,158 -37.11

55 55 Copenhagen Stock Exchange 704,006 762,050 -7.62

56 56 New Zeland Futures Exchange 497.181 493,250 0.80

57 54 NQLX 257,000 858,900 -70.08

58 61 CBOT Futures Exchange 91,332 -- --

59 58 Mercado Termino de Buenos Aires 85,593 39,610 116.09

60 52 BrokerTec Futures Exchange -- 1,356,825 --

61 57 MidAmerica Commodity Exchange -- 142,298 --

Source: Future Industry, March / April 2005. The month magazine of FIA

150


Table 5: Top 40 Futures Exchanges (Volume figures do not include options on futures)

Rank

2004

2003

Exchange Volume

2004 2003

%

Change

1 1 Eurex 684,630,502 668,650,028 2.39

2 2 Chicago Mercantile Exchange 664,884,607 530,989,007 25.22

3 3 Chicago Board of Trade 489,230,144 373,669,290 30.93

4 4 Euronext.liffe 310,673,375 267,822,143 16.00

5 5 Mexican Derivative Exchange 210,355,031 173,820,944 21.02

6 6 Bolsa de Mecandorias Exchange 173,533,508 113,895061 52.36

7 7 New York Mercantile Exchange 133,284,153 111,789,658 19.23

8 10 Dalian Commodity Exchange 88,034,153 74,973,493 17.42

9 8 The Tokyo Commodity Exchange 74,447,426 87,252,219 -14.68

10 15 National Stock Exchange of India 67,406,562 36,141,561 86.51

11 11 London Metal Exchange 67,171,973 68,570,154 -2.04

12 9 Korean Futures Exchange 65,261,326 75,159,690 -13.17

13 13 Sydney Futures Exchange 50,968,901 41,831,862 21.84

14 12 Zhengzhou Commodity Exchange 48,474,548 49,817,798 -2.70

15 14 Shanghai Futures Exchange 40,577,373 40,079,750 1.24

16 17 International Petroleum Exchange 35,466,941 33,258,385 6.64

17 16 Singapore Exchange 28,169,379 35,356,776 -20.33

18 18 OMX Exchanged 27,264,123 24,315,286 12.13

19 19 Tokyo Grain Exchange 25,705,687 21,084,727 21.92

151


20 20 New York Board of Trade 23,955,212 18,822,048 27.27

21 23 JSE Securities Exchange South

Africa

19,811,664 14,947,523 32.54

20 20 New York Board of Trade 23,955,212 18,822,048 27.27

22 22 Tokyo Stock Exchange 18,331,928 15,965,175 14,82

23 21 MEFF 17,592,259 17,110,745 2.81

24 26 Taiwan Future Exchange 14,911,839 9,953,118 49.82

25 24 Osaka Securities Exchange 14,583,283 13,231,287 10.22

26 25 Bourse de Montreal 12,900,821 10,676,279 20.84

27 27 Hong Kong Exchange & Clearing 11,884,152 8,174,652 45.38

28 34 Mercado a Termino de Rosario 7,735,890 2,708,313 185.64

29 31 Tokyo International Financial

Futures Exchange

7,655,510 4,771,917 60.43

30 28 Italian Derivative Market 6,551,211 7,302,565 -10.29

31 41 Eurex US 6,186,008 -- --

32 30 Budapest Stock Exchange 4,252,595 4,939,893 -13.91

33 29 Osaka Mercantile Exchange 3,842,533 6,162,589 -37.65

34 33 Fukuoka Futures Exchange 3,036,733 2,739,383 10.85

35 35 Kansas City Board of Trade 2,834,799 2,634,424 7.61

36 32 Kansai Commodities Exchange 2,803,812 3,441,365 -18.53

37 36 Malaysia Derivative Exchange

Berhad

2,632,543 2,009,460 31.01

38 37 Winnipeg Commodity Exchange 2,030,455 1,811,616 12.08

152


39 38 One Chicago 1,922,726 1,619,194 18.75

40 39 Oslo Stock Exchange 1,748,742 1,201,319 45.57

Source: Future Industry, March / April 2005. The month magazine of FIA

153


Appendix I:

Questionnaire

1. Do you about Derivates are? And how does it revolve around the equity markets?

a) Yes b) No c) N/A

2. Which would you rate product-wise distribution of Turnover of NSE in 2004 – 2005?

a) Index Futures b) Stock Futures c) Index Options d) Stock Options

3. What do you think be the daily average turnover i.e. growth of business at NSE

a) 8000, b) 10000, c) 12000, d) above12million Rs.

4. Do you understand by the term “Daily open interest”?

a) Yes b) No c) N/A

5. What do you think could be the daily open interest at NSE for Index Futures?


6. What according to you could be approximate close price for Nifty Futures from

2004 -2005?


7. Do you understand by the term if “Daily implied interest rate”?

154


a) Yes b) No c) N/A

8. What according to you could be approximate daily implied interest rate from

2004 – 2005?


9. Do you understand by the term “Implied Volatility”?

a) Yes b) No c) N/A

10. What according to you could be the intra-day evolution of implied volatility on the

9th Dec 2002?

a) 0.15, b) 0.25, c) 0.35, d) 0.45, e) 0.55

11. What according to you would be the NIFTY volatility smile at 3pm on the 9th Dec

2002?

a) 0.15, b) 0.25, c) 0.35, d) 0.45, e) 0.55

12. What according to you could be the volatility smile at the close of day i.e.9th

Dec 2002?

a) BCCL, b) Infosys, c) Satyams, d) BPL

155


Appendix J:

Conversion Table:

India Currency (Rs) UK Currency (Pounds) USA Currency (Dollars)

88.57/- Rs 1 Pound 0.528 Dollar

885.7/- Rs 10 Pounds 5.28 Dollar

8,857 /- Rs 100 Pounds 52.8 Dollar

88,570 /- Rs 1000 Pounds 528 Dollar

885,700 /- Rs 10000 Pounds 5,280 Dollar

8,857,000 /- Rs 100000 Pounds 52,800 Dollar

88,570,000 /- Rs 1000000 Pounds 528,000 Dollar

885,700,000 /- Rs 1000000 Pounds 5,280,000 Dollar

156


Appendix K

1. NPV

Web 27 opines a figure which represents the total of future cash inflows from

a project, less cash outflows, inflation and/or a required rate of return.

Net Present Value (NPV) = Present Value (PV) – Amount Invested.

2. CAPM

Web 28 opines Economic theory describing the relationship between returns

in security and risk.

3. APT

Arbitrage Pricing Theory.

4. Call option

Web29 opines a call option bestows the right to buy an underlying asset at a

given price. The short seller also known as writer has an obligation to sell

shares to the holder, if the option is exercised. In simple terms it is an

agreement that gives an investor the right (but not the obligation) to buy a

stock, bond, commodity, or other instrument at a specified price within a

specific time period.

157


5. Put Option

Web 30 opines an option provides the holder the right to buy (but not the

obligation) or sell a normally fixed quantity of an underlying asset on, or

before, a specified date in future. The two types are: Puts and Calls. Buyers of

the call option have the right to buy the underlying asset at a given price.

Sellers (AKA writer) are obliged to sell, if the option is exercised. Conversely,

buyers of put options have the rights to sell the asset at the given price. The

writer of a put option is obliged to buy from the holder (buyer) if the option is

exercised.

6. Currency Swaps

Web 31 opines that contract which commits two counter parties to exchange

streams of interest payments in different currencies for an agreed period of

time of time and to exchange principal amounts in different currencies at a

pre-agreed exchange rate at maturity.

7. Interest Rate Swaps

Web 32 opines an agreement between two parties (known as counterparties)

where one stream of future interest payments is exchanged for another based

on a specified principal amount. Interest rate swaps often exchange a fixed

payment for a floating payment that is linked to an interest rate (most often the

LIBOR). A company will typically use interest rate swaps to limit, or manage,

its exposure to fluctuations in interest rates, or to obtain a marginally lower

interest rate than it would have been able to get without the swap.

158


8. OTC - Other Trading Contracts. The OTC market of derivative contracts

has been existing in some form or other since many years.

9. Teji –mandi - Call options and Put options.

10. Jota phatak – Straddles

11. Bhav- bhav – Stake

12. BSE –Bombay Stock Exchange.

13. NSE – National Stock Exchange.

14. SPAN

Web 33- opines it is a Risk Parameter for the Stock Market and the objective

SPAN is to identify overall risk in a portfolio of futures and options contracts

for each member.

15. SEBI – Securities and Exchange Board of India.

16. PRISM – Parallel Risk Management System.

159


17. NSCCL - The National Securities Clearing Corporation Ltd.

18. F&O Segment in NSE – Futures and Options segment in NSE

19. Underlying Market Price - A price which acts as the security upon which

a futures or options contract is based.

20. Volatility (variability) of the underlying instrument - A measure of

price fluctuations in the equity market.

21. Strike Price - Is the price when the seller sells and get a profit while

selling i.e. the seller sell the share i.e. equity when the market is on a

boom.

22. Time to Expiration - opines Interest rate future contracts shall expire on

the last Thursday of the expiry month. If the last Thursday is a trading

holiday, the contract shall expire on the previous trading day. Further,

where the last Thursday falls on the annual or half- yearly closing dates of

the bank, the expiry and the last trading day in respect of these derivatives

contracts would be pre-poned to the previous trading day.

160

Risk Management

Documents

rbis guiding principle

chartered financial analyst

identical implied volatilities

blue chip companies

highly susceptible futures

shreekrishna mutual funds

highly leveraged nature

premium receivable amount