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A Project Report Entitled “Financial Weapon for Mass Destruction: Derivatives with special reference to Anand Rathi Securities Ltd.” SUBMITTED IN PARTIAL FULFILLAMENT FOR AWARD OF POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT (PGDBM) Organization Guide: Submitted By : Abhijeet Marathe -08 - 1 - Summer Internship Report
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Page 1: (Summer Project)

A Project Report Entitled

“Financial Weapon for Mass Destruction: Derivatives

with special reference to Anand Rathi Securities Ltd.”

SUBMITTED IN PARTIAL FULFILLAMENT FOR AWARD OF POST GRADUATE DIPLOMA IN BUSINESS MANAGEMENT (PGDBM)

Organization Guide: Submitted By:

Abhijeet A.

Marathe

Abhijeet Marathe -08 - 1 - Summer Internship Report

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CERTIFICATE

I here by certify that this project report entitled “Financial

Weapon for Mass Destruction: Derivatives” submitted by

Abhijeet A. Marathe to International School of Business &

Media, Bangalore, is a bonafide and original research work

carried out under my guidance and supervision. It is piece of

research of sufficiently high standard to warrant its

submission to college for the award of said diploma.

No part of the thesis has been submitted any degree or

diploma or published in any other form. The assistance and

the help rendered during the course of his investigation in the

form of basic source material and information have been duly

acknowledged.

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DECLARATION

I hereby declare that the project report entitled “Financial Weapon

for Mass Destruction: Derivatives” is a bonafide and authentic

work done by me under the guidance of Mr.. The project is

entirely original and not been submitted to any university for the

award of any degree, diploma or any other similar title.

The sources of material & data used in this study have been duly

acknowledged.

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ACKNOWLEDGMENT

The completion of project on "Financial Weapon for Mass

Destruction: Derivatives" has given us immense pleasure and

knowledge. We would like to thank , who helped us in each and

every step in completion of this project.

I am greatly indebted to Mr. Nitin Goel (Asst. Manager),

sincerely acknowledge the cooperation of Mr. Vaibhav

Shrivastava (Equity Manager), Anand Rathi Financial Services

Ltd., Nagpur, Who guided us and gave us their valuable time.

We owe our heartiest thank to Mr. Ravindra Maloo (Vice

President, ARSL) who provided us such a platform and guided us

with his valuable information.

We must acknowledge our gratitude towards all the employees of

ARSL for their help and last but not the least, to all our family

members and friends for their constant help and support.

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OBJECTIVE OF SUMMER INTERNSHIP

The objective with which I undertook this internship is mentioned as follows:

To observe the processes, methods and system followed in the organisation

to achieve its aim.

To understand the organisational processes, organisational hierarchy,

organisational goals, communication channels in the particular organisation.

To get a hands-on experience of the corporate world.

To undertake a project and get a practical exposure of any financial sector.

To acquire thorough knowledge base on a particular subject.

To learn various pre requisite qualities expected of a manager.

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COMPANY PROFILE

Overview

ANAND RATHI is a premier integrated financial services provider, and ranked among

the top five in South Asia in all its business segments, services over 200 thousands

individual investors in various capacities, and provides investor services to over 300

corporate. ANAND RATHI covers the entire spectrum of financial services such as

Stock broking, Depository Participants, Distribution of financial products - mutual

funds, bonds, fixed deposit, equities, Insurance Broking, Commodities Broking,

Personal Finance Advisory Services, Merchant Banking & Corporate Finance,

placement of equity, IPOs, among others. ANAND RATHI has a professional

management team and ranks among the best in technology, operations and research

of various industrial segments.

Anand Rathi – Early DaysAnand Rathi is a leading full service securities firm providing the entire gamut of

financial services. The firm, founded in 1994 by Mr. Anand Rathi, today has a pan

India presence as well as an international presence through offices in Dubai and

Bangkok. AR provides a breadth of financial and advisory services including wealth

management, investment banking, corporate advisory, brokerage & distribution of

equities, commodities, mutual funds and insurance, structured products - all of which

are supported by powerful research teams.

The firm's philosophy is entirely client centric, with a clear focus on providing long

term value addition to clients, while maintaining the highest standards of excellence,

ethics and professionalism. The entire firm activities are divided across distinct client

groups: Individuals, Private Clients, Corporate and Institutions and was recently

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ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the

ultra-rich.

In year 2007 Citigroup Venture Capital International joined the group as a financial partner.

Name: Abhijeet Marathe

Course: PGPBM

Year of Passing: 2009

Project Title: Financial Weapon For Mass Destruction: Derivatives

Subject: Finance

Project Type: Summers

EXECUTIVE SUMMARY

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I undertook my summer Internship with Anand Rathi Stock Broking Ltd. ANAND

RATHI is a premier integrated financial services provider, and ranked among the top

five in the country in all its business segments, services over 16 million individual

investors in various capacities, and provides investor services to over 300 corporate.

ANAND RATHI covers the entire spectrum of financial services such as Stock

broking, Depository Participants, Distribution of financial products - mutual funds,

bonds, fixed deposit, equities, Insurance Broking, Commodities Broking, Personal

Finance Advisory Services, Merchant Banking & Corporate Finance, placement of

equity, IPOs, among others.

I got an opportunity to work on project titled “Financial Weapon for Mass Destruction:

Derivative”.

ANAND RATHI GROUP COMPANIES

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Anand Rathi is a leading full service securities firm providing the entire gamut of

financial services. The firm, founded in 1994 by Mr. Anand Rathi, today has a pan

India presence as well as an international presence through offices in Dubai and

Bangkok. AR provides a breadth of financial and advisory services including wealth

management, investment banking, corporate advisory, brokerage & distribution of

equities, commodities, mutual funds and insurance, structured products - all of which

are supported by powerful research teams.

The firm's philosophy is entirely client centric, with a clear focus on providing long

term value addition to clients, while maintaining the highest standards of excellence,

ethics and professionalism. The entire firm activities are divided across distinct client

groups: Individuals, Private Clients, Corporate and Institutions and was recently

ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the

ultra-rich.

In year 2007 Citigroup Venture Capital International joined the group as a financial

partner.

Milestones:

1994: Started activities in consulting and Institutional equity sales with staff of 15

1995: Set up a research desk and empanelled with major institutional investors

1997: Introduced investment banking businessesRetail brokerage services launched

1999:

Lead managed first IPO and executed first M & A deal

2001: Initiated Wealth Management Services

2002: Retail business expansion recommences with ownership model

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2003:

Wealth Management assets cross Rs1500 crores

Insurance broking launched

Launch of Wealth Management services in Dubai

Retail Branch network exceeds 50

2004:

Commodities brokerage and real estate services introduced

Wealth Management assets cross Rs3000crores

Institutional equities business re launched and senior research team put in

place

Retail Branch network expands across 100 locations within India

2005:

Real Estate Private Equity Fund Launched

Retail Branch network expands across 200 locations within India

2006:

AR Middle East, WOS acquires membership of Dubai Gold & Commodity

Exchange (DGCX)

Ranked amongst South Asia's top 5 wealth managers for the ultra-rich by

Asia Money 2006 poll

Ranked 6th in FY2006 for All India Broker Performance in equity distribution

in the High Net worth Individuals (HNI) Category

Ranked 9th in the Retail Category having more than 5% market share

Completes its presence in all States across the country with offices at 300+

locations within India

2007:

Citigroup Venture Capital International picks up 19.9% equity stake

Retail customer base crosses 200 thousand

Establishes presence in over 450 locations

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SWOT Analysis (Strength, weakness, opportunities & threats)

Anand Rathi Core strengths:

Breadth of Services

In line with its client-centric philosophy, the firm offers to its clients the entire spectrum of financial services ranging from brokerage services in equities and commodities, distribution of mutual funds, IPOs and insurance products, real estate, investment banking, merger and acquisitions, corporate finance and corporate advisory.

Clients deal with a relationship manager who leverages and brings together the product specialists from across the firm to create an optimum solution to the client needs.

Management Team

AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience.

In-Depth Research

Our research expertise is at the core of the value proposition that we offer to our clients. Research teams across the firm continuously track various markets and products. The aim is however common - to go far deeper than others, to deliver incisive insights and ideas and be accountable for results.

Weakness:

1) Motivational Forces

The motivational factors to the greater extent were missing in the organization. There

was not much of motivation provided to most of the employee base. The method that

was followed to encourage the employees to improve there performance was more

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inclined towards the fear of not missing on there targets particularly in context of sales

and marketing people.

2) Knowledge

There were handful of people who had high level of knowledge about Derivatives.

Anand Rathi group should arrange training sessions for their employees.

Opportunities:1) Huge Client Base

There are great opportunities for the Anand Rathi employees to generate the

targeted business because they have large cliental in central India.

2) Awareness in Retail Segment

Continuously rising awareness about the market and derivatives in retail segment is

beneficial for the firm as they don’t have to educate clients about the business.

3) Strong Growing Economy

Because of the strong growing economy, Indian market became fundamentally strong

and Foreign institutional investors also find it beneficial to invest in Indian Market.

Threats: 1) Cut throat Competition:

There is a cut throat competition amongst the broking houses for the acquisition of

clients. This has increased the client switchovers from one broking house to another

because of the additional services from other broking houses.

2) Decreasing Brokerages:

Broking houses mainly work for generating brokerage through equity markets.

Nowadays it is not as easy as it was because each broking house is decreasing its

brokerage levels to acquire more clients. Because of this employees have to work

more to generate the same amount of brokerage.

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COPS Analysis (culture ,organization ,people ,system)

During the six months internship, I got many opportunities to interact with the

employees as well as other interns from different institutions, who had joined the

organization with me, which gave a lot of opportunity to understand more about the

various organizational processes in the Company. The overall environment in the

office was very friendly.

During the period of my internship I observed the various

organizational processes taking place at the work place.

Some of these were based on my own experiences and

others were the observations as an independent observer.

The various organizational processes observed in the

company were as follows:

As I observed that stock trading involves the sentiments and emotions of the people.

The traders were very focused on their job and hardly had the time to gauge on

other’s emotions. The trading section required just to give the requisite services to the

client but the PR department needed to chase the clients and had the targets to be

achieved on a regular basis. So the trading section people were more or less involved

in providing services in their responsibility areas. Whereas in the PR department was

more concerned to chasing the targets.

At the time of my internship, there were some students perusing their internship in the

PR department on the same project and under some other guide. The first step in the

project was collecting the data. I was supposed to collect at least database of 15

people in a day without fail. In case of any default the students were required to get

the pending databases the next day. This attitude towards the interns encouraged

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them to avoid the reporting heads to the extend possible. Many of them switched over

their profiles and guides.

On the other hand at the trading section did not required too much of reviewing and

also the clients had little grievances from them, so the employees in this section were

more relaxed and satisfied with their work and work environment.

Thankfully no such thing happened with me. My guide Mr. was a very cooperative

man. He always encouraged me to ask any doubts and suggested me to do self

study. He never demotivated me. He understood that I was keen on learning many

things about the market and the companies, so he always focused on discussing all

the issues which otherwise not dealt properly with would have discouraged me from

thinking of going ahead with finance. I even observed that when markets soared

high, he would encourage and cheer the trading staff for their job. Many times the

juniors came with their problems and he handled them with utmost detail and

concern.

Communication Process

The communication process happening in the organization was very direct and

informal. The seniors and subordinates communicated directly to each other. The

bosses and other staff members were very approachable even to the interns. I

was accompanied by six of my class mates in the same project, so we were

pretty comfortable with ourselves as a team. We were initially introduced to all

the employees of the trading department as the interns for the coming two

months and all were requested to provide all support that was needed.

The trading hours of the Stock markets are till 3.30 in the afternoon, so

employees are usually free in the evening hours, which gave me a huge

opportunity to have long discussion with my boss and other member of the staff,

which definitely added to my learning during the internship.

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Apart from this also most of the communication like reporting, problems etc

happened directly. Nobody could even get a clue about the designation of the

people based on the communication pattern followed in the company. When

market was in a better condition, there would be lot of cheerfulness in the

environment, where everybody would be discussing about the profit their clients

have made. Just the reverse situation happens when there is a down trend in

market. The environment would be tensed. Senior employees shouting at the

traders or the juniors for not taking due care about it. A lot of analysis as well as

instruction is given through word of mouth.

Even most of the clients used to order directly to the personal relations

department either through telephone or meeting in person.

Interaction Influence Process

The intra departmental interaction was pretty smooth in terms of conveying the

ideas to the administrative heads of the one department. My most of the time

went away in the Trading Section and so every discussion regarding the internal

problems, decision etc happened only after the market hours i.e. 3.30 pm. The

jobs in this particular department were so divided that everyone was given a

different responsibility, which did not required much of interference by others.

One of the phenomenon's that I observed in the company was that if there was a

minor problem in the working in any section then all the employees will assemble

and discuss the issue may be accompanied by the branch coordinator or

technical support manager. So, every one was willing to support and help in the

issues which may not be pertaining to their function directly. As far as influencing

the decisions of the top management is concerned the employees were given

enough autonomy to work in their own way, so I did not came across any such

incidence where the middle level were forced into something.

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Decision Making Process:

The decision-making process was carried out in a top down hierarchy. The

company head office is situated in Bangalore and all the decisions are taken there

and later on communicated to the branch offices. For example if the stock market

crashed severely in a span of very short duration, which will cause a default for

margin for various brokerage houses. To access the position of its clients, the HO

will decide to call off the trading across all offices in the country on open market

day.

The decisions like recruitment, training, business development etc. were delegated at

the branch level. The head of the respective department would take a call on such

issues. The decision pertaining to the limits offered to the clients were taken by the

senior staff and some of the decisions were further delegated to the junior staff. At the

time of my internship, all the interns were give a basic training seven days; this

training was managed and guided by the most junior staff of the company. They

decided the schedule of training based on the availability of the trainer etc.

Goal Setting Process:

There was hardly any goal activity happening in company. The organization is

quite bureaucratic in nature. In fact I did not found any instance where the

employees were ever reminded of the company objectives or goals leave apart

the setting of the goals. The work atmosphere was too casual. The employees

use to just dispose off their responsibilities, doing only what is required with no

connection to the goals or objectives of the company at large. I could not see any

intensity in the work done by the employees there.

This is in particular to the trading section that there was no incentive for

performance and no punishment for underperformance. And at the Personal

Relations department, the Sales and Marketing executives had their own targets,

which were decided by the management, and most of them followed a similar

style of working. This also suggested that the employees had lackadaisical

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attitude towards the work, though they had performance incentives for their better

performance. The sales people used to compete against each other, which lead

to hiding of information from each other. I don’t know whether it was positive or

negative for the company.

Control Process

No importance was given to any control process in the marketing department.

The things used to be ignored till the time they became a problem. The decisions

were taken on ad-hoc basis and no proper planning was one on these fronts. In

the initial phase of internship, the interns were given training but it was carried out

in a completely haphazard manner. On the other hand in the in the trading section

most of the control was exercised through the technological systems. For all the

important parameters the systems were in place. For example the computer

software would generate the limits available in each client’s account on a day to

day basis. In case the limit fell below a certain limit the system gave alert for the

same. In case of purchase of shares in the account of client who had inadequate

balance in his account, the delivery was his shares were always given only after

the payment was collected.

Performance characteristics

The performance characteristics that were classifiable were mostly result

oriented. There were some concrete parameters defined for each profile. The

employees had to perform well along these parameters to get a positive

performance rating. For the sales people it was there monthly, half yearly and

yearly targets. For dealers it was about getting business of five times their own

salary. So, these parameters ensured the productive of the employees.

The quality of work done could be rated as above average because the

performance parameters were pre-determined so every employee had too

achieve this bare minimum level of standards and these standards were pretty

realistic and achievable.

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The absenteeism was quite low as the work was not too hectic or rigorous.

Expect for the markets most of the staff could move in and out of the office. No

strict control over the office in and out time was exercised. The trading section

staff would reach office before the markets open without fail and worked till late

evening without fail. The marketing and sales staff would usually come bit late in

the morning but the kind of there job did not allowed them to have a fixed off time

from the job.

As stated earlier the work environment was such that no one valued time and

punctuality. I never observed that anybody cared about any sort of deadlines, in

fact most of the time there were no deadlines either. So, definitely there was a lot

of wastage of time. Apart from the time factor, other resources were utilized with

minimal wastage.

PROBLEMS FACED DURING THE INTERNSHIP

The initial problem faced by me was my complete ignorance about the stock market.

Moreover when I was given this project on Derivatives, I was not able to understand

even a bit of it. I used to go through a lot of books. Most of the book’s language was

not properly understood by me. I felt that I was getting nowhere. The theories and

what in practicality I was asked to do in derivatives was completely different. Later on

I found that the theories are for supporting the assumptions taken. Everything has

logic to it. My guide helped me to look at these issues from a very rational point of

view.

Another problem faced was that there were a lot of mathematical calculations and

statistical tools to be used in the derivatives or even the mutual funds comparison.

Every term had different computations given in different books or from different net

based tutorials. It really confused many times till they were discussed before my guide

and other team mates.

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.

LEARNING AND EXPERIENCE

I was able to learn and experience a lot of things during the period of my internship at

ANAND RATHI. These learning were not only restricted to the responsibilities that I

handled but also in terms of the interaction patterns that happen within the

organization.

Knowledge about the Financial Markets

Prior to my summer training, I had zilch knowledge on financial markets. But by

undergoing this training I got to know many things in greater clarity and detail about

how the markets operate, how derivatives are used with calculated risk, what are the

jobs of the equity managers, what all tools and techniques backed by theories exist.

Investment Principle

I got my first practical knowledge on finance and that too on investments. I learnt that

it is risk and reward that any investor will take into consideration before parting away

with his money. Before designing or planning anything for the client one needs to

gauge upon the client’s risk taking ability and risk tolerance. Therefore in Anand Rathi

whenever a new client is approached they first try to canalize the client and

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understand his need and expectation form his investments. Only them they decide

what better avenues are open for the client.

Teamwork

The importance of forming self managed teams and getting the work done through a

proper channel was one of my most important learning.

Your work matters at the end of the day.

When my guide knew about my suffering owing to my ignorance on this subject and

being badly handled by my teammates, he came to my rescue. He gave lot of god

advices. He said that at the end of the day what matters is your work and contribution

towards the objective. He said that management in its real sense is getting one’s work

done either by hook or crook. Though he cleared that crook doesn’t mean unethical

practices all the way. One needs to focus on the objective rather than get disturbed by

the obstacles in the way. He encouraged me to quench my inquisitiveness, even

though that might be trivial for all others.

I learned to be patient, tactful and perseverance

All through this project, I learnt the basic aspects that were missing on my part. Earlier

I used to be impatient when my efforts were not given due recognition. But when I

worked here, I learnt that patience is very important in this field. At one point of time

you may be gaining by the increased prices of your shares or assets and at another

time you may be losing all the money you have. So, one needs to strike a balance

between sudden gain and loss. My interactions with my teammates made me more

tactful in delivering what I am supposed to convey and what I am not supposed to

convey in the corporate world where we have to first perceive the thin line of

competition and collaboration. And perseverance is something that every one of us

has to develop in order to strive in volatile tempered industry like Anand Rathi or so to

say any stock broking firm.

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INTRODUCTION OF DERIVATIVES

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

or more basic variables, called underlying. The underlying asset can be

equity, index, foreign exchange (forex), commodity or any other asset.

Derivative products initially emerged as hedging devices against fluctuations

in commodity prices and commodity-linked derivatives remained the sole

form of such products for almost three hundred years. The financial

derivatives came into spotlight in post-1970 period due to growing instability

in the financial markets. However, since their emergence, these products have

become very popular and by 1990s, they accounted for about two thirds of

total transactions in derivative products.

Definition:

In the Indian context the Securities Contracts (Regulation) Act, 1956

(SC(R) A) defines “derivative” as:

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

of underlying securities."

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

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

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

commodity or any other asset.

For example; wheat farmers may wish to sell their harvest at a future

date to eliminate the risk of a change in prices by that date. Such a transaction

is an example of a derivative. The price of this derivative is driven by the

spot price of wheat which is the “underlying”.

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Derivatives are securities under the SC(R) A and hence the regulatory

framework under the SC(R) A governs the trading of derivatives.

Emergence of Derivatives Market

Starting from a controlled economy, India has moved towards a world where

prices fluctuate every day.

The introduction of risk management instruments in India gained momentum

in the last few years due to liberalization process and Reserve Bank of India's

(RBI) efforts in creating currency forward market.

Derivatives are an integral part of liberalization process to manage risk.

NSE gauging the market requirements initiated the process of setting up

In July 1999, derivatives trading commenced in India.

1991 Liberalization process initiated

14-Dec-95NSE asked SEBI for permission to trade index

futures.

18-Nov-96SEBI setup L.C.Gupta Committee to draft a

policy framework for index futures.

11-May-98 L.C.Gupta Committee submitted report.

07-Jul-99RBI gave permission for OTC forward rate

agreements (FRAs) and interest rate swaps.

24-May-00SIMEX chose Nifty for trading futures and

options on an Indian index.

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25-May-00SEBI gave permission to NSE and BSE to do

index futures trading.

09-Jun-00Trading of BSE Sensex futures commenced at

BSE.

12-Jun-00 Trading of Nifty futures commenced at NSE.

25-Sep-00 Nifty futures trading commenced at SGX.

02-Jun-01 Individual Stock Options & Derivatives

Milestones

Emergences of Derivatives

Derivative Markets in India

Trading takes place either on a separate and independent Derivative

Exchange or on a separate segment of an existing Stock Exchange.

Derivative Exchange or segment operates as a self regulatory

Securities and Exchange Board of India (SEBI) acts as the guardian.

Clearing & settlement of all derivative trades made on a Derivative

Exchange or Segment are done through a Clearing Corporation - an

independent body set to act as a regulatory.

Types of Derivatives

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Forwards: A forward contract is a customized contract between two

entities, where settlement takes place on a specific date in the future at

today’s pre-agreed price.

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

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

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

standardized exchange-traded contracts, such as futures of the Nifty index.

Options: An Option is a contract, which gives the right, but not an

obligation, to buy or sell the underlying at a stated date and at a stated price.

While a buyer of an option pays the premium and buys the right to exercise

his option, the writer of an option is the one who receives the option premium

and therefore obliged to sell/buy the asset if the buyer exercises it on him.

Options are of two types - Calls and Puts options:

‘Calls’ give the buyer the right, but not the obligation to

buy a given quantity of the underlying asset at a given price

on or before a given future date.

‘Puts’ give the buyer the right, but not the obligation to sell

a given quantity of underlying asset at a given price on or

before a given future date.

Warrants: Options generally have lives of up to one year. The majority of

options traded on exchanges have maximum maturity of nine months. Longer

dated options are called Warrants and are generally traded over-the counter.

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

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

index options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash

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

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

Interest rate swaps: These entail swapping only the interest

related cash flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and

interest between the parties, with the cash flows in one direction

being in a different currency than those in the opposite direction.

(London interbank offered rate)

Participants

Three broad categories of participants - hedgers, speculators, and

arbitrageurs - trade in the derivatives market.

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

options markets to reduce or eliminate this risk.

Speculators wish to bet on future movements in the price of an asset.

Futures and options contracts can give them an extra leverage; that is, they

can increase both the potential gains and potential losses in a speculative

venture.

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Arbitrageurs are in business to take advantage of a discrepancy between

prices in two different markets. If, for example, they see the futures price of

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

positions in the two markets to lock in a profit.

Commodity derivatives market

Commodity derivatives market trade contracts for which the underlying asset

is commodity. It can be an agricultural commodity like wheat, soybeans,

cotton, etc or precious metals like gold, silver, etc.

Difference between Commodity and Financial

derivatives

The basic concept of a derivative contract remains the same whether the

underlying happens to be a commodity or a financial asset. However there are

some features, which are very peculiar to commodity derivative markets.

In the case of financial derivatives, most of these contracts are cash

settled. Even in the case of physical settlement, financial assets are

not bulky and do not need special facility for storage.

Due to the bulky nature of the underlying assets, physical settlement

in commodity derivatives creates the need for warehousing.

The concept of varying quality of asset does not really exist as far as

financial underlings are concerned.

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However in the case of commodities, the quality of the asset

underlying a contract can vary at times.

Exchange-traded vs. OTC derivatives markets

Derivatives that trade on an exchange are called exchange-traded

derivatives, whereas privately negotiated derivative contracts are called OTC

(Over the Counter) contracts. The OTC derivatives markets have witnessed

rather sharp growth over the last few years, which have accompanied the

modernization of commercial and investment banking and globalization of

financial activities. The recent developments in information technology have

contributed to a great extent to these developments. While both exchange-

traded and OTC derivative contracts offer many benefits, the former have

rigid structures compared to the latter.

The OTC derivatives markets have the following features compared to

exchange-traded derivatives:

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

located within individual institutions,

2. There are no formal centralized limits on individual positions,

leverage, or margining,

3. There are no formal rules for risk and burden sharing,

4. There are no formal rules or mechanisms for ensuring market stability

and integrity, and for safeguarding the collective interests of market

participants.

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5. A regulatory authority and the exchange’s self-regulatory

organization do not regulate the OTC contracts, although they are

affected indirectly by national legal systems, banking supervision and

market surveillance.

Exchange traded Vs. OTC Market.

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NSE’s derivatives market

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

futures on June 12, 2000. The trading in index options commenced on June 4,

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

2001. Single stock futures were launched on November 9, 2001.

Today, both in terms of volume and turnover, NSE is the largest derivatives

exchange in India. Currently, the derivatives contracts have a maximum of 3-

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

month, 2 months and 3 months expiry.

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F&O Trade Volume index options European options, stck opt-

American opt. euro opt can not be exercised. And American

opt can be.

Derivative Contracts

Forward contracts

A forward contract is an agreement to buy or sell an asset on a specified

date for a specified price. One of the parties to the contract assumes a long

position and agrees to buy the underlying asset on a certain specified future

date for a certain specified price. The other party assumes a short position

and agrees to sell the asset on the same date for the same price. Other

contract details like delivery date, the parties to the contract negotiate price

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and quantity bilaterally. The forward contracts are normally traded outside

the exchanges. The salient features of forward contracts are:

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

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

contract size, expiration date and the asset type and quality.

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

asset.

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

the same counterparty, which often results in high prices being

charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing transaction

costs and increasing transactions volume. This process of standardization

reaches its limit in the organized futures market.

Forward contracts are very useful in hedging and speculation. The classic

hedging application would be that of an exporter who expects to receive

payment in dollars three months later. He is exposed to the risk of exchange

rate fluctuations. By using the currency forward market to sell dollars

forward, he can lock on to a rate today and reduce his uncertainty. Similarly

an importer who is required to make a payment in dollars two months hence

can reduce his exposure to exchange rate fluctuations by buying dollars

forward. If a speculator has information or analysis, which forecasts an

upturn in a price, then he can go long on the forward market instead of the

cash market. The speculator would go long on the forward, wait for the price

to raise, and then take a reversing transaction to book profits.

Limitations of forward markets

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Forward markets world-wide are afflicted by several problems:

Lack of centralization of trading,

Illiquidity, and

Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and

generality. The forward market is like a real estate market in that any two

consenting adults can form contracts against each other. This often makes

them design terms of the deal, which are very convenient in that specific

situation, but makes the contracts non-tradable. Counterparty risk arises from

the possibility of default by any one party to the transaction.

When one of the two sides to the transaction declares bankruptcy, the other

suffers. Even when forward markets trade standardized contracts, and hence

avoid the problem of illiquidity, still the counterparty risk remains a very

serious issue.

Futures

Futures markets were designed to solve the problems that exist in

forward markets. A futures contract is an agreement between two parties to

buy or sell an asset at a certain time in the future at a certain price. But unlike

forward contracts, the futures contracts are standardized and exchange traded.

To facilitate liquidity in the futures contracts, the exchange specifies certain

standard features of the contract. It is a standardized contract with standard

underlying instrument, a standard quantity and quality of the underlying

instrument that can be delivered, (or which can be used for reference

purposes in settlement) and a standard timing of such settlement. A futures

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contract may be offset prior to maturity by entering into an equal and

opposite transaction. More than 99% of futures transactions are offset this

way.

The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery

The units of price quotation and minimum price change

Location of settlement

Distinction between futures and forwards

Futures vs. Forwards

Sr. No. Futures Forwards

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1. Trade on an organized

exchange

OTC in nature

2. Standardized contract terms Customized contract

3. Terms more liquid Less liquid

4. Requires margin payments No margin payment

5. Follows daily settlement Settlement happens at

end of period

Futures terminology

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

Futures price: The price at which the futures contract trades in the

futures market.

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Contract cycle: The period over which a contract trades. The

index futures contracts on the NSE have one-month, two-months and

three-month expiry cycles, which expire on the last Thursday of the

month.

Expiry date: It is the date specified in the futures contract. This is

the last day on which the contract will be traded, at the end of which it

will cease to exist.

Contract size: The amount of asset that has to be delivered less

than one contract. For instance, the contract size on NSE’s futures

market is 50 Nifties.

Basis: In the context of financial futures, basis can be defined as the

futures price minus the spot price. There will be a different basis for

each delivery month for each contract. In a normal market, basis will

be positive. This reflects that futures prices normally exceed spot

prices.

Cost of carry: The relationship between futures prices and spot

prices can be summarized in terms of what is known as the cost of

carry. This measures the storage cost plus the interest that is paid to

finance the asset less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin

account at the time a futures contract is first entered into is known as

initial margin.

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Marking-to-market: In the futures market, at the end of each

trading day, the margin account is adjusted to reflect the investor’s

gain or loss depending upon the futures closing price. This is called

marking–to–market.

Maintenance margin: This is somewhat lower than the initial

margin. This is set to ensure that the balance in the margin account

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

below the maintenance margin, the investor receives a margin call and

is expected to top up the margin account to the initial margin level

before trading commences on the next day.

Options

Options are fundamentally different from forward and futures

contracts. An option gives the holder of the option the right to do something.

The holder does not have to exercise this right.

In contrast, in a forward or futures contract, the two parties have committed

themselves to doing something. Whereas it costs nothing (except margin

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requirements) to enter into a futures contract, the purchase of an option

requires an up–front payment.

Option terminology

Index options: These options have the index as the underlying. Some

options are European while others are American. Like, index futures

contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options

currently trade on over 500 stocks in the United States. A contract gives the

holder the right to buy or sell shares at the specified price.

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

option premium buys the right but not the obligation to exercise his option on

the seller/writer.

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

receives the option premium and is thereby obliged to sell/buy the asset if the

buyer exercises on him.

Call option: A call option gives the holder the right but not the obligation

to buy an asset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to

sell an asset by a certain date for a certain price.

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Option price/premium: Option price is the price, which the option

buyer pays to the option seller. It is also referred to as the option premium.

The option premium can be broken down into two components:-

Intrinsic value: - The option premium can be broken down into

two components – intrinsic value and time value. The intrinsic value

of a call is the amount the option is ITM, if it is ITM. If the call is

OTM, its intrinsic value is zero.

Time value: - The time value of an option is the difference

between its premium and its intrinsic value

Expiration date: The date specified in the options contract is known as

the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the

strike price or the exercise price.

American options: American options are options that can be exercised at

any time up to the expiration date. Most exchange-traded options are

American.

European options: European options are options that can be exercised

only on the expiration date itself. European options are easier to analyze than

American options, and properties of an American option are frequently

deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that

would lead to a positive cash flow to the holder if it were exercised

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immediately. A call option on the index is said to be in-the-money when the

current index stands at a level higher than the strike price (i.e. spot price >

strike price).

At-the-money option: An at-the-money (ATM) option is an option that

would lead to zero cash flow if it were exercised immediately. An option on

the index is at-the-money when the current index equals the strike price (i.e.

spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an

option that would lead to a negative cash flow, it were exercised

immediately. A call option on the index is out-of-the-money when the current

index stands at a level, which is less than the strike price (i.e. spot price <

strike price).

Futures and options

An interesting question to ask at this stage is - when would one

use options instead of futures?

Options are different from futures in several interesting senses. At a practical

level, the option buyer faces an interesting situation. He pays for the option in

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full at the time it is purchased. After this, he only has an upside. There is no

possibility of the options position generating any further losses to him (other

than the funds already paid for the option). This is different from futures,

which is free to enter into, but can generate very large losses. This

characteristic makes options attractive to many occasional market

participants, who cannot put in the time to closely monitor their futures

positions. Buying put options is buying insurance. To buy a put option on

Nifty is to buy insurance, which reimburses the full extent to which Nifty

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

people, and to mutual funds creating “guaranteed return products”.

Distinction between futures and options

Futures vs. Options

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Sr. No. Futures Options

1. Exchange traded, with

novation

Same as futures

2. Exchange defines the product Same as futures

3. Price is zero, strike price

moves

Strike price is fixed,

price moves

4. Price is zero No margin payment

5. Both long and short at risk Only short at risk.

RESEARCH

The term research can be defined as “A Scientific and systematic search for

pertinent information on a specific topic.” A research is a careful

investigation or inquiry especially through search for new fact in branch of

knowledge. It is an increase in the existing stock of knowledge making for

advancement.

We decided to do the project in two parts. The first part of the project is

comprised of the brief detail of stock exchange i.e. BSE and NSE and their

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indices and the second part deals with the study of Derivative market and its

instruments.

The first part of the project i.e. stock exchange gives a very short detail about

the role of exchange, Bombay Stock exchange and National Stock Exchange.

There is also a short description of Sensex and about Nifty 50. It also has the

list of companies, which has a major impact over these indices.

The second part of the project is about Derivatives. Indian stock market has

undergone tremendous changes over the years. The derivative market has its

own dynamics. So we tried to cover the introductory part of Derivatives. It

covers the definition, types and the other basic details about it.

SOURCE OF DATA COLLECTION

Primary Data: - is the first hand information collected directly from the

employees of ARSL. They explained us the basics of Derivative market and

also shared their experience with their F&O clients.

Secondary Data: - is collected through Internet and Books

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SUGGESTIONS

The study done was a tool to study the Derivative market's setup and to know

WORKING OF A Brokerage firm. The study proved fruitful and many facts

came into light. Following are some of the recommendations for ARSL:

ARSL should provide recreation facility to their employees.

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ARSL should organize some promotional campaigns for making

people aware about Derivatives.

They can also arrange some training and educational programs for

their employees.

BIBLIOGRAPHY

BOOKS:

Financial Management: I M Pandey.

NCFM's Derivatives Market Module: NSE

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WEBSITES:

www.rathi.com

www.derivativesIndia.com

www.bseindia.com

www.nseindia.com

www.moneycontrol.com

www.valueresearchonline.com

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