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EXECUTIVE SUMMARY

The emergence of the market for derivatives products, most notably

forwards, futures and options, can be tracked back to the willingness of risk -averse

economic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. Derivatives are risk management instruments, which

derive their value from an underlying asset. The following are three broad

categories of participants in the derivatives market Hedgers, Speculators and

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

market participants about the future and lead the price of underlying to the

perceived future level. In recent times the Derivative markets have gained

importance in terms of their vital role in the economy. The increasing investments

in stocks (domestic as well as overseas) have attracted my interest in this area.

Numerous studies on the effects of futures and options listing on the underlying

cash market volatility have been done in the developed markets. The derivative

market is newly started in India and it is not known by every investor, so SEBI

has to take steps to create awareness among the investors about the derivative

segment. In cash market the profit/loss of the investor depends on the ma rket price

of the underlying asset. The investor may incur huge profit or he may incur huge

loss. But in derivatives segment the investor enjoys huge profits with limited

downside. Derivatives are mostly used for hedging purpose. In order to increase

the derivatives market in India, SEBI should revise some of their regulations like

contract size, participation of FII in the derivatives market. In a nutshell the study

throws a light on the derivatives market.

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OBJECTIVES OF THE STUDY:

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives.

To know the role of derivatives trading in India.

To study about risk management with the help of derivatives.

SCOPE OF THE STUDY:

The project covers the derivatives market and its instruments. For better understanding

various strategies with different situations and actions have been given. It includes the data

collected in the recent years and also the market in the derivatives in the recent years. This

study extends to the trading of derivatives done in the National Stock Markets.

LIMITAITONS OF STUDY:

The time available to conduct the study was only 2 months. It being a wide topic had a

limited time.

Limited resources are available to collect the information about the commodity trading.

The study is conducted in Mumbai only .

Some of the aspects may not be covered in my study.

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LITERATURE REVIEW

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 fluctuations in asset prices. By their very nature,

the financial markets are marked by a very high degree of volatility. Through the use of

derivative products, it is possible to partially or fully transfer price risks by locking-in asset

prices. As instruments of risk management, these generally do not influence the fluctuations in

the underlying asset prices. However, by locking-in asset prices, derivative products minimize

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

averse investors.

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. In recent years, the market for financial derivatives

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

also turnover. In the class of equity derivatives, futures and options on stock indices have

gained more popularity than on individual stocks, especially among institutional investors, who

are major users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices with

various portfolios and ease of use. The lower costs associated with index derivatives vis-vis

derivative products based on individual securities is another reason for their growing use.

As in the present scenario, Derivative Trading is fast gaining momentum, I have chosen

this topic.

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RESEARCH METHODOLOGY

DATA COLLECTION TOOLS:

Data mainly collected from both primary and secondary sources.

PRIMARY DATA:

Primary data was collected through Structured Questionnaire/Interview

method from the field work. Primary data was also collected directly from the

investors.

SECONDARY DATA:

Secondary data that were collected through survey, published mater ials,

newspaper, books, etc.

Sample Size:

120 investors.

TOOLS AND TECHNIQUES

Information has to be collected on the basis of the questionnaire distributed

to the borrowers.

Internet/ prominent search engines have been used for collecting the Data,

market watch is also used to some extent for interpretation analysis.

All data collected are carefully classified, tabulated for the purpose of

research and interpreted on the basis of charts and tables.

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INTRODUCTION

The origin of derivatives can be traced back to the need of farmers to protect themselves

against fluctuations in the price of their crop. From the time it was sown to the time it was

ready for harvest, farmers would face price uncertainty. Through the use of simple derivative

products, it was possible for the farmer to partially or fully transfer price risks by locking-in

asset prices. These were simple contracts developed to meet the needs of farmers and were

basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would receive

for his harvest in September. In years of scarcity, he would probably obtain attractive prices.

However, during times of oversupply, he would have to dispose off his harvest at a very low

price. Clearly this meant that the farmer and his family were exposed to a high risk of price

uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would face a

price risk that of having to pay exorbitant prices during dearth, although favourable prices could

be obtained during periods of oversupply. Under such circumstances, it clearly made sense for

the farmer and the merchant to come together and enter into contract whereby the price of the

grain to be delivered in September could be decided earlier. What they would then negotiate

happened to be futures-type contract, which would enable both parties to eliminate the price

risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and

merchants together. A group of traders got together and created the to-arrive contract that

permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts

proved useful as a device for hedging and speculation on price charges. These were eventually

standardized, and in 1925 the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn, pepper,

cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of

financial underlying like stocks, interest rate, exchange rate, etc.

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DERIVATIVE DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can be equity,

forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may

wish to sell their harvest at a future date to eliminate the risk of change in price 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 in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts

in commodities all over India. As per this the Forward Markets Commission (FMC) continues

to have jurisdiction over commodity futures contracts. However when derivatives trading in

securities was introduced in 2001, the term security in the Securities Contracts (Regulation)

Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently,

regulation of derivatives came under the purview of Securities Exchange Board of India

(SEBI). We thus have separate regulatory authorities for securities and commodity derivative

markets.

Derivatives are securities under the SCRA and hence the trading of derivatives is governed

by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956

defines derivative to include-

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

risk instrument or contract differences or any other form of security.

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

securities.

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TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives over the Counter Derivatives

National Stock Bombay Stock National Commodity &Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

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Derivatives

Future Option Forward Swaps

TYPES OF DERIVATIVES

Figure.2 Types of Derivatives

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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, price and quantity are

negotiated bilaterally by the parties to the contract. The forward contracts are n o r m a l l y

traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

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.

The contract price is generally not available in public domain.

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 counter-

party, which often results in high prices being charged.

However forward contracts incertain 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 often confused with futures contracts. The confusion

is primarily because both serve essentially the same economic functions of

allocating risk in the presence of future price uncertainty. However futures are a significant

improvement over the forward contracts as they eliminate counterparty risk and

offer more liquidity.

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FUTURE CONTRACT

In finance, a futures contract 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

settlement price, normally, converges towards the futures price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which

differs from an options contract, which gives the buyer the right, but not the obligation, and the

option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a

futures position has to sell his long position or buy back his short position, effectively closing

out the futures position and its contract obligations. Futures contracts are exchange traded

derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a short term

interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the notional

amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional

amount of the deposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds can be

delivered. In case of physical commodities, this specifies not only the quality of the

underlying goods but also the manner and location of delivery. The delivery month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.

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2. Margin:

Although the value of a contract at time of trading should be zero, its price constantly

fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk

to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands

that contract owners post a form of collateral, commonly known as Margin requirements are

waived or reduced in some cases for hedgers who have physical ownership of the covered

commodity or spread traders who have offsetting contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as

determined by historical price changes, which is not likely to be exceeded on a usual day's

trading. It may be 5% or 10% of total contract price.

Mark to market Margin: Because a series of adverse price changes may exhaust the initial

margin, a further margin, usually called variation or maintenance margin, is required by the

exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each

day, called the "settlement" or mark-to-market price of the contract.

To understand the original practice, consider that a futures trader, when taking a position,

deposits money with the exchange, called a "margin". This is intended to protect the exchange

against loss. At the end of every trading day, the contract is marked to its present market value.

If the trader is on the winning side of a deal, his contract has increased in value that day, and

the exchange pays this profit into his account. On the other hand, if he is on the losing side, the

exchange will debit his account. If he cannot pay, then the margin is used as the collateral from

which the loss is paid.

3. Settlement

Settlement is the act of consummating the contract, and can be done in one of two ways,

as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is

delivered by the seller of the contract to the exchange, and by the exchange to the buyers

of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled

out by purchasing a covering position - that is, buying a contract to cancel out an earlier

sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a

long).

Cash settlement - a cash payment is made based on the underlying reference rate, such as

a short term interest rate index such as Euribor, or the closing value of a stock market

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index. A futures contract might also opt to settle against an index based on trade in a

related spot market.

Expiry is the time when the final prices of the future are determined. For many equity index

and interest rate futures contracts, this happens on the Last Thursday of certain trading month.

On this day the t+2 futures contract becomes the t forward contract.

PRICING OF FUTURE CONTRACT

In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward

price) must be the same as the cost (including interest) of buying and storing the asset. In other

words, the rational forward price represents the expected future value of the underlying

discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the

future/forward, , will be found by discounting the present value at time to maturity

by the rate of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields, and

convenience yields. Any deviation from this equality allows for arbitrage as follows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today (on the spot

market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed

forward price.

3. He then repays the lender the borrowed amount plus interest.

4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today (on the spot

market); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has appreciated at the

risk free rate.

3. He then receives the underlying and pays the agreed forward price using the matured

investment. [If he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.

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TABLE 1-

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between two

parties (not traded on the

exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized contracts.

Counter-party

risk

Exists. Exists. However, assumed by the clearing

corp., which becomes the counter party to

all the trades or unconditionally

guarantees their settlement.

Liquidation

Profile

Low, as contracts are tailor

made contracts catering to the

needs of the needs of the

parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets are

scattered.

Efficient, as markets are centralized and

all buyers and sellers come to a common

platform to discover the price.

Examples Currency market in India. Commodities, futures, Index Futures and

Individual stock Futures in India.

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OPTIONS -

A derivative transaction that gives the option holder the right but not the obligation to

buy or sell the underlying asset at a price, called the strike price, during a period or on a specific

date in exchange for payment of a premium is known as option. Underlying asset refers to

any asset that is traded. The price at which the underlying is traded is called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying

asset-stock or any financial asset, at a specified price on or before a specified date is known as

a Call option. The owner makes a profit provided he sells at a higher current price and buys

at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying

asset-stock or any financial asset, at a specified price on or before a specified date is known as

a Put option. The owner makes a profit provided he buys at a lower current price and sells at

a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference

shares, bonds and warrants become the subject of options.

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SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange a

series of cash flows at specified intervals known as payment or settlement dates. They can be

regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange

(swap) payments, based on some notional principle amount is called as a SWAP. In case of

swap, only the payment flows are exchanged and not the principle amount. The two commonly

used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his series

of fixed rate interest payments to a party in exchange for his variable rate interest payments.

The fixed rate payer takes a short position in the forward contract whereas the floating rate

payer takes a long position in the forward contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the interest

on loan in one currency are swapped for the principle and the interest payments on loan in

another currency. The parties to the swap contract of currency generally hail from two different

countries. This arrangement allows the counter parties to borrow easily and cheaply in their

home currencies. Under a currency swap, cash flows to be exchanged are determined at the

spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by

subsequent changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to access one

market and then exchange the liability for another type of liability. It also allows the investors

to exchange one type of asset for another type of asset with a preferred income stream.

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OTHER KINDS OF DERIVATIVES

The other kind of derivatives, which are not, much popular are as follows:

BASKETS -

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

most popular form of baskets.

LEAPS -

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

introduce option contracts with a maturity period of 2-3 years. These long-term option contracts

are popularly known as Leaps or Long term Equity Anticipation Securities.

WARRANTS -

Options generally have lives of up to one year, the majority of options traded on options

exchanges having a maximum maturity of nine months. Longer-dated options are called

warrants and are generally traded over-the-counter.

SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the expiry of

the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts,

the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an

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

floating.

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INDIAN 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 liberalisation process and Reserve Bank of Indias (RBI)

efforts in creating currency forward market. Derivatives are an integral part of liberalisation

process to manage risk. NSE gauging the market requirements initiated the process of setting

up derivative markets in India. In July 1999, derivatives trading commenced in India

Table 2. Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for

index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs)

and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian

index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures

trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

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Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have become

the most important markets in the world. Today, derivatives have become part and parcel of

the day-to-day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading methods

and was using traditional outdated methods of trading. There was a huge gap between the

investors aspirations of the markets and the available means of trading. The opening of Indian

economy has precipitated the process of integration of Indias financial markets with the

international financial markets. Introduction of risk management instruments in India has

gained momentum in last few years thanks to Reserve Bank of Indias efforts in allowing

forward contracts, cross currency options etc. which have developed into a very large market.

Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have become

the most important markets in the world. Financial derivatives came into the spotlight along

with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods

System of fixed exchange rates leading to introduction of currency derivatives followed by

other innovations including stock index futures. Today, derivatives have become part and

parcel of the day-to-day life for ordinary people in major parts of the world. While this is true

for many countries, there are still apprehensions about the introduction of derivatives. There

are many myths about derivatives but the realities that are different especially for Exchange

traded derivatives, which are well regulated with all the safety mechanisms in place.

What are these myths behind derivatives? Derivatives increase speculation and do not serve any economic purpose

Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveraged instruments.

Derivatives are complex and exotic instruments that Indian investors will find difficulty

in understanding

Is the existing capital market safer than Derivatives?

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Derivatives increase speculation and do not serve any economic purpose:

Numerous studies of derivatives activity have led to a broad consensus, both in the private and

public sectors that derivatives provide numerous and substantial benefits to the users.

Derivatives are a low-cost, effective method for users to hedge and manage their exposures to

interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool

was felt first in the commodities market. Agricultural futures and options helped farmers and

processors hedge against commodity price risk. After the fallout of Bretton wood agreement,

the financial markets in the world started undergoing radical changes. This period is marked

by remarkable innovations in the financial markets such as introduction of floating rates for the

currencies, increased trading in variety of derivatives instruments, on-line trading in the capital

markets, etc. As the complexity of instruments increased many folds, the accompanying risk

factors grew in gigantic proportions. This situation led to development derivatives as effective

risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to

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

futures and options. An equity fund, for example, can reduce its exposure to the stock market

quickly and at a relatively low cost without selling off part of its equity assets by using stock

index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks and

raising capital, derivatives improve the allocation of credit and the sharing of risk in the global

economy, lowering the cost of capital formation and stimulating economic growth. Now that

world markets for trade and finance have become more integrated, derivatives have

strengthened these important linkages between global markets, increasing market liquidity and

efficiency and facilitating the flow of trade and finance

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Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian capital market is

not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for

the introduction of derivatives, and how Indian market fares:

TABLE 3.

PRE-REQUISITES INDIAN SCENARIOLarge market Capitalisation India is one of the largest market-capitalised countries in

Asia with a market capitalisation of more than Rs.765000crores.

High Liquidity in theunderlying

The daily average traded volume in Indian capital markettoday is around 7500 crores. Which means on an averageevery month 14% of the countrys Market capitalisationgets traded. These are clear indicators of high liquidity inthe underlying.

Trade guarantee The first clearing corporation guaranteeing trades hasbecome fully functional from July 1996 in the form ofNational Securities Clearing Corporation (NSCCL).NSCCL is responsible for guaranteeing all open positionson the National Stock Exchange (NSE) for which it doesthe clearing.

A Strong Depository National Securities Depositories Limited (NSDL) whichstarted functioning in the year 1997 has revolutionalisedthe security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange Boardof India) today the Indian capital market enjoys a strong,independent, and innovative legal guardian who ishelping the market to evolve to a healthier place for tradepractices.

Comparison of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options and banning

of Badla is disadvantageous and introduced early, but I feel that this new system is very useful

especially to retail investors. It increases the no of options investors for investment. In fact it

should have been introduced much before and NSE had approved it but was not active because

of politicization in SEBI.

The figure 3.3a 3.3d shows how advantages of new system (implemented from June 20001)

v/s the old system i.e. before June 2001

New System Vs Existing System for Market Players

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Figure 3.3aSpeculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premiumhold till expiry.

Advantages

Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.

Figure 3.3b

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game.another exchange. the Market moves. in weekly settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

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Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option.

3)Sell deep OTM call optionwith underlying shares, earnpremium + profit with increase prcie

Advantages Availability of Leverage

Figure 3.3dSmall Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains

profit/loss. 2) Hedge position if protected &holding underlying upsidestock unlimited.

Advantages Losses Protected.

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Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few

years, which has accompanied the modernization of commercial and investment banking and

globalisation 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.

It has been widely discussed that the highly leveraged institutions and their OTC derivative

positions were the main cause of turbulence in financial markets in 1998. These episodes of

turbulence revealed the risks posed to market stability originating in features of OTC derivative

instruments and markets.

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, and

5. The OTC contracts are generally not regulated by a regulatory authority and the

exchanges self-regulatory organization, although they are affected indirectly by

national legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market stability.

The following features of OTC derivatives markets can give rise to instability in institutions,

markets, and the international financial system: (i) the dynamic nature of gross credit

exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on

available aggregate credit; (iv) the high concentration of OTC derivative activities in major

institutions; and (v) the central role of OTC derivatives markets in the global financial system.

Instability arises when shocks, such as counter-party credit events and sharp movements in

asset prices that underlie derivative contracts, occur which significantly alter the perceptions

of current and potential future credit exposures. When asset prices change rapidly, the size and

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configuration of counter-party exposures can become unsustainably large and provoke a rapid

unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the progress

has been limited in implementing reforms in risk management, including counter-party,

liquidity and operational risks, and OTC derivatives markets continue to pose a threat to

international financial stability. The problem is more acute as heavy reliance on OTC

derivatives creates the possibility of systemic financial events, which fall outside the more

formal clearing house structures. Moreover, those who provide OTC derivative products, hedge

their risks through the use of exchange traded derivatives. In view of the inherent risks

associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian

law considers them illegal.

25

FACTORS CONTRIBUTING TO THE GROWTH OFDERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the financial

theories.

A.} PRICE VOLATILITY A price is what one pays to acquire or use something of value. The objects having value maybe

commodities, local currency or foreign currencies. The concept of price is clear to almost

everybody when we discuss commodities. There is a price to be paid for the purchase of food

grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is

called interest rate. And the price one pays in ones own currency for a unit of another currency

is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have demand and

producers or suppliers have supply, and the collective interaction of demand and supply in

the market determines the price. These factors are constantly interacting in the market causing

changes in the price over a short period of time. Such changes in the price are known as price

volatility. This has three factors: the speed of price changes, the frequency of price changes

and the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market adjustments

through price changes. These price changes expose individuals, producing firms and

governments to significant risks. The breakdown of the BRETTON WOODS agreement

brought an end to the stabilising role of fixed exchange rates and the gold convertibility of the

dollars. The globalisation of the markets and rapid industrialisation of many underdeveloped

countries brought a new scale and dimension to the markets. Nations that were poor suddenly

became a major source of supply of goods. The Mexican crisis in the south east-Asian currency

crisis of 1990s has also brought the price volatility factor on the surface. The advent of

telecommunication and data processing bought information very quickly to the markets.

Information which would have taken months to impact the market earlier can now be obtained

in matter of moments.

Even equity holders are exposed to price risk of corporate share fluctuates rapidly.

26

These price volatility risks pushed the use of derivatives like futures and options increasingly

as these instruments can be used as hedge to protect against adverse price changes in

commodity, foreign exchange, equity shares and bonds.

B.} GLOBALISATION OF MARKETS Earlier, managers had to deal with domestic economic concerns; what happened in other part

of the world was mostly irrelevant. Now globalisation has increased the size of markets and as

greatly enhanced competition .it has benefited consumers who cannot obtain better quality

goods at a lower cost. It has also exposed the modern business to significant risks and, in many

cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness

of our products vis--vis depreciated currencies. Export of certain goods from India declined

because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of

steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The

fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that

globalisation of industrial and financial activities necessitates use of derivatives to guard

against future losses. This factor alone has contributed to the growth of derivatives to a

significant extent.

C.} TECHNOLOGICAL ADVANCES A significant growth of derivative instruments has been driven by technological breakthrough.

Advances in this area include the development of high speed processors, network systems and

enhanced method of data entry. Closely related to advances in computer technology are

advances in telecommunications. Improvement in communications allow for instantaneous

worldwide conferencing, Data transmission by satellite. At the same time there were significant

advances in software programmes without which computer and telecommunication advances

would be meaningless. These facilitated the more rapid movement of information and

consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole resources

are rapidly relocated to more productive use and better rationed overtime the greater price

volatility exposes producers and consumers to greater price risk. The effect of this risk can

easily destroy a business which is otherwise well managed. Derivatives can help a firm manage

the price risk inherent in a market economy. To the extent the technological developments

27

increase volatility, derivatives and risk management products become that much more

important.

D.} ADVANCES IN FINANCIAL THEORIES Advances in financial theories gave birth to derivatives. Initially forward contracts in its

traditional form, was the only hedging tool available. Option pricing models developed by

Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970s,

work of Lewis Edeington extended the early work of Johnson and started the hedging of

financial price risks with financial futures. The work of economic theorists gave rise to new

products for risk management which led to the growth of derivatives in financial markets.

The above factors in combination of lot many factors led to growth of derivatives instruments

28

BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT Futures and options contract can be used for altering the risk of investing in spot market.

For instance, consider an investor who owns an asset. He will always be worried that the price

may fall before he can sell the asset. He can protect himself by selling a futures contract, or by

buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as

you will see later. This will help offset their losses in the spot market. Similarly, if the spot

price falls below the exercise price, the put option can always be exercised.

2.] PRICE DISCOVERY Price discovery refers to the markets ability to determine true equilibrium prices.

Futures prices are believed to contain information about future spot prices and help in

disseminating such information. As we have seen, futures markets provide a low cost trading

mechanism. Thus information pertaining to supply and demand easily percolates into such

markets. Accurate prices are essential for ensuring the correct allocation of resources in a free

market economy. Options markets provide information about the volatility or risk of the

underlying asset.

3.] OPERATIONAL ADVANTAGES As opposed to spot markets, derivatives markets involve lower transaction costs.

Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price

changes. However, futures markets tend to be more liquid than spot markets, because herein

you can take large positions by depositing relatively small margins. Consequently, a large

position in derivatives markets is relatively easier to take and has less of a price impact as

opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take

a short position in derivatives markets than it is to sell short in spot markets.

4.] MARKET EFFICIENCY The availability of derivatives makes markets more efficient; spot, futures and options

markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is

29

possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these

markets help to ensure that prices reflect true values.

5.] EASE OF SPECULATION Derivative markets provide speculators with a cheaper alternative to engaging in spot

transactions. Also, the amount of capital required to take a comparable position is less in this

case. This is important because facilitation of speculation is critical for ensuring free and fair

markets. Speculators always take calculated risks. A speculator will accept a level of risk only

if he is convinced that the associated expected return is commensurate with the risk that he is

taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying at the expiration of

derivative contract. Thus derivatives help in discovery of future as well as current

prices.

An important incidental benefit that flows from derivatives trading is that it acts as a

catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run. Transfer of

risk enables market participants to expand their volume of activity.

30

DATA INTERPRETATION

16%

22%

41%

17%4%

1. Age?

under 25

25-35

35-45

45-55

above 55

92%

8%

2. Gender?

Male

Female

31

1%

36%

57%

6%

3. Educational qualifications?

HSC

Graduate

Post-graduate

Technical Education

11%

1%

54%

31%

3%

4. Occupation?

Student

Housewife

Working executive

Entrepreneur

Retired

32

In this annual income of the respondent was examined. Majority of respondents

i.e. 48% have annual income above 10 lacs. 13% respondents have income less

than 1 lac. 11% respondents have income between 1 lac - 3 lac. 18% have

between 5 lac - 10 lac and only 10% respondents have 3 lac - 5 lac.

13%

11%

10%

18%

48%

5. Annual Income?

Less than 1 lac

1 lac 3 lac

3 lac 5 lac

5 lac 10 lac

Above 10 lac

33

According to majority of respondents i.e. 44% their relatives introduced them with

the share market, 33% respondents entered into share market because of their

friends, 10% respondents entered through financial advisers, 8% people followed

media for introducing themselves with share market and only 5% people

introduced to share market by stock broker.

33%

44%

10%

8%5%

6. Who introduced you to share market?

Friends

Relatives

Financial Adviser

Media

Stock Broker

34

In this respondents were asked regarding their preferred investment horizon.

Majority of respondents i.e. 48% investing in both the long term and short term

schemes, 42% respondents are doing short term investment and remaining i.e. only

10% are doing long term investment.

42%

10%

48%

7. What is your preferred investmenthorizon?

Short term investment

Long term investment

Both

35

In this respondents experience in stock trading was examined. Majority of

respondents i.e. 30% have experience between 1-3 year and only 7% have more

than 9 year of experience. Out if remaining 27% respondent have 4-6 year of

experience, 20% have less than 1 year and 16% have 7-9 year experience.

20%

30%27%

16%7%

8. Your experience in stock trading?

Less than 1 year

1-3 years

4-6 years

7-9 years

More than 9 years

36

Respondents were asked regarding their experience in derivatives trading.

Majority of respondents i.e. 29% have experience of deriva tives trading between

4-6 year, 28% of respondents investing between 1-3 year, 27% respondent

investing less than 1 year and only 16% investing for more than 6 year.

27%

28%

29%

16%

9. Your experience in Derivatives (F&O)trading?

Less than 1 year

1-3 years

4-6 years

More than 6 years

37

In this motivating factors for investing in derivatives were observed. Returning in

derivative market is attracting majority of respondents i.e. 77%, low risk in this

market motivates 10% investors. 8% investors invest due to liquidity & 3% invest

because it is safe market.

77%

8%3%

10%2%

10. What factors motivate you to invest inderivatives market?

Return

Liquidity

Safety

Low risk

Others

38

37% respondents invest in options on individual stocks. 28% invest in stock index

options. Out of remaining respondents 18% invest in stock index futures & 17%

in futures on individual stock.

18%

28%

17%

37%

11. Which type of derivative option you usefor investment?

Stock index futures

Stock index options

Futures on individual stocks

Options on individual stocks

39

In this factors considered by respondent while investing in derivatives was

observed, More than 50% respondents considered profitability while investing in

derivatives, 28% respondents invest on the basis of economic condition, 12%

observed market trend while investing, 4% respondents invest based on industry

conditions.

12%

51%

28%

4%5%

12. Which factors do you consider whileinvesting in derivatives?

Market Trend

Profitability

Economic Condition

Industry Condition

Others

40

Majority of respondents i.e. 39% use the tool of fundamental analysis & only 6%

respondents investing on the basis of broking tips.

Majority of respondents i.e. 39% believe that expected rate of return from

derivatives market will be 16 to 20 %

12%6%

39%7%

36%

13. Which tools do you used while trading inderivative market?

Based on News

Broking Tips

Fundamental Analysis

Technical Analysis

Random

14%

18%

39%

10%

19%

14. What is the expected Rate of return fromderivative market?

5% -10%

11% - 15%

16% - 20%

21% -25%

Above 25%

41

Majority of respondents i.e. 30% invest in 10% to 20% of stock market in

derivative market.

Majority of respondents i.e. 68% be patience if market reverses against your

position.

15%

18%

30%

13%

24%

15. Percentage of stock market investmentinvested in derivatives market?

Up to 5%

5% - 10%

10% - 20%

20% - 30%

Above 30%

3%3%

22%

4%68%

16. If market reverses against your position,what is your response?

Panic

Fear

Confident

Hope

Patience

42

Majority of respondents i.e. 41% book profit if futures and options moves as you

expect.

Majority of respondents i.e. 92% will wait for profit if futures and options moves

against their position.

41%

39%

20%

17. If Futures & Options moves as youexpected, what do you do?

Book profit

Wait for more profit

Increase the position

8%

92%

18. If Futures & Options moves against yourposition, what do you do?

Book loss

Wait for profit

43

Majority of respondents i.e. 53% believe that there will be no effect on stopping

mini-nifty contract trading.

Majority of respondents i.e. 40% believe that trading in derivatives will grow very

fast in future.

27%

20%

53%

19. What is your take on SEBIs recent moveon stopping Mini-NIFTY contracts trading?

Good move to protect smallinvestors

Will affect investors perceptiontowards F&O

No effect

40%

33%

6%

21%

20. Do you expect that the trading inderivatives in India will

Grow very fast

Grow Moderately

Grow slow

Cant say anything

44

FINDINGS & CONCLUSION

From the above analysis it can be concluded that:

1. Derivative market is growing very fast in the Indian Economy. The turnover

of Derivative Market is increasing year by year in the Indias largest stock

exchange NSE. In the case of index future there is a phenomenal increase

in the number of contracts. But whereas the turnover is declined

considerably. In the case of stock future there was a slow increase observed

in the number of contracts whereas a decline was also observed in its

turnover. In the case of index option there was a huge increase observed

both in the number of contracts and turnover.

2. After analysing data it is clear that the main factors that are driving the

growth of Derivative Market are Market improvement in communication

facilities as well as long term saving & investment is also possible through

entering into Derivative Contract. So these factors encourage the Derivative

Market in India.

3. It encourages entrepreneurship in India. It encourages the investor to take

more risk & earn more return. So in this way it helps the Indian Economy

by developing entrepreneurship. Derivative Market is more regulated &

standardized so in this way it provides a more controlled environment. In

nutshell, we can say that the rule of High risk & High return apply in

Derivatives. If we are able to take more risk then we can earn more profit

under Derivatives.

45

RECOMMENDATIONS

RBI should play a greater role in supporting derivatives.

Derivatives market should be developed in order to keep it at par with other

derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

46

BIBLIOGRAPHY

Books referred:

Options Futures, and other Derivatives by John C Hull

Derivatives FAQ by Ajay Shah

NSEs Certification in Financial Markets: - Derivatives Core module

Financial Markets & Services by Gordon & Natarajan

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.ncdex.com

www.google.com

www.derivativesindia.com

47

Questionnaire(Please tick the appropriate option)

1. Age?

Under 25 25-35

35-45 45-55Above 55

2. Gender?

Male Female

3. Educational qualifications?H.S.C Graduate

Post-graduate Technical Education

4. Occupation?

Student Housewife

Working executive Entrepreneur

Retired

5. Annual Income?

Less than 1,00,000 1,00,000 3,00,000

3,00,000 5,00,000 5,00,000 10,00,000

Above 10,00,000

6. Who introduced you to share market?

Friends Relatives

Financial Adviser Media

Stock Broker

7. What is your preferred investment horizon?

Short term investment Long term investment

Both

8. Your experience in stock trading?

Less than 1 year 1-3 years

4-6 years 7-9 years

More than 9 years

48

9. Your experience in Derivatives (F&O) trading?

Less than 1 year 1-3 years

4-6 years More than 6 years

10. What factors motivate you to invest in derivatives market?

Return Liquidity

Safety Low risk

Others

11. Which type of derivative option you use for investment?

Stock index futures Stock index options

Futures on individual stocks Options on individual stocks

12. Which factors do you consider while investing in derivatives?

Market Trend Profitability

Economic Condition Industry Condition

Others

13. Which tools do you used while trading in derivative market?

Based on News Broking Tips

Fundamental Analysis Technical Analysis

Random

14. What is the expected Rate of return from derivative market?

5% -10% 11% - 15%

16% - 20% 21% -25%

Above 25%

15. Percentage of stock market investment invested in derivatives market?

Up to 5% 5% - 10%

10% - 20% 20% - 30%

Above 30%

16. If market reverses against your position, what is your response?

Panic Fear

Confident Hope

Patience

49

17. If Futures & Options moves as you expected, what do you do?

Book profit Wait for more profit

Increase the position

18. If Futures & Options moves against your position, what do you do?

Book loss Wait for profit

19. What is your take on SEBIs recent move on stopping Mini -NIFTYcontracts trading?

Good move to protect small investors

Will affect investors perception towards F&O

No effect

20. Do you expect that the trading in derivatives in India will

Grow very fast Grow Moderately

Grow slow cant say anything