Major Research Project on:-

“A study on Derivatives in Indian capital market”

Research Project Submitted To:-

Devi Ahilya Vishwavidyalaya, Indore

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGRSS OF

MASTER OF BUSINESS ADMINISTRATION

SUBMITTED THROUGH

Arihant Institute of management studies indore (m.p.)

SESSION-2009-11

GUIDED BY: - SUBMITTED BY:-Mrs. Pinky Shrivastava Kapil Kumar Tiwari CO-GUIDED BY: - Arihant Institute of Management Mr.Vivek vyas Studies, Indore MBA (Finance & Marketing)

CERTIFICATE

This is to certify that Mr. Kapil Kumar Tiwari has undergone the project entitles “A study on Derivatives in Indian capital market” towards the partial fulfillment of his two years Master Degree of Business Administration (MBA FT) successfully. She has carried out this project with full sincerity and dedication and the work is original and genuine.

Director: - Faculty:-

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ACKNOWLEDGMENT

I here by declare that the project report entitled

“A study on Derivatives in Indian capital market”

In partial fulfillment of the requirements for the degree of

MASTER OF BUSINESS ADMINISTRATION

It is my original work and not submitted for the any other degree, diploma, Internship or any other similar titles.

Thank you

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Kapil Kumar Tiwari Arihant Institute of Management

Studies, Indore MBA (Finance & Marketing)

TABLE OF CONTANTS

1. Introduction

1. History of derivatives2. Milestones3. Development of derivative market in India4. Derivatives permitted by SEBI5. Need of financial Derivatives6. Participants in the market:- Hedgers, Speculators, Arbitragers7. Type of derivatives8. Options:- Definitions, types 9. Options strategies

2. Review of Literature3. Rational of the study4. Research Methodology 1. Objective 2. Method of data collection.5. Statistical Analysis6. Result, Finding & Suggetions 1. Limitation 2. Conclusion7. Referancess

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Introduction

In the last 20 years derivatives have become increasingly important in the world of finance. Futures and options are now traded actively on many exchanges throughout the world. Forward contracts, swaps, and many different types of options are regularly traded outside exchanges by financial institutions, fund managers, and corporate treasurers in what is termed the over-the-counter market. Derivatives are also sometimes added to a bond or stock issue.

Derivatives are the most complex of financial instruments. The word ‘derivative’ comes from the verb ‘derive’. A derivative is a contract whose value is derived from the value of another asset, known as underlying, which could be a share, a stock market index, an interest rate, a commodity, or a currency.

For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean.Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset.For example, a farmer fears that the price of soybean (underlying), when his crop is ready for delivery will be lower than his cost of production.Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period).In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa.If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes even more valuable.This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying.If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or for that matter even weather, then the derivative is known as a commodity derivative.If the underlying is a financial asset like debt instruments, currency, share price index, equity shares, etc, the derivative is known as a financial derivative.

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History of derivativesThe history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in theprice of their crops due to delayed monsoon, or overproduction. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardized around 1865. From then on, futures contracts have remained more or less in the same form, as we knowthem today.

Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005.

Derivatives have the characteristic of leverage or gearing. With a small initial outlay of funds one can deal large volumes. Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.There is a huge variety of derivative products that are traded on organized exchanges or OTC markets.

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The ancient derivatives

1400’s Japanese rice futures

1600’s dutch tulip bulb options

1800’s puts and call options

The recent: financial derivatives listed markets

1972 Financial Currency Futures1973 Stock Options1977 Treasury Bond Futures1981 Euro Dollars Futures1982 Index Futures1983 Stock Index Options1990 Foreign Index Warrants And Leaps1991 Swap Futures1992 Insurance Futures1993 Flex Options

OTC Markets1981 Currency Swaps1982 Interest Rate Swaps1983 Currency And Bond Options

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Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the promulgation ofthe Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition onoptions in securities. The market for derivatives, however, did not take off, as there was noregulatory framework to govern trading of derivatives. SEBI set up a 24–membercommittee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to developappropriate regulatory framework for derivatives trading in India. The committee submittedits report on March 17, 1998 prescribing necessary pre–conditions for introduction ofderivatives trading in India. The committee recommended that derivatives should bedeclared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’could also govern trading of securities. SEBI also set up a group in June 1998 under theChairmanship of Prof.J.R.Varma, to recommend measures for risk containment inderivatives market in India. The report, which was submitted in October 1998, worked outthe operational details of margining system, methodology for charging initial margins,broker net worth, deposit requirement and real–time monitoring requirements.The Securities Contract Regulation Act (SCRA) was amended in December 1999 toinclude derivatives within the ambit of ‘securities’ and the regulatory framework wasdeveloped for governing derivatives trading. The act also made it clear that derivativesshall be legal and valid only if such contracts are traded on a recognized stock exchange,thus precluding OTC derivatives. The government also rescinded in March 2000, the three–decade old notification, which prohibited forward trading in securities.Derivatives trading commenced in India in June 2000 after SEBI granted the finalapproval to this effect in May 2001. SEBI permitted the derivative segments of two stockexchanges, NSE and BSE, and their clearing house/corporation to commence trading andsettlement in approved derivatives contracts. To begin with, SEBI approved trading inindex futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This wasfollowed by approval for trading in options based on these two indexes and options onindividual securities.The trading in BSE Sensex options commenced on June 4, 2001 and the trading inoptions on individual securities commenced in July 2001. Futures contracts on individualstocks were launched in November 2001. The derivatives trading on NSE commenced withS&P CNX Nifty Index futures on June 12, 2000. The trading in index options commencedon June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.Single stock futures were launched on November 9, 2001. The index futures and optionscontract on NSE are based on S&P CNXTrading and settlement in derivative contracts is done in accordance with the rules,byelaws, and regulations of the respective exchanges and their clearing house/corporationduly approved by SEBI and notified in the official gazette. Foreign Institutional Investors(FIIs) are permitted to trade in all Exchange traded derivative products.The following are some observations based on the trading statistics provided in the NSE

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report on the futures and options (F&O):• Single-stock futures continue to account for a sizable proportion of the F&Osegment. It constituted 70 per cent of the total turnover during June 2002. Aprimary reason attributed to this phenomenon is that traders are comfortable withsingle-stock futures than equity options, as the former closely resembles theerstwhile badla system.• On relative terms, volumes in the index options segment continues to remain poor.This may be due to the low volatility of the spot index. Typically, options areconsidered more valuable when the volatility of the underlying (in this case, theindex) is high. A related issue is that brokers do not earn high commissions byrecommending index options to their clients, because low volatility leads to higherwaiting time for round-trips.• Put volumes in the index options and equity options segment have increased sinceJanuary 2002. The call-put volumes in index options have decreased from 2.86 inJanuary 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that thetraders are increasingly becoming pessimistic on the market.• Farther month futures contracts are still not actively traded. Trading in equityoptions on most stocks for even the next month was non-existent.• Daily option price variations suggest that traders use the F&O segment as a lessrisky alternative (read substitute) to generate profits from the stock pricemovements. The fact that the option premiums tail intra-day stock prices isevidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day.If calls and puts are not looked as just substitutes for spot trading, the intra-daystock price variations should not have a one-to-one impact on the option premiums.

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Derivatives permitted by SEBI

Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced in June 2003 and exchange traded interest rate futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004. During December 2007 SEBI permitted mini derivative (F&O) contract on Index (Sensex and Nifty). Further, in January 2008, longer tenure Index options contracts and Volatility Index and in April 2008, Bond Index was introduced. In addition to the above, during August 2008, SEBI permitted Exchange traded Currency Derivatives.

A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria:-

o The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis.o The stock’s median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock’s quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.o The market wide position limit in the stock shall not be less than Rs.50 crores.

A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued.

Need for financial derivativesThere are several risks inherent in financial transactions and asset liability positions. Derivatives are risk shifting devices, they shift risk from those ‘who have it but may not want it’ to ‘those who have the appetite and are willing to take it’. The three broad types of price risks are as follows

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Market risk: market risk arises when security prices go up due to reasons affecting the sentiments of the whole market. Market risk is also referred to as ‘systematic risk’ since it can not be diversified away because the stock market as a whole may go up or down from time to time.

Interest rate risk: this risk arises in the case of fixed income securities such as treasury bills, government securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example the market price of fixed income securities could fall if the interest rate shot up.

Exchange rate risk: in case of imports, exports, foreign loans or investments, foreign currency is involved which gives rise to exchange rate risk.

To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have emerged.

Participants in the Derivatives Market:Hedger: Reduces / eliminates his risk.Speculator: Bets on future movements in the price of an asset.Arbitrageur: Takes advantage of a discrepancy between prices in two different markets.

Dealers work for major banks and securities houses. Hedgers consists of corporations,investment institutions, banks and governments that want to reduce exposure to marketvariables such as interest rates, share values, bond prices, currency exchange ratesand commodity prices.

Speculators are those such as hedge funds that want to bet onthe prices of commodities and financial assets and on key market variables such asinterest, indices, and exchange rates. It is usually much cheaper to speculate usingderivatives than on the underlying. As a result, the risks and returns are much greater.

Arbitrageurs exploit mispricing in the market to create risk-free profits. Those that arenot members of a future and options exchange have to employ a broker to fill theirorders.Trading in these markets are regulated by Commodity Futures Trading Commission(CFTC) and International Swaps and Derivatives Association (ISDA) and the NationalFutures Association (NFA).

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. The explosive growth of derivatives in the developed centuries is fuelled by the following.

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The increased volatility in global financial markets. The technological changes enabling cheaper communication and computing power. Breakthrough in modern financial theory, providing economic agents a wider

choice of risk management strategies and instruments that optimally combine the risk and returns over a large number of financial assets.

Political developments wherein the role of government in economic arena has become more of a facilitator and less of a prime mover. Thus the move towards market oriented policies and the deregulation in financial markets has lead to increase in financial risk at the individual participant’s level.

Increased integration of domestic financial markets with international markets.

Hedging

Many of the participants in futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. This risk might relate to the price of oil, a foreign exchange rate, the level of the stock market, or some other variable. A perfect hedge is one that completely eliminates the risk. In practice, perfect hedges are rare. To quote one trader: "The only perfect hedge is in a Japanese garden." For the most part, therefore, a study of hedging using futures contracts is a study of the ways in which hedges can be constructed so that they perform as close to perfect as possible.The hedger simply takes a futures position at the beginning of the life of the hedge and closes out the position at the end of the life of the hedge. In Chapter 14 we will examine dynamic hedging strategies in which the hedge is monitored closely and frequent adjustments are made. Throughout this chapter we will treat futures contracts as forward contracts, that is, we will ignore daily settlement. This means that we can ignore the time value of money in most situations because all cash flows occur at the time the hedge is closed out.

Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the insurer (risk taker) for another type of risk.

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Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

Short hedgeAn investment strategy that is focused on mitigating a risk that has already been taken. The "short" portion of the term refers to the act of shorting a security, usually a derivatives contract, that hedges against potential losses in an investment that is held long (i.e., the risk that was already taken). If a short hedge is executed well, gains from the long position will be offset by losses in the derivatives position, and vise versa.An investment transaction that is intended to provide protection against a decline in the value of an asset. For example, an investor who holds shares of Nextel and expects the stock to decline may enter into a short hedge by purchasing a put option on Nextel stock. If Nextel does subsequently decline, the value of the put option should increase.

Hedging and ShareholdersOne argument sometimes put forward is that the shareholders can, if they wish, do the hedging themselves. They do not need the company to do it for them. This argument is, however, open to question. It assumes that shareholders have as much information about the risks faced by a company as does the company's management. In most instances, this is not the case. The argument also ignores commissions and other transactions costs. These are less expensive per dollar of hedging for large transactions than for small transactions. Hedging is therefore likely to be less expensive when carried out by the company than by individual shareholders. Indeed, the size of futures contracts makes hedging by individual shareholders impossible in many situations. One thing that shareholders can do far more easily than a corporation is diversify risk. A shareholder with a well-diversified portfolio may be immune to many of the risks faced by a corporation. For example, in addition to holding shares in a company that uses copper, a well diversified shareholder may hold shares in a copper producer, so that there is very little overall exposure to the price of copper. If companies are acting in the best interests of well-diversified shareholders, it can be argued that hedging is unnecessary in many situations. However, the extent to which managements are in practice influenced by this type of argument is open to question.

BASIS RISKThe hedges in the examples considered so far have been almost too good to be true. The hedger was able to identify the precise date in the future when an asset would be bought or sold. The hedger was then able to use futures contracts to remove almost all the risk arising from the price of the asset on that date. In practice, hedging is often not quite as straightforward. Some of the reasons are as follows:1. The asset whose price is to be hedged may not be exactly the same as the asset

underlying the futures contract.2. The hedger may be uncertain as to the exact date when the asset will be bought or sold.

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3. The hedge may require the futures contract to be closed out well before its expiration date.These problems give rise to what is termed basis risk. This concept will now be explained.The BasisThe basis in a hedging situation is as follows:Basis — Spot price of asset to be hedged - Futures price of contract usedIf the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures contract. Prior to expiration, the basis may be positive or negative. When the underlying asset is a low-interestrate currency or gold or silver, the futures price is greater than the spot price. This means that the basis is negative. For high-interest-rate currencies and many commodities, the reverse is true, and the basis is positive. When the spot price increases by more than the futures price, the basis increases. This is referred to as a strengthening of the basis. When the futures price increases by more than the spot price, the basis declines. This is referred to as a weakening of the basis

Long hedgers

A situation where an investor has to take a long position in futures contracts in order to hedge against future price volatility. A long hedge is beneficial for a company that knows it has to purchase an asset in the future and wants to lock in the purchase price. A long hedge can also be used to hedge against a short position that has already been taken by the investor.For example, assume it is January and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $1.50 per pound, but the May futures price is $1.40 per pound. In January the aluminum manufacturer would take a long position in 1 May futures contract on copper. This locks in the price the manufacturer will pay.If in May the spot price of copper is $1.45 per pound the manufacturer has benefited from taking the long position, because the hedger is actually paying $0.05/pound of copper compared to the current market price.  However if the price of copper was anywhere below $1.40 per pound the manufacturer would be in a worse position than where they would have been if they did not enter into the futures contract.

ARGUMENTS FOR AND AGAINST HEDGINGThe arguments in favor of hedging are so obvious that they hardly need to be stated. Most companies are in the business of manufacturing or retailing or wholesaling or providing a service. They have no particular skills or expertise in predicting variables such as interest rates, exchange rates, and commodity prices. It makes sense for them to hedge the risks associated with these variables as they arise. The companies can then focus on their main activities—in which presumably they do have particular skills and expertise. By hedging, they avoid unpleasant surprises such as sharp rises in the price of a commodity.

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HEDGE RATIO

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure.

1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.

2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.

1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.

2. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk.

Derivatives traders at the Chicago Board of Trade .

Speculation and arbitrage

Commercial speculation, i.e. speculation by buyers and sellers of commodities, has been used since the 19th century to enable commodity traders and processors to protect themselves against short term price volatility. Buyers are protected against sudden price increases, sellers against sudden price falls. For commodity buyers and sellers, commercial speculation is a form of price insurance. Noncommercial speculation takes place not to protect against or “hedge” price risk, but to benefit by anticipating and “betting long” for prices to go up or “short” for prices to go down. Non-commercial speculators provide capital to enable the ongoing function of the market as commercial speculators liquidate their contract positions by paying for the contracted commodity or selling the contract tooffset the risk of other contract positions held. Non-commercial speculation is an investment, but one that can overlap with the interests of agriculture when appropriately regulated. However, today’s speculation has become excessive relative to the value of the commodity as determined by supply and demand and other fundamental factors. For

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example, according to the FAO, as of April 2008 corn volatility was 30 percent and soybean volatility 40 percent beyond what could be accounted for by market fundamentals. Price volatility has become so extreme that by July some commercial or “traditional” speculators could no longer afford to use the market to hedge risks effectively.Prices are particularly vulnerable to being moved by big speculative “bets” when a commodity’s supply and demand relationship is “tight” due to production failures, high demand and/or lack of supply management mechanisms.

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.

Types of derivatives

DERIVATIVES(On the basis of)

Market mechanism 1) Over the counter 2) Exchange traded

Underlying assets 1) Currency 2) Commodity 3) Equity 4) Interest rate 5) Index

Contract 1) Forward 2) Future 3) Option 4) Swap

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On the basis of Market mechanism

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.

Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options

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bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

On the basis of underlying assets

Currency - Currency derivatives is a contract between the seller and the buyer, whose value is to be derived from the underlying asset, the currency amount. A derivative based on currency exchange rates is a future contract which stipulates the rate at which a given currency can be exchanged for another currency as at a future date

Commodity - Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts

Equity - Equity Derivative on Investopedia - A derivative instrument with underlying assets based on equity securities

Interest rate - An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. These structures are popular for investors with customized cash flow needs or Specific views on the interest rate movements (such as volatility movements or simple directional movements) and are therefore usually traded OTC; see financial engineering.

Index - Index derivatives are a powerful tool for risk management for anyone who has portfolios composed of positions in equity. Using index futures and index options, investors and portfolio managers can hedge themselves against the risk of a downturn in the market when they should so desire.

On the basis of contract

There are four major classes of derivatives:

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Forward - Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive

Future - special forms of forward contracts that are designed to reduce the disadvantages associated with forward agreements. Indeed, they are Forwards whose terms have been standardized to that they can be traded in a public marketplace. Less Flexible, but more liquid

Option - An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless

Swap -: A swap is an agreement made between two parties to exchange payments on regular future dates. Swaps are OTC products and there is a risk for default. Swaps a reused to manage or hedge risk associated with volatile interest rates, currency exchange rates, commodity prices, and share prices. It can be considered a series of forward contracts.

Contractual agreements between 2 parties in which each party agrees to exchange a stream of cash for a stipulated period of time based upon certain agreed-upon parameters and the price Fluctuations in some underlying specified commodity or market index.

ForwardsA forward contract is a particularly simple derivative, a contract between two parties. It is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-counter market—usually between two financial institutions or between a financial institution and one of its clients.One of the parties to a forward 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.Forward contracts on foreign exchange are very popular. Most large banks have a "forwarddesk" within their foreign exchange trading room that is devoted to the trading of forward contracts.Both sides are obligated to complete the deal, however there is a risk one side might default on its obligations.

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These are not traded on exchanges because they are negotiated directly between twoParties.Features of Forward Contracts:

Over the Counter Trading (OTC). No down Payment Settlement at Maturity. Linearity (Loss of a forward buyer is the gain of the forward seller) No Secondary Market Necessity of a third party Delivery.

Forward Rate contracts for commodities.Forward Rate contracts for currency.Forward Rate contracts for Interest Rates.

VALUING FORWARD CONTRACTSThe value of a forward contract at the time it is first entered into is zero. At a later stage it may prove to have a positive or negative value. Using the notation introduced earlier, we suppose Fo is the current forward price for contract that was negotiated some time ago, the delivery date is in T years, and r is the 7-year risk-free interest rate. We also define:

K: Delivery price in the contract/: Value of a long forward contract todayA general result, applicable to all forward contracts (both those on investment assets and those on consumption assets), is

f = (F0- K)e~rT

FuturesA financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures. The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract.

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Types of future

Currency FuturesCurrency futures were first introduced in the international money market in Chicago, USA in the year 1972. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short in the same type of contract to offset your position. This serves to exit your position, much like selling a stock in the equity markets would close a trade.

Currency futures are futures markets where the underlying commodity is a currency exchange rate, such as the Euro to US Dollar exchange rate, or the British Pound to US Dollar exchange rate. Currency futures are essentially the same as all other futures markets (index and commodity futures markets), and are traded in exactly the same way.

Futures based upon currencies are similar to the actual currency markets (often known as Forex), but there are some significant differences. For example, currency futures are traded via exchanges, such as the CME (Chicago Mercantile Exchange), but the currency markets are traded via currency brokers, and are therefore not as controlled as the currency futures. Some day traders prefer the currency markets, and some day traders prefer the currency futures. I recommend the currency futures as they do not suffer from some of the problems that currency markets suffer from, such as currency brokers trading against their clients, and non centralized pricing.

Bond futures - A bond future is a contractual obligation for the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased.

Stock index futures - A futures contract on a stock or financial index. For each index there may be a different multiple for determining the price of the futures contract.

Popular Currency Futures

Many of the most popular futures markets that are based upon currencies are offered by the CME (Chicago Mercantile Exchange), including the following :

EUR - The Euro to US Dollar currency future GBP - The British Pound to US Dollar currency future CHF - The Swiss Franc to US Dollar currency future AUD - The Australian Dollar to US Dollar currency future CAD - The Canadian Dollar to US Dollar currency future RP - The Euro to British Pound currency future RF - The Euro to Swiss Franc currency future

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Futures contracts are now traded very actively all over the world. The two largest futures exchanges in the United States are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). The two largest exchanges in Europe are the London International Financial Futures and Options Exchange and Eurex.

THE SPECIFICATION OF THE FUTURES CONTRACTWhen developing a new contract, the exchange must specify in some detail the exact nature of the agreement between the two parties. In particular, it must specify the asset, the contract size (exactly how much of the asset will be delivered under one contract), where delivery will be made, and when delivery will be made. Sometimes alternatives are specified for the grade of the asset that will be delivered or for the delivery locations. As a general rule, it is the party with the short position (the party that has agreed to sell the asset) that chooses what will happen when alternatives are specified by the exchange. When the party with the short position is ready to deliver, it files a notice of intention to deliver with the exchange. This notice indicates selections it has made with respect to the grade of asset that will be delivered and the delivery location.

The Contract SizeThe contract size specifies the amount of the asset that has to be delivered under one contract. This is an important decision for the exchange. If the contract size is too large, many investors who wish to hedge relatively small exposures or who wish to take relatively small speculative positions will be unable to use the exchange. On the other hand, if the contract size is too small, trading may be expensive as there is a cost associated with each contract traded.

Delivery ArrangementsThe place where delivery will be made must be specified by the exchange. This is particularly important for commodities that involve significant transportation costs.

Delivery MonthsA futures contract is referred to by its delivery month. The exchange must specify the precise period during the month when delivery can be made. For many futures contracts, the delivery period is the whole month. The delivery months vary from contract to contract and are chosen by the exchange to meet the needs of market participants. For example, the main delivery months for currency futures on the Chicago Mercantile Exchange are March, June, September, and December; corn futures traded on the Chicago Board of Trade have delivery months of January, March, May, July, September, November, and December. At any given time, contracts trade for the closest delivery month and a number of subsequent delivery months. The exchange specifies when trading in a particular month's contract will begin. The exchange also specifies the last day on which trading can take place for a given contract. Trading generally ceases a few days before the last day on which delivery can be made.

Daily Price Movement LimitsFor most contracts, daily price movement limits are specified by the exchange. If the price moves down by an amount equal to the daily price limit, the contract is said to be limit down. If it moves up by the limit, it is said to be limit up. A limit move is a move in either

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direction equal to the daily price limit. Normally, trading ceases for the day once the contract is limit up or limit down. However, in some instances the exchange has the authority to step in and change the limits. The purpose of daily price limits is to prevent large price movements from occurring because of speculative excesses. However, limits can become an artificial barrier to trading when the price of the underlying commodity is increasing or decreasing rapidly. Whether price limits are, on balance, good for futures markets is controversial.

Position LimitsPosition limits are the maximum number of contracts that a speculator may hold. The purpose of the limits is to prevent speculators from exercising undue influence on the market.

OptionsOptions are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction.

Call option - Call Options give the option buyer the right to buy the underlying asset.

Long call option –

Components

A long call is simply the purchase of one call option.

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Risk / Reward

Maximum Loss: Limited to the premium paid up front for the option.

Maximum Gain: Unlimited as the market rallies.

Characteristics

When to use: When you are bullish on market direction and also bullish on market volatility.

A long call option is the simplest way to benefit if you believe that the market will make an upward move and is the most common choice among first time investors.

Being long a call option means that you will benefit if the stock/future rallies, however, you risk is limited on the downside if the market makes a correction.

From the above graph you can see that if the stock/future is below the strike price at expiration, your only loss will be the premium paid for the option. Even if the stock goes into liquidation, you will never lose more than the option premium that you paid initially at the trade date.

Not only will your losses be limited on the downside, you will still benefit infinitely if the market stages a strong rally. A long call has unlimited profit potential on the upside.

Short Call

Components

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A short call is simply the sale of one call option. Selling options is also known as "writing" an option.

Risk / Reward

Maximum Loss: Unlimited as the market rises.

Maximum Gain: Limited to the premium received for selling the option.

Characteristics

When to use: When you are bearish on market direction and also bearish on market volatility.

A short is also known as a Naked Call. Naked calls are considered very risky positions because your risk is unlimited.

Long Put

Components

A long put is simply the purchase of one put option.

Risk / Reward

Maximum Loss: Limited to the net premium paid for the option.

Maximum Gain: Unlimited as the market sells off.

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Characteristics

When to use: When you are bearish on market direction and bullish on market volatility.

Like the long call a long put is a nice simple way to take a position on market direction without risking everything. Except with a put option you want the market to decrease in value.

Buying put options is a fantastic way to profit from a down turning market without shorting stock. Even though both methods will make money if the market sells off, buying put options can do this with limited risk.

Short Put

Components

A short put is simply the sale of a put option.

Risk / Reward

Maximum Loss: Unlimited in a falling market.

Maximum Gain: Limited to the premium received for selling the put option.

Characteristics

When to use: When you are bullish on market direction and bearish on market volatility.

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Like the Short Call Option, selling naked puts can be a very risky strategy as your losses are unlimited in a falling market.

Although selling puts carries the potential for unlimited losses on the downside they are a great way to position yourself to buy stock when it becomes "cheap". Selling a put option is another way of saying "I would buy this stock for [strike] price if it were to trade there by [expiration] date."

A short put locks in the purchase price of a stock at the strike price. Plus you will keep any premium received as a result of the trade.

For example, say AAPL is trading at $98.25. You want to buy this stock buy think it could come off a bit in the next couple of weeks. You say to yourself "if AAPL sells off to $90 in two weeks I will buy."

At the time of writing this the $90 November put option (Nov 21) is trading at $2.37. You sell the put option and receive $237 for the trade and have now locked in a purchase price of $90 if AAPL trades that low in the 10 or so days until expiration. Plus you get to keep the $237 no matter what.

Options strategies

An option strategy is implemented by combining one or more option positions and possibly an underlying stock position. Options are financial instruments that give the buyer the right to buy (for a call option) or sell (for a put option) the underlying security at some specific point of time in the future (European Option) or until some specific point of time in the future (American Option) for a price (strike price), which is fixed in advance (when the option is bought).

Calls increase in value as the underlying stock increases in value. Likewise puts increase in value as the underlying stock decreases in value. Buying both a call and a put means that if the underlying stock moves up the call increases in value and likewise if the underlying stock moves down the put increases in value. The combined position can increase in value if the stock moves significantly in either direction. (The position loses money if the stock stays at the same price or within a range of the price when the position was established.) This strategy is called a straddle. It is one of many options strategies that investors can employ.

Options strategies can favor movements in the underlying stock that are bullish, bearish or

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neutral. In the case of neutral strategies, they can be further classified into those that are bullish on volatility and those that are bearish on volatility. The option positions used can be long and/or short positions in calls and/or puts at various strikes.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the time frame in which the rally will occur in order to select the optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to employ for a given nominal amount of exposure. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price does not go down by the option's expiration date. These strategies may provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy.

Bearish strategies

Bearish options strategies are the mirror image of bullish strategies. They are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy.

The most bearish of options trading strategies is the simple put buying strategy utilised by most novice options traders.

Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilise bear spreads to reduce cost. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price does not go up by the options expiration date. These strategies may provide a small upside protection as well.

Straddle

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An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date.Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly, but is unsure as to which direction. The stock price must move significantly if the investor is to make a profit. As shown in the diagram above, should only a small movement in price occur in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to perform. Additionally, on stocks that are expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.

Strangle

Components

Long one OTM CallLong one OTM Put

Long one put option with a lower strike price and long one call option at a higher strike price.

Risk / Reward

Maximum Loss: Limited to the total premium paid for the call and put options.

Maximum Gain: Unlimited as the market moves in either direction

An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is

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profitable only if there are large movements in the price of the underlying asset. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be.The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

Box SpreadThe box spread is a strategy that comes into play in the practice of options trading. The idea behind a box spread is to create a situation in which there is zero risk in regard to the payoff of the actions taken in the strategy. This essentially involves creating a chain of events that results in a no arbitrage assumption. The total of the net premium used in the acquisition process is to be equal to the present value of the payoff on the transaction.

Box spreads make use of a series of puts and calls to obtain the desired result. Within the context of this strategy, the investor may choose to follow a bull spread with a bear spread in order to create the desired balance between premium and payoff. The bull spread may involve a long call option coupled with a short call option that is then followed by a bear spread that involves a long put option and a short put option. This series of transactions, when diagrammed, can easily be demonstrated in the form of a rectangular box, resulting in naming the procedure a box spread.

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Several factors can determine if a box spread is a feasible option for the investor. The condition of arbitrages plays a central role, since the balance of the results is directly impacted. Executing the puts and calls properly will also make a big difference to the success of the strategy. Choosing to short the wrong call, for example, will throw the entire equation out of line, and not result in the balance between the net premium and the present value that was hoped for.

It is possible to create two different variations of the box spread. The long box spread will involve the utilization of four options, generally with the same underlying asset and the same terminal or payoff date. This is different from the short box spread, which will usually involve two options. In both instances, the same basic combination of puts and calls is used.

Butterfly spread

The butterfly spread is an options spread that is geared toward incurring only a limited amount of risk, while having the potential to provide a small amount of profit from the strategy. Essentially, the butterfly spread involves combining a bear spread with a bull spread, and requires following a strict process in order to maximize the chance for making a profit and still manage to limit risk.

The actual process of executing a butterfly spread involves three different strike prices coupled with two lower transactions being part of the bull spread component and two higher transactions arranged in a bear spread. The trades can be arranged in various combinations of puts and calls, depending on the circumstances and the exact configuration that is anticipated to have the best chance of realizing a profit. Most analysts agree that there are four combinations of puts and calls that will result in a butterfly spread.

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One basic requirement of the butterfly spread is to arrange the buying and selling so that they involve a range of markets and several different expiration dates. Two of the options should have a higher strike price. Executing the bull and bear spreads to accomplish the butterfly spread is done with the hope that the underlying stock price will remain stable, as this will result in a modest profit from the premium income that is realized on the combination of the options.

While it is important to note that the butterfly spread is designed to be a relatively safe investment tactic, there is some potential for loss. However, if the procedure is followed closely, and the right combination of securities is utilized in the butterfly spread, the chances for creating a small profit are very good. As an investment strategy for persons who tend to be somewhat conservative with investing, but do want to make some attempt to try something a little different, the butterfly spread is an excellent choice.

REVIEW OF LITERATURE

Derivatives trading in the stock market have been a subject of enthusiasm of research in the field of finance. Derivatives trading have two attributes on the basis of its effectiveness. So there have often been contrary views among the researchers of what may be the impact of derivatives trading. According to the nature of this instrument it is argued that this could enhance the market efficiency by establishing the market. There are many empirical findings for both there roles of derivatives trading. Here some review of literature for both these results are presented.

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Many theories have been developed about the pros and cons of the impact of derivatives trading in the stock market. A common agreement has been found among the studies that the introduction of derivatives products, specially the equity index futures enables traders to transact large volumes at much lower transaction costs relative to the cash market.

A major theoretical argument for the benefit of derivatives trading is that it reduces the volatility of the stock market. The logic is that it reduces the asymmetric information among the investors and information reduces the speculation in the trading system. A variety of theoretical arguments have been advanced over the years to explain why speculative trading in general, or the existence of derivatives markets in particular, might affect the volatility of the underlying asset market.

In recent past, the volatility of stock returns has been a major topic in finance literature. Empirical researchers have tried to find a pattern in stock return movements or factors determining these movements. Generally, volatility is considered as a measurement of risk in the stock market return and a lot of discussions have taken place about the nature of stock return volatility. Therefore, understanding factors that affect stock return volatility is an imperative task in many ways.

A numbers of theoretical and empirical studies have been done on the impact of the introduction of derivatives in the stock markets on the stock return volatility. The studies are concerned with both the developed as well as developing countries. There are two sets of views according to the theoretical as well as empirical findings. One is of the view that introduction of derivatives has increased the volatility and market performance, through forwarding its speculative roles and the other view is that the introduction of derivatives has reduced the volatility in the stock market thus increasing the stability of the stock market.

Peter Carr, Roger Lee worked on “Volatility Derivatives” in 2009. He also surveys the early literature on the subject. Finally he provides relatively simple proofs of some fundamental results related to variance swaps and volatility swaps. Volatility derivatives are a class of derivative securities where the payoff explicitly depends on some measure of the volatility of an underlying asset.

Debdas Rakshit, Chanchal Chatterjee worked on “Accounting for financial derivatives: An overview” in 2008. The present article seeks to provide a brief outlook of the general accounting aspects of derivative trading in India. In the area of modern finance, various new financial instruments have assumed significance in Indian economy. Financial derivatives are most important as well as significant among them. After their introduction in India in June 2000, financial derivatives have gained a significant ground in the Indian stock market. But till date no specific accounting standard has been formulated for accounting as well as disclosure of the results of derivative trading in India.

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Stefan Ankirchner, Peter Imkeller, Goncalo dos Reis worked on “Pricing and hedging of derivatives based on non-tradable underlying” in 2007. This paper is concerned with the study of insurance related derivatives on financial markets that are based on non-tradable underlings, but are correlated with tradable assets. We calculate exponential utility-based indifference prices, and corresponding derivative hedges. In this case the optimal hedge can be represented by the price gradient multiplied with the correlation coefficient. This way we obtain a generalization of the classical 'delta hedge' in complete markets.

The behaviour of volatility in the equity market in India, for the pre and post derivatives period, has been examined using conditional variance for the period of 1999-2003 in (Nath, 2003). He modeled conditional volatility using different method such as GARCH (1,1). He has considered 20 stocks randomly from the Nifty and Junior Nifty basket as well as benchmark indices itself. As result, he observed that for most of the stocks, the volatility came down in the post-derivative trading period. All these methods suggest that the volatility of the market as measured by benchmark indices like S&P CNX Nifty and Nifty Junior have fallen in the post-derivatives period.

The impacts of the introduction of the derivatives contracts such as Nifty futures and options contracts on the underlying spot market volatility have been examined using a model that captures the heteroskedasticity in returns that is recognised as the Generalised Auto Regressive Conditional Heteroskedasticity (GARCH) Model in Shenbagaraman (2003). She used the daily closing prices for the period 5th Oct. 1995 to 31st Dec. 2002 for the CNX Nifty the Nifty Junior and S&P500 returns. Results indicate that derivatives introduction has had no significant impact on spot market volatility but the nature of the GARCH process has changed after the introduction of the futures trading.

Both theoretical and empirical aspect of the question of how the speculation, in general, and derivative securities in particular, effects the underlying asset markets has been explained in Mayhew (2000). The theoretical research has revealed that there are many different aspects of the relationship between cash and derivative markets. Although many models predict that derivatives should have a stabilizing effect, this result normally requires restrictive assumptions. At the end of the day, the theoretical literature gives ambiguous predictions about the effects of derivatives markets.

Price discovery and volatility have been examined in the context of introduction of Nifty futures at the National Stock Exchange (NSE) in June 2000 applying Cointegration and Generalised Auto Regressive Conditional Heteroscedasticity (GARCH) techniques respectively from January1998 to October 2002 in Raju and Karande (2003). Their finding suggests that the introduction of futures has reduced volatility in the cash market.

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The impact of trading in the Dow Jones Industrial Average index futures and futures options on the conditional volatility of component stocks has been examined in Rahman (2001). The conditional volatility of intraday returns for each stock before and after the introduction of derivatives is estimated with the GARCH model. Estimated parameters of conditional volatility in pre-futures and post-futures periods are then compared to determine if the estimated parameters have changed significantly after the introduction of various derivatives. The data for this study consist of transaction prices from the 30 stocks comprising the DJIA. Transaction prices for April through June 1997 (pre-futures period) and April through June 1998 (post-futures period) are used. The results suggest that the introduction of index futures and options on the DJIA has produced no structural changes in the conditional volatility of component stocks. The null hypothesis of no change in conditional volatility from pre futures to post futures periods cannot be rejected.

Gupta (2002) has examined the impact of index futures introduction on stock market volatility. Further, he has also examined the relative volatility of spot market and futures market. He has used daily price data (high, low, open and close) for BSE Sensex and S&P CNX Nifty Index from June 1998 to June 2002. Similar data from June 9, 2000 to March 31, 2002 have also been used for BSE Index Futures and from June 12, 2000 to June 30, 2002 for the Nifty Index Futures. He has used four measures of volatility the first is based upon close-to-close prices, the second is based upon open-to-open prices, the third is Parkinson’s Extreme Value Estimator, and the fourth is Garman-Klass measure volatility (GKV). The empirical results indicate that the over-all volatility of the underlying stock market has declined after the introduction of index futures on both the indices.

The impact of the introduction of index futures on the volatility of stock market in India was examined employing daily data of Sensex and Nifty CNX for period of Jan 1997-March 2003 in Bandivadekar and Ghosh (2005). The return volatility has been modeled using GARCH framework. They found strong relationship between information of introduction of derivatives and return volatility. They have concluded that the introduction of derivatives has reduced the volatility of the stock market. The same study was done by Hetamsaria and Swain (2003). they have examined the impact of the introduction of index futures on the volatility of stock market in India applying regression analysis. They have used Nifty 50 index price data for the period of Jan 1998 - March 2003. They found that the volatility of the Nifty return has declined after the introduction of index futures.

Darrat, Rahman, and Zhong (2002) have examined the impact of the introduction of index futures on the volatility of stock market in India and causal relationship between volume in the futures market and spot market. They have used EGARCH approach and Granger Causality (G C) test. Their finding suggests that index futures trading may not be blamed for the increasing volatility in the spot market. They found that volatility in the spot market has produced volatility in the futures market.

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Board, Sandamann and Sutcliffe (2001), have tested the hypothesis that increases in the futures market trading activity increases spot market price volatility. They used the GARCH model and Schewert Model and found that the result does not support the hypothesis. The data samples are taken from the U K market. Jeanneau and Micu (2003) have explained that information based or speculative transaction also creates a link between volatility and activity in asset and derivatives market. This link depends in part on whether the new information is private or public and on the type of asset traded. In theory, the arrival of new private information should be reflected in a rise in the volatility of return and trading volumes in single equity and equity related futures and options.

The majority of studies have employed the standard ARCH or GARCH model to examine volatility shifting. Mostly the findings are supporting the hypothesis that introduction of derivatives has reduced the market volatility. These studies use daily observations to estimate volatility, whereas interday data are used here. Given that financial markets display high speeds of adjustment, studies based on longer intervals such as daily observations may fail to capture information contained in intraday market movements. Moreover, because of modern communications systems and improved technology, volatility measures based on daily observations ignore critical information concerning intraday price patterns. Andersen (1996) pointed out that the focus of the market microstructure literature is on intraday patterns rather than interday dynamics.

This study is also based on the hypothesis that the introduction of the derivatives products has reduced the risk inefficiency in the BSE stock market. Three derivatives products (index futures, stock futures and index options) have been used that have been introduced in the different time periods. The time period is also for about 8 years including the most recent earning period as 2005-2006. Derivatives turnover also have been used for the same return series.

RATIONAL OF STUDY Derivative reduce the risk, the concept of derivatives comes in the financial market. Derivative securities provide them a valuable set of tools for managing this risk. Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. Derivatives trading in the stock market have been a subject of enthusiasm of research in the field of finance the most desired instruments that allow market participants to manage risk in the modern securities trading are known as derivatives. The derivatives are defined as the future contracts whose value depends upon the underlying assets. In recent past, the volatility of stock returns has been a major topic in finance literature. Generally, volatility is considered as a measurement of risk in the stock market return and a lot of discussions have taken place about the nature of stock return volatility. Therefore, understanding factors that affect stock return volatility is

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an imperative task in many ways. Stock prices and their volatility add to the concern of attention in the stock market, especially in India. This research project describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term. This research is concerned with the study of financial derivatives in Indian capital market and correlation between cash market (underlying asset) and derivative.

RESEARCH METHODOLOGY

Research methodology is a step-by-step process to solve the research problem. For every researcher the research methodology is different as per the problem which the researcher has to solve. Research methodology is carried out for my project under the following sub-headings.

OBJECTIVES:- The introduction of equity index derivative contracts in Indian market has not been very old but today the total notional trading values in derivatives contracts are ahead of cash market. Given such dramatic changes, the objective of this study is to study the behavior of volatility in cash market after the introduction of derivatives contracts. This is to examine with help of some tools and charts whether the which factors influence the price of derivative contract and reduced or increase the risk in the Indian stock market.

1. To study the financial derivatives.2. To study the cash market and financial derivative price. 3. To study the factors which influence the derivatives price?4. To Major risk factor in derivatives.

TOOLS FOR DATA COLLECTION:-

The research based on secondary data which will be collected from NSE (National Stock Exchange) and some other authentic sources. The study will be carried out on the daily closing prices of cash market and derivatives.

STATISTICAL ANALYSIS:-

After tabulating the data correlation, Charts and other statistical tools will be used as per the feasibility.

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BIBLIOGRAPHY

Peter Carr, Roger Lee (November 2009) “Volatility Derivatives” Annual Reviews of journal “Annual Review of Financial Economics” Volume 1, Issue 1, Pages 319-339

Professor Jayanth R. Varma (February 2007) “Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges” Indian Institute of Management, Ahmedabad, 380 015, India.

Stefan Ankirchner, Peter Imkeller, Goncalo dos Reis (December 2007) “Pricing and hedging of derivatives based on non-tradable underlying” Published in Mathematical Finance, Volume 2010, Issue 20, pages 289-312.

Source of secondary data collection

www.nseindia.com

www.myiris.com

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