Derivatives Market in India(1)

7/30/2019 Derivatives Market in India(1)

1/67

PROJECT REPORT

ON

DERIVATIVE SYSTEM

GAUTAM BUDH TECHNICAL UNIVERSITY,LUCKNOW

Submitted for the partial fulfillment of degree ofMaster of Business Administration

Session: 2012-13

FIVE SCHOOL OF BUSINESS COLLEGE

KANPUR

1


2/67

ACKNOWLEDGEMENT

I am short of words to express my thankfulness to the entire distinguished person who,during the course of my project work, gave me their unflinching support to valuableguidance, which helped me to make this endeavors.

I owe by my heart gratitude to my revered guides whose expertise opened a number ofdoors for me and to go through the right one.

I also thank my friends and associates who had to put up with my intense preoccupationand mood swings, especially my colleagues to whom I feel I was particularly mean.

And finally, I thank to our respected Mrs.Joyti mishra, without whom this project

would never have gotten started.

Compiled By

2


3/67

PREFACE

As per the direction of our course structure, we the students of MBA-III SEM have toundergo summer training for the period of 4-6 weeks with the different commercial

enterprises of the country. I have undergone training in LSE. I made a project onderivative system.

This report is a record of the training. The objective of the project is to study thederivative system in india.

3


4/67

INDEX

S. NO PARTICULAR

1 INTRODUCTION TO STOCK MARKET AND STOCK EXCHAGE

2 INTRODUCTION TO LUDHIANA STOCK EXCHANGE

3 HISTORY OF DERIVATIVES

4 INTRODUCTION TO DERIVATIVES

5 ROLE OF DERIVATIVE MARKET

6 SCOPE OF DERIVATIVES

7 ECONOMIC FUNCTION OF DERIVATIVES

8 DERIVATIVES INSTRUMENT

9 PARTICIPANTS IN DERIVATIVES MARKET

10 REGULATORY FRAMEWORK

11 CONCLUSION

12 BIBLIOGRAPHY

13 ANNEXURE

4


5/67

INTRODUCTION TO

STOCK MARKET AND STOCK EXCHANGE

5


6/67

A STOCK MARKET OR EQUITY MARKET is a public (a loose network ofeconomic transactions, not a physical facility or discrete) entity for the trading ofcompany stock(shares) and derivatives at an agreed price; these are securities listed on a

stock exchange as well as those only traded privately.

Stock markets refer to a market place where investors can buy and sell stocks. The priceat which each buying and selling transaction takes is determined by the market forces .

Let us take an example for a better understanding of how market forces determine stockprices. ABC Co. Ltd. enjoys high investor confidence and there is an anticipation of anupward movement in its stock price. More and more people would want to buy this stock(i.e. high demand) and very few people will want to sell this stock at current marketprice (i.e. less supply). Therefore, buyers will have to bid a higher price for this stock to

match the ask price from the seller which will increase the stock price of ABC Co. Ltd.On the contrary, if there are more sellers than buyers (i.e. high supply and low demand)for the stock of ABC Co. Ltd. Inthe market, its price will fall down.

In earlier times, buyers and sellers used to assemble at stock exchanges to make atransaction but now with the dawn of IT, most of the operations are done electronicallyand the stock markets have become almost paperless. Now investors dont have to gatherat the Exchanges, and can trade freely from their home or office over the phone .

TYPES OF STOCK MARKET

There are two types of stock market

1. Primary market - The primary market is the place where the shares are issued for thefirst time. So when a company is getting listed for the first time at the stock exchange andissuing shares this process is undertaken at the primary market. That means the processof the Initial Public Offering or IPO and the debentures are controlled at the primary stockmarket.

2. Secondary market - The secondary market is the stock market where existing stocksare brought and sold by the retail investors through the brokers. It is the secondary marketthat controls the price of the stocks. Generally when we speak about investing or trading at

the stock market we mean trading at the secondary stock market. It is the secondary marketwhere we can invest and trade in the stocks to get the profit from our stock marketinvestment.

6
http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Stock_exchangehttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Stock_exchange


7/67

A STOCK EXCHANGE is an entitythat provides services forstock brokers and tradersto trade stocks, bonds, and othersecurities. Stock exchanges also provide facilities forissue and redemption of securities and other financial instruments, and capital events

including the payment of income and dividends. Securities traded on a stock exchangeincludeshares issued by companies, unit trusts,derivatives, pooled investment productsandbonds.

To be able to trade a security on a certain stock exchange, it must be listed there.Usually, there is a central location at least for record keeping, but trade is increasinglyless linked to such a physical place, as modern markets are electronic networks, whichgives them advantages of increased speed and reduced cost of transactions. Trade on anexchange is by members only.

The initial offering of stocks and bonds to investors is by definition done in theprimary

market and subsequent trading is done in the secondary market. A stock exchange isoften the most important component of a stock market. Supply and demand in stockmarkets is driven by various factors that, as in all free markets, affect the price of stocks .

There is usually no compulsion to issue stock via the stock exchange itself, nor muststock be subsequently traded on the exchange. Such trading is said to be off exchange orover-the-counter. This is the usual way that derivatives and bonds are traded.Increasingly, stock exchanges are part of a global market for securities.

7
http://en.wikipedia.org/wiki/Entityhttp://en.wikipedia.org/wiki/Entityhttp://en.wikipedia.org/wiki/Stock_brokerhttp://en.wikipedia.org/wiki/Trader_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Dividendhttp://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Unit_trusthttp://en.wikipedia.org/wiki/Unit_trusthttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Electronic_networkshttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Primary_markethttp://en.wikipedia.org/wiki/Primary_markethttp://en.wikipedia.org/wiki/Secondary_markethttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Free_markethttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Entityhttp://en.wikipedia.org/wiki/Stock_brokerhttp://en.wikipedia.org/wiki/Trader_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Security_(finance)http://en.wikipedia.org/wiki/Dividendhttp://en.wikipedia.org/wiki/Shareshttp://en.wikipedia.org/wiki/Unit_trusthttp://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Electronic_networkshttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Primary_markethttp://en.wikipedia.org/wiki/Primary_markethttp://en.wikipedia.org/wiki/Secondary_markethttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Free_markethttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Derivative_(finance)http://en.wikipedia.org/wiki/Bond_(finance)


8/67

STOCK EXCHANGE IN INDIA

BOMBAY STOCK EXCHANGE

This stock exchange, Mumbai, popularly known as "BSE" was established in 1875 as "

The Native share and stock brokers association", as a voluntary non-profit makingassociation. It has an evolved over the years into its present status as the premiere stockexchange in the country. It may be noted that the stock exchanges the oldest one in Asia,even older than the Tokyo Stock exchange which was founded in 1878.

The exchange, while providing an efficient and transparent market for trading insecurities, upholds the interests of the investors and ensures redressed of theirgrievances, whether against the companies or its own member brokers. It also strives toeducate and enlighten the investors by making available necessary informative inputsand conducting investor education programmes.

A governing board comprising of 8 elected directors, 3 SEBI nominees, 4 publicrepresentatives and an executive director is the apex body, which decides the policiesand regulates the affairs of the exchange. The Executive director as the chief executiveofficer is responsible for the day today administration of the exchange.

NATIONAL STOCK EXCHANGE

The NSE was incorporated in Nov 1992 with an equity capital of Rs. 25 crs. TheInternational securities consultancy (ISC) of Hong Kong has helped in setting up NSE.ISC has prepared the detailed business plans and installation of hardware and softwaresystems. The promotions for NSE were financial institutions, insurances companies,

banks and SEBI

capital market ltd, Infrastructure leasing and financial services ltd and stock holdingcorporation ltd.

It has been set up to strengthen the move towards professionalization of the capitalmarket as well as provide nation wide securities trading facilities to investors.

NSE is not an exchange in the traditional sense where brokers own and manage theexchange. A two tier administrative set up involving a company board and a governingaboard of the exchange is envisaged.

NSE is a national market for shares PSU bonds, debentures and government securitiessince infrastructure and trading facilities are provided.

8


9/67

9


10/67

HISORY OF

LUDHIANA STOCK EXCAHNGE

10


11/67

LUDHIANA STOCK EXCHANGE

The Ludhiana Stock Exchange Limited was established in 1981, by Sh. S.P. Oswal ofVardhman Group and Sh. B.M. Lal Munjal of Hero Group, leading industrial luminaries,to fulfill a vital need of having a Stock Exchange in the region of Punjab, Himachal

Pradesh, Jammu & Kashmir and Union Territory of Chandigarh. Since its inception, theStock Exchange has grown phenomenally. The Stock Exchange has played an importantrole in channelizing savings into capital for the various industrial and commercial unitsof the State of Punjab and other parts of the country. The Exchange has facilitated themobilization of funds by entrepreneurs from the public and thereby contributed in theoverall, economic, industrial and social development of the States under its jurisdiction.

Ludhiana Stock Exchange is one of the leading Regional Stock Exchange and has beenin the forefront of other Stock Exchange in every spheres, whether it is formation ofsubsidiary for providing the platform of trading to investors, for brokers etc. in the era ofScreen based trading introduced by National Stock Exchange and Bombay Stock

Exchange, entering into the field of Commodities trading or imparting education to thePublic at large by way of starting Certification Programmes in Capital Market.

The vision and mission of Stock Exchange is:

"Reaching small investors by providing services relating to Capital Market includingTrading, Depository Operations etc and creating Mass Awareness by way of educationand trading in the field of capital market .

To create educated investors and fulfilling the gap of skilled work force in the domain inCapital Market ."

Further, the Exchange has 295 members out of which 162 are registered withNational Stock Exchange as Sub-brokers and 121 with Bombay Stock Exchange as sub-brokers through our subsidiary.

GOVERNANCE AND MANAGEMENT

LSE has a strong governance and administration, which encompasses a right balance ofIndustry Experts with highest level educational background, practicing professionals andindependent experts in various fields of Financial Sector. The administration is presentlyheaded by Sr. General Manager CUM Company Secretary and team of persons havingindepth knowledge of Secretarial, Legal and Education & Training.

The Governing Board of our Exchange comprises of eleven members, out of which twoare Public Interest Directors, who are eminent persons in the fields of Finance andAccounts, Education, Law, Capital Markets and other related fields, Six are ShareholderDirectors, and Three are Broker Member Director and the Exchange has four StatutoryCommittees namely Disciplinary Committee, Arbitration Committee, DefaultsCommittee and Investor Services Committee. In addition, it has advisory and standingcommittees to assist the administration.LSE has a Code of Conduct in place that governs the elected Board Members and the

11


12/67

Senior Management Team. The same is monitored through periodic disclosureprocedures. The Exchange has an Ethics Committee, which looks into any issue ofconflict of interest and has in place general code of conduct for the Senior Officials.

The composition of the Governing Board is as under:-

Sr. No. Name of Director Category

1 Prof. Padam Parkash KansalChairman(Shareholder Director)

2 Sh. Joginder KumarVice Chairman(Shareholder Director)

3 Sh. Rajinder Mohan Singla Shareholder Director

4 Sh. Satish Nagpal Shareholder Director

5 Sh. Vikas Batra Shareholder Director

6 Sh. Varun Chhabra Shareholder Director

7 Dr. Raj SinghRegistrar of Companies (PublicInterest Director)

8 Sh. Ashwani Kumar Public Interest Director

9 Sh. V.P. Gaur Public Interest Director

10 Sh. Jaspal Singh Trading member Director

11 Sh. Sunil Gupta Trading Member Director

12 Sh. Sanjay Anand Trading member Director

STRENTHS OF LUDHIANA STOCK EXCHANGE

LSE brand is popular among masses. The brand image of LSE can be

capitalized.

Requisite infrastructure for the Capital Market activities which includes a multi-

storied, centrally air conditioned building situated in the financial hub of the cityi.e. Feroze Gandhi Market.

Well experienced staff handling operations of Stock Exchange.

Competent Board and professional management.

Much needed networking of sub brokers in the entire region, who are having rich

experience in Stock Market operations for the last 25 years.

More than 40,000 clients spread across Punjab, Himachal Pradesh, Jammu &

Kashmir and adjoining areas of Haryana and Rajasthan. The turnover of our subsidiary is the highest amongst all subsidiaries of Regional

Stock Exchanges in India.

LISTING OF COMPANIES AT LUDHIANA STOCK EXCHANGE

At present, Ludhiana Stock Exchange has 330 listed companies, out of which 214 areregional and 116 are Non-regional. The total listed capital of aforesaid companies is Rs.3168.91 Crores app. The market capitalization of the said companies is more than Rs.

12


13/67

3372.34 crores. The Stock Exchange is covering the vast investor base through thelisting of above said companies, which are situated in the region comprising of Punjab,Himachal Pradesh, Jammu & Kashmir, and Chandigarh. Despite the fact, theimplementation of SEBI (Delisting of Securities) guidelines, 2003 has resulted into theDelisting of good companies listed at Exchange, however still there are leading

Companies listed with our Exchange, notable among them are United BreweriesLimited, Vardhman Acrylics Limited, SMC global securities limited, HimachalFuturistic Communications Limited etc. Ludhiana Stock Exchange has facilitated thecapital generation for agro based industries as Punjab is a agricultural led economy. Itwill continue to do so, once it gets approval for a tie up with bigger Exchanges forcommencing trading operations.

INVESTORS RELATED SERVICES

The Exchange has been providing a variety of services for the benefit of investingpublic. The services include Investor Service Centers, Investor Protection fund and

Investor Educational Seminars.

(i).Investor Service CentersThe Exchange has set-up Investor Service Centers at various DP branches of itssubsidiary for providing information relating to Capital Market to the general public. TheCenters subscribe to leading economic, financial dailies and periodicals. They also storethe Annual Reports of the companies listed at the Stock Exchange. The Investor ServiceCenters are also equipped with a Terminal for providing live rates of trading at NSEand BSE. A large number of the investors visit the centers to utilize the services beingprovided by the Exchange.

(ii).Investor Awareness SeminarsThe Exchange has been organizing Investor Awareness Seminars for the benefit ofInvestors of the region comprising State of Punjab, Himachal Pradesh, Jammu &Kashmir, Chandigarh and adjoining areas of Haryana and Rajasthan. This massiveexercise of organizing Investor Awareness Seminars has been launched as a part ofSecurities Market Awareness Campaign launched by SEBI in January, 2003. TheExchange apprises the investors about Dos and Donts to be observed while dealing inSecurities Market. Till date, Exchange has organized more than 200 workshops in theregion mentioned above.

(iii).Website of the Exchange:

www.lse.co.in The Exchange has its own website with the domain name www.lse.co.in.The website provides valuable information about the latest market commentary, researchreports about companies, daily status of International markets, a separate module forInternet trading, information about listed companies and brokers and sub-brokers of theExchange and its subsidiary. The website also contains many useful links on portfoliomanagement, investor education, frequently asked questions about various topics relatingto Primary and Secondary Market, information about Mutual Funds, Financials of theCompany including Quarterly Results, Share Prices, Profit and Loss Accounts, Balance

13


14/67

Sheet and Many More. The website also contains daily Technical Charts of variousscrips being traded in BSE and NSE.

14


15/67

HISTORY

OF DERIVATIVES

15


16/67

The history of derivatives is surprisingly longer than what most people think. Some textseven find the existence of the characteristics of derivative contracts in incidents ofMahabharata. Traces of derivative contracts can even be found in incidents that dateback to the ages before Jesus Christ.

However, the advent of modern day derivative contracts is attributed to the need forfarmers to protect themselves from any decline in the price of their crops due to delayedmonsoon, or overproduction.

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japanaround 1650. These were evidently standardized contracts, which made them much liketoday's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, wasestablished in 1848 where forward contracts on various commodities were standardizedaround 1865. From then on, futures contracts have remained more or less in the same

form, as we know them today.

Derivatives have had a long presence in India. The commodity derivative market hasbeen functioning in India since the nineteenth century with organized trading in cottonthrough the establishment of Cotton Trade Association in 1875. Since then contracts onvarious other commodities have been introduced as well.

Exchange traded financial derivatives were introduced in India in June 2000 at the twomajor stock exchanges, NSE and BSE. There are various contracts currently traded onthese exchanges.

The National Stock Exchange of India Limited (NSE) commenced trading in derivativeswith the launch of index futures on June 12, 2000. The futures contracts are based on thepopular benchmark S&P CNX Nifty Index.

The Exchange introduced trading in Index Options (also based on Nifty) on June 4,2001. NSE also became the first exchange to launch trading in options on individualsecurities from July 2, 2001. Futures on individual securities were introduced onNovember 9, 2001.

Futures and Options on individual securities are available on 230 securities stipulated bySEBI.

With the opening of the economy to multinationals and the adoption of the liberalizedeconomic policies, the economy is driven more towards the free market economy. Thecomplex nature of financial structuring itself involves the utilization of multi currencytransactions. It exposes the clients, particularly corporate clients to various risks such asexchange rate risk, interest rate risk, economic risk and political risk.

16


17/67

With the integration of the financial markets and free mobility of capital, risks alsomultiplied. For instance, when countries adopt floating exchange rates, they have to facerisks due to fluctuations in the exchange rates. Deregulation of interest rate cause interestrisks. Again, securitization has brought with it the risk of default or counter party risk.Apart from it, every assetwhether commodity or metal or share or currencyis

subject to depreciation in its value . It may be due to certain inherent factors and externalfactors like the market condition, Governments policy, economic and political conditionprevailing in the country and so on.

In the present state of the economy, there is an imperative need of the corporate clients toprotect there operating profits by shifting some of the uncontrollable financial risks tothose who are able to bear and manage them. Thus, risk management becomes a must forsurvival since there is a high volatility in the present financial markets

In this context, derivatives occupy an important place as risk reducing machinery.Derivatives are useful to reduce many of the risks discussed above. In fact, the financial

service companies can play a very dynamic role in dealing with such risks. They canensure that the above risks are hedged by using derivatives like forwards, future, options,swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to thefinancial service companies. This really protects the clients from unforeseen risks andhelps them to get there due operating profits or to keep the project well within the budgetcosts. To hedge the various risks that one faces in the financial market today, derivativesare absolutely essential.

17


18/67

INTRODUCTION

TO DERIVATVES

18


19/67

Derivatives are defined as financial instruments whose value derived from the prices ofone or more other assets such as equity securities, fixed-income securities, foreigncurrencies, or commodities.

Derivatives are also a kind of contract between two counterparties to exchange paymentslinked to the prices of underlying assets.

Derivative can also be defined as a financial instrument that does not constituteownership, but a promise to convey ownership.

Examples are options and futures. The simplest example is a call option on a stock. Inthe case of a call option, the risk is that the person who writes the call (sells it andassumes the risk) may not be in business to live up to their promise when the timecomes. In standardized options sold through the Options Clearing House, there are

supposed to be sufficient safeguards for the small investor against this.

Derivatives are compared to insurance. Just as you pay an insurance company a premiumin order to obtain some protection against a specific event, there are derivative productsthat have a payoff contingent upon the occurrence of some event for which you must paya premium in advance.

Example

Suppose you have a home of Rs. 50, 00,000. You insure this house for premium of Rs15000 (It is a very risky house!) Now you think about policy (ignoring the house) as an

investment.

Suppose the house is fine after 1 year. You have lost the premium of Rs 15000.

Suppose your house is fully damaged and broken in one year . You receive Rs50,00,0000 on just paying premium of Rs 15,000.If you have bought insurance of anysort you have bought an option. Option is one type of a derivative.

Derivatives are usually broadly categorized by:

the relationship between the underlying asset and the derivative (e.g., forward, option,);

the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives,interest rate derivatives, commodity derivatives orcredit derivatives);

the market in which they trade (e.g., exchange-traded orover-the-counter); and

their pay-off profile.

19
http://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Option_(finance)http://en.wikipedia.org/wiki/Equity_derivativehttp://en.wikipedia.org/wiki/Foreign_exchange_derivativehttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Credit_derivativeshttp://en.wikipedia.org/wiki/Over-the-counter_(finance)http://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Option_(finance)http://en.wikipedia.org/wiki/Equity_derivativehttp://en.wikipedia.org/wiki/Foreign_exchange_derivativehttp://en.wikipedia.org/wiki/Interest_rate_derivativehttp://en.wikipedia.org/wiki/Credit_derivativeshttp://en.wikipedia.org/wiki/Over-the-counter_(finance)


20/67

ROLE

OF DERIVATIVES:

20


21/67

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 theprice may fall before he can sell the asset. He can protect himself by selling a futurescontract, or by buying a Put option. If the spot price falls, the short hedgers will gain inthe futures market,. This will help offset their losses in the spot market. Similarly, if thespot price falls below the exercise price, the put option can always be exercised.

Derivatives markets help to reallocate risk among investors. A person who wants toreduce risk, can transfer some of that risk to a person who wants to take more risk.Consider a risk- averse individual. He can obviously reduce risk by hedging. When he

does so, the opposite position in the market may be taken by a speculator who wishes totake more risk. Since people can alter their risk exposure using futures and options,derivatives markets help in the raising of capital. As an investor, you can always investin an asset and then change its risk to a level that is more acceptable to you by usingderivatives.

2. PRICE DISCOVERY

Price discovery refers to the markets ability to determine true equilibrium prices. Futuresprices are believed to contain information about future spot prices and help indisseminating such information. As we have seen, futures markets provide a low cost

trading mechanism. Thus information pertaining to supply and demand easily percolatesinto such markets. Accurate prices are essential for ensuring the correct allocation ofresources in a free market economy. Options markets provide information about thevolatility 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 spotmarkets, because herein you can take large positions by depositing relatively smallmargins. Consequently, a large position in derivatives markets is relatively easier to takeand has less of a price impact as opposed to a transaction of the same magnitude in thespot market. Finally, it is easier to take a short position in derivatives markets than it is tosell short in spot markets.

21


22/67

SCOPE OF

DERIVATIVES IN INDIA

22


23/67


24/67

ECONOMIC FUNCTION

OF THE DERIVATIVE MARKET

24


25/67

In spite of the fear and criticism with which the derivative markets are commonly lookedat, these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participantsabout the future and lead the prices of underlying to the perceived future level. The

prices of derivatives converge with the prices of the underlying at the expiration of thederivative contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may notlike them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets.With the introduction of derivatives, the underlying market witnesses higher tradevolumes because of participation by more players who would not otherwise participatefor lack of an arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In theabsence of an organized derivatives market, speculators trade in the underlying cashmarkets. Margining, monitoring and surveillance of the activities of various participantsbecome extremely difficult in these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as acatalyst for new entrepreneurial activity. The derivatives have a history of attractingmany bright, creative, well-educated people with an entrepreneurial attitude. They oftenenergize others to create new businesses, new products and new employmentopportunities, the benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of activity.

Derivative securities have penetrated the Indian stock market and it emerged thatinvestors are using these securities for different purposes, namely, risk management,profit enhancement, speculation and arbitrage. High net worth individuals andproprietary traders account for a large proportion of broker turnover. Interestingly, someretail participation was also witnessed despite the fact that these securities are consideredlargely beyond the reach of retail investors (because of complexity and relatively highinitial investment). Based on the survey results, the authors identified some important

policy issues such as the need to bring in more institutional participation to make thederivative market in India more efficient and to bring it in line with the best practices.Further, there is a need to popularize option instruments because they may prove to be auseful medium for enhancing retail participation in the derivative market.

25


26/67

DERIVATIVES

INSTRUMENTS

26


27/67

A) Forward Contract

There are no sure things in global markets. Deals that looked good six months ago canquickly turn sour if unforeseen economic and political developments trigger fluctuationsin exchange rates or commodity prices

Over the years traders have developed tools to cope with these uncertainties. One of thistool is the forward agreements

A contract that commits one party to buy and other to sell a given quantity of an assetfor fixed price on specified future date.

In Forward Contracts one of the parties assumes a long position and agrees to buy theunderlying asset at a certain future date for a certain price. The specified price is calledthe delivery price. The contract terms like delivery price, quantity are mutually agreedupon by the parties to contract. No margins are generally payable by any of the parties to

the other.

Features of Forward Contract

1. It is negotiated contract between two parties i.e. Forward contract being a bilateralcontracts, hence exposed to counterparty risk.

2. Each Contract is custom designed and hence unique in terms of contract size,expiration date, asset quality, asset type etc.

3. Contract has to be settled in delivery or cash on expiration date

4. In case one of two parties wishes to reverse a contract, he has to compulsorily go tothe other party. The counter party being in a monopoly situation can command at theprice he wants.

Example

A Ltd requires $500000 on May 2006 for repayment of loan installment andinterest .As on December 2005 it appears to the company that the dollar may becomedearer as compared to the exchange rate, prevailing on that date say.

Accordingly A Ltd may enter into forward contract with banker for $500000.TheForward rate may be higher or lower than spot rate prevailing on the date of the forwardcontract. Let us assume forward rate as on December 2005 was 1$=Rs 44 as against spotrate of Rs 43.50. As on future i.e. May 2006 the banker will pay A Ltd $500000 at Rs 44irrespective of the spot rate as on that date.

27


28/67

B) FUTURES

A Future contract is an agreement between two parties to buy or sell an asset at a certaintime in future at a certain price. Future contracts are special type of forward contracts inthe sense that the former are standardized exchange-traded contracts.

A future contract is one in which one party agrees to buy from/ sell to the other party aspecified asset at price agreed at the time of contract and payable on future date. Theagreed price is known as strike price. The underlying asset can be commodity, currencydebt, or equity. The Futures are usually performed by payment of difference betweenstrike price and market price on fixed future date and not by the physical delivery andpayment in full on that date.

Features of Future Contract

The common features of futures are:

1) Futures are exchange-traded derivatives.

2) Futures are highly standardized.

3) The underlying asset The particular asset as well as the quantity are specified in thefutures contract.

4) The currency - The currency in which the contract is to be executed is also specified.

5) Settlement - The delivery month and the last trading date are also mentioned in the

contract.

6) Futures are used for hedging, particularly in a bear market. Those who have aninterest in the underlying asset can protect themselves from the risk of price changes viafutures contracts.

7) Futures have lower transaction costs than other debt instruments.

28
http://www.economywatch.com/options-and-futures/futures.htmlhttp://www.economywatch.com/options-and-futures/futures.htmlhttp://www.economywatch.com/options-and-futures/futures.htmlhttp://www.economywatch.com/options-and-futures/futures.html


29/67

MARGINS

Participants in a futures contract are required to deposit margins in order to open andmaintain a futures position. Futures margin requirements are set by the exchanges and

are typically only 2 to 10 percent of the full value of the futures contract. Margins arefinancial guarantees required of both buyers and sellers of futures contracts to ensure thatthey fulfill their futures contract obligations.

Initial Margin

Before a futures position can be opened, there must be enough available balance in thefutures trader's margin account to meet the initial margin requirement. Upon opening thefutures position, an amount equal to the initial margin requirement will be deducted fromthe trader's margin account and transferred to the exchange's clearing firm. This moneyis held by the exchange clearinghouse as long as the futures position remains open.

Maintenance Margin

The maintenance margin is the minimum amount a futures trader is required to maintainin his margin account in order to hold a futures position. The maintenance margin levelis usually slightly below the initial margin. If the balance in the futures trader's marginaccount falls below the maintenance margin level, he or she will receive a margin call totop up his margin account so as to meet the initial margin requirement.

Variation margin

If a margin call is made additional money is deposited by the investor/trader, to bring theaccount to level of initial margin. This amount is called variation margin.

Example

Let's assume we have a speculator who has Rs10000 in his trading account. He decidesto buy September RIL at Rs 40 per share. Each RIL futures contract represents 1000shares and requires an initial margin of Rs 9000 and has a maintenance margin level setat 6500. Since his account is 10000, which is more than the initial margin requirement,he can therefore open up one September RIL futures position. One day later, the price ofSeptember RIL drops to Rs38 per share. Our speculator has suffered an open position

loss of Rs2000 (Rs2 x 1000 barrels) and thus his account balance drops to Rs8000.Although his balance is now lower than the initial margin requirement, he did not get themargin call as it is still above the maintenance level of Rs6500.

29


30/67

MARKING TO MARKET

Once a future contract is bought/sold and a contract is issued, its value with respect tomarket price of futures fluctuates on a daily basis. his render the owner liable to adversechanges in value, and create a credit risk to exchange. To minimize this risk, theexchange demands that contract owner pay what is known as margin.

At the end of every trading day , the contract is marked to its closing market price of thefuture contract. If the closing price of future contract is not given , one can use theclosing price of the underlying for this purpose. If the trader is on winning side of a deal,his contract is increases in value that day, and exchange become liable to a trader and hismargin account is credited with differential amount. On the other hand, if he is on losingside, he may face a margin call from the exchange/broker , depending on the fall in

margin account balance and in this case he is liable to exchange for difference. In thisway each account is credited or debited accordingly to the settlement price on a dailybasis. This is known as marking to market.

30


31/67

Settlement Mechanism

Daily Mark-to-Market Settlement

The position in the futures contracts for each member is marked-to-market to the dailysettlement price of the futures contracts at the end of each trade day.

The profits/ losses are computed as the difference between the trade price or the previousday's settlement price, as the case may be, and the current day's settlement price. TheCMs who have suffered a loss are required to pay the mark-to-market loss amount toNSCCL which is passed on to the members who have made a profit. This is known asdaily mark-to-market settlement.

CMs are responsible to collect and settle the daily mark to market profits / lossesincurred by the TMs and their clients clearing and settling through them. The pay-in andpay-out of the mark-to-market settlement is on T+1 days (T = Trade day). The mark tomarket losses or profits are directly debited or credited to the CMs clearing bankaccount.

Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM to the finalsettlement price and the resulting profit / loss is settled in cash.

The final settlement of the futures contracts is similar to the daily settlement processexcept for the method of computation of final settlement price. The final settlementprofit / loss is computed as the difference between trade price or the previous day'ssettlement price, as the case may be, and the final settlement price of the relevant futurescontract.

Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearingbank account on T+1 day (T= expiry day).

Open positions in futures contracts cease to exist after their expiration day of futurescontracts on index and individual securities

31
http://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/settlement_price.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htm


32/67

PAY OFF OF FUTURES

A Pay off is the likely profit/loss that would accrue to a market participant with changesin the price of the underlying asset. Futures contracts have linear payoffs. In simplewords, it means that the losses as well as profits, for the buyer and the seller of futurescontracts, are unlimited.

Pay off for Buyer of futures: (Long futures)

The pay offs for a person who buys a futures contract is similar to the pay off for aperson who holds an asset. He has potentially unlimited upside as well as downside.Take the case of a speculator who buys a two-month Nifty index futures contract when

the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. Whenthe index moves up, the long futures position starts making profits and when the indexmoves down it starts making losses

Pay off for seller of futures: (short futures)

The pay offs for a person who sells a futures contract is similar to the pay off for aperson who shorts an asset. He has potentially unlimited upside as well as downside.Take the case of a speculator who sells a two-month Nifty index futures contract whenthe Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. Whenthe index moves down, the short futures position starts making profits and when the

index moves up it starts making losses.

Example

On 1st September Mr. A enters into Futures contract to purchase 100 equity shares of XLtd at an agreed price of Rs 100 in December. If on maturity date the price of equitystock rises to Rs120 Mr. A will receive Rs 20 per share and if the price of share falls toRs 90 Mr. A will pay Rs 10 per share. As compared to forward contract the futures aresettled only by the difference between the strike price and market price as on maturitydate.

32


33/67

DISTICTION BETWEEN FORWARD AND FUTURE :

The basic nature of a forward and future, in a strict legal sense, is the same, with thedifference that futures are market-driven organized transactions. As they are exchange-traded, the counterparty in a futures transaction is the exchange. On the other hand, aforward is mostly an over-the-counter transaction and the counterparty is the contractingparty. To maintain the stability of organized markets, market-based futures transactionsare subject to margin requirements, not applicable to OTC forwards. Futures markets arenormally marked to market on a settlement day, which could even be daily, whereasforward contracts are settled only at the end of the contract. So the element of credit riskis far higher in case of forward contract.

33


34/67

C) OPTIONS

Option As the name implies, trading in options involves choice Someone who invest in

option is purchasing right but not the obligation, to buy or sell a specified underlyingitem at an agreed upon price, known as exercise price or strike price.

In other words

Options are contracts that give the buyers the right (but not the obligation) to buy or sella specified quantity of certain underlying assets at a specified price on or before aspecified date. On the other hand, the seller is under obligation to perform the contract(buy or sell). The underlying asset can be a share, index, interest rate, bond, rupee-dollarexchange rate, sugar, crude oil, Soya bean, cotton, coffee etc.

An option contract is a unilateral agreement in which one party, the option writer, isobligated to perform under the contract if the option holder exercises his or her option.(The option holder pays a fee or "premium" to the writer for this option.) The optionholder, however, is not under any obligation and will require performance only when theexercise price is favorable relative to current market prices. If, on the one hand, pricesmove unfavorably to the option holder, the holder loses only the premium. If, on theother hand, prices move favorably for the option holder, the holder has theoreticallyunlimited gain at the expense of the option writer . In an option contract the exerciseprice (strike price), delivery date (maturity date or expiry), and quantity and quality ofthe commodity are fixed.

34


35/67

THERE ARE TWO BASIC TYPES OF OPTIONS

1. CALL OPTION

2. PUT OPTION

1. CALL OPTION

The option that gives the buyer the right to buy is called a call option.

A call option grants the holders of the contract the right, but not the obligation, topurchase a good from the writer of the option in consideration for the payment of cash

(the option premium).

Example: Suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd(HLL) at a strike price of Rs250 per share. This option gives you the right to buy 2,000shares of HLL at Rs250 per share on or before March 28, 2006. The seller of this calloption who has given you the right to buy from him is under the obligation to sell 2,000shares of HLL at Rs250 per share on or before specified date say March 28, 2004whenever asked.

2. PUT OPTION

The option that gives the buyer the right to sell is called a put option.

A put option grants the holder the right, but not the obligation, to sell the underlyinggood to the option writer.

Suppose you bought a put option of 2,000 shares of HLL at a strike price of Rs250 pershare. This option gives its buyer the right to sell 2,000 shares of HLL at Rs250 per shareon or before specified date say March 28, 2006. The seller of this put option who hasgiven you the right to sell to him is under obligation to buy 2,000 shares of HLL atRs250 per share on or before March 28, 2006 whenever asked.

35


36/67

OPTION PREMIUM

The option premium, paid by the option holder to the writer, is the price of the option.This option premium consists of two components: Intrinsic value and Time value, i.e.option premium = Intrinsic value + Time value.

Intrinsic value of an option is that part of option premium which represents the extent towhich the option is In The Money. The intrinsic value is determined by the differencebetween the current trading price and the strike price. Only in-the-money options haveintrinsic value. Intrinsic value can be computed for in-the-money options by taking thedifference between the strike price and the current trading price. Out-of-the-moneyoptions have no intrinsic value. The balance i.e. premium intrinsic value is the timevalue of the option.

An option's time value is dependent upon the length of time remaining to exercise theoption, the moneynessof the option, as well as the volatility of the underlying security'smarket price. The time value of an option decreases as its expiration date approaches andbecomes worthless after that date. This phenomenon is known as time decay. As such,options are also wasting assets. For in-the-money options, time value can be calculatedby subtracting the intrinsic value from the option price. Time value decreases as theoption goes deeper into the money. For out-of-the-money options, since there is zerointrinsic value, time value = option price.

Consider ACC one month call option with a strike price of 920 and ACC put option with

a strike price of 1000. Calculation of intrinsic and time value will be as follow

ACC 920 Call Stock price ACC 1000 Put Stock price

Premium =40 S=950 S=920 S=900 Premium =35 S=987 S=1000 S=1050

Status S>XITM

S=XATM

S


37/67

OPTIONS CLASSIFICATIONS

Options are often classified as

In the money - These result in a positive cash flow towards the investor.

At the money - These result in a zero-cash flow to the investor.

Out of money - These result in a negative cash flow for the investor.

The following summarizes the relationship between an options strike price X and themarket price S of underlying asset.

Market scenario Call Option Put Option

S>X In the money Out of the money

SX

ITM

S=X

ATM

S


38/67

For both Call & Put : Only ITM options gives positive payoff; Only ITM Optionsare exercised

SETTLEMENT PROCEDURE

Settlement of options contracts on index and individual securities

Daily Premium Settlement

Buyer of an option is obligated to pay the premium towards the options purchased byhim. Similarly, the seller of an option is entitled to receive the premium for the optionssold by him. The same person may sell some contracts and buy some contracts as well.The premium payable and the premium receivable are netted to compute the netpremium payable or receivable for each client for each options contract at the time ofsettlement.

The CMs who have a premium payable position are required to pay the premium amountto NSCCL which is in turn passed on to the members who have a premium receivableposition. This is known as daily premium settlement.

CMs are responsible to collect and settle for the premium amounts from the TMs andtheir clients clearing and settling through them.

The pay-in and pay-out of the premium settlement is on T+1 day (T = Trade day). Thepremium payable amount and premium receivable amount are directly debited orcredited to the CMs clearing bank account.

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike pricesexisting at the close of trading hours, on the expiration day of an option contract. Longpositions at in-the money strike prices are automatically assigned to short positions inoption contracts with the same series, on a random basis.

For index options contracts and options contracts on individual securities, exercise styleis European style. Final Exercise is Automatic on expiry of the option contracts.

Option contracts, which have been exercised, shall be assigned and allocated to Clearing

Members at the client level.

Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of therelevant Clearing Members with the respective Clearing Bank.

Final settlement loss/ profit amount for option contracts on Index is debited/ credited tothe relevant CMs clearing bank account on T+1 day (T = expiry day).

38
http://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htmhttp://nseindia.com/products/content/derivatives/equities/clearing_bank.htm


39/67

Final settlement loss/ profit amount for option contracts on Individual Securities isdebited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiryday).

Open positions, in option contracts, cease to exist after their expiration day.

The pay-in / pay-out of funds for a CM on a day is the net amount across settlements andall TMs/ clients, in F&O Segment.

39


40/67

PAY OFF IN OPTIONS

CALL OPTIONS (PAY OFF)

A brought 1 Lot of HUL that is 1000, with the strike price for 250 paid 2.9 Premium PerShare.

Settlement Price is 263.5

Buyers Pay OFF:

Spot price 263.5

Strike price 250.00

Amount 13.5

Premium Paid (-) 2.9

Net Profit 10.6*1000=10600

Buyer Profit = Rs 10600(Net Amount)

Because it is positive it is IN THE MONEY contract,

SELLERS PAY OFF:

It is in the money for the buyer, so it is out of the money for seller , hence his loss is also

increases.

Strike price 263.5

Spot price 250.00

Amount -13.5

40


41/67

Premium Received 2.9

Loss -10.6*1000=-10600

Seller loss = Rs -10600(Loss)

Because it is negative it is out of the money, hence seller will get more loss,

Illustration 2:

An investor buys one European Call option on one share of Reliance Petroleum at apremium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the contractmatures on 30 September . The payoffs for the investor on the basis of fluctuating spotprices at any time are shown by the payoff table (Table 1). It may be clear form thegraph that even in the worst case scenario, the investor would only lose a maximum ofRs.2 per share which he/she had paid for the premium. The upside to it has an unlimited

profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse ofthe call options buyer. The maximum loss that he can have is unlimited though a profitof Rs.2 per share would be made on the premium payment by the buyer.

S Xt c Payoff Net Profit

57 60 2 0 -2

58 60 2 0 -2

59 60 2 0 -2

60 60 2 0 -2

61 60 2 1 -1

62 60 2 2 0

63 60 2 3 1

64 60 2 4 2

65 60 2 5 3

66 60 2 6 4

A European call option gives the following payoff to the investor: max (S - Xt, 0).The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).

Notes:

S - Stock Price

41


42/67

Xt - Exercise Price at time 't'

C - European Call Option Premium

Payoff - Max (S - Xt, O )

GRAPH

42


43/67

PUT OPTION (PAY OFF)

B purchased a 1 lot of HUL that is 1000, with strike price for Rs 250, the premiumpayable is 20.25

spot market price enclosed at 268.4

BUYERS PAY OFF:

Strike Price 250

Spot price 268.4

Net Pay Off -18.4*1000=-18400

Already Premium paid is 20.25 per share

So, he get loss up to Rs 18400

Because it is negative, out of the money contract, hence buyer gets more loss.

SELLERS PAY OFF:

As seller is entitled only for premium so, if he is in profit and also seller has to get totalprofit .

Spot Price 268.5

Strike Price 250.0

Net Pay off 18.4*1000=18400

Already Premium Received 20.25

43


44/67

So, he can get profit up to Rs 18400

Because it is positive, in the money Contract, hence seller gets more profit.

Illustration 2:

An investor buys one European Put Option on one share of Reliance Petroleum at apremium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matureson 30 September. The payoff table shows the fluctuations of net profit with a change inthe spot price.

Payoff from Put Buying/Long (Rs.)

S Xt p Payoff Net Profit

55 60 2 5 3

56 60 2 4 2

57 60 2 3 1

58 60 2 2 0

59 60 2 1 -1

60 60 2 0 -2

61 60 2 0 -2

62 60 2 0 -2

63 60 2 0 -2

64 60 2 0 -2

The payoff for the put buyer is :max (Xt - S, 0)The payoff for a put writer is : -max(Xt - S, 0) or min(S - Xt, 0)

GRAPH

44


45/67

SUMMARY OF OPTIONS

Call option buyer Call option writer (seller)

Pays premium

Right to exercise and buy the share

Profits from rising prices

Limited losses, potentially unlimited

gain

Receives premium

Obligation to sell shares if exercised

Profits from falling prices or remaining

neutral

Potentially unlimited losses, limited gain

Put option buyer Put option writer (seller)

Pays premium Right to exercise and sell shares

Profits from falling prices

Limited losses, potentially unlimited

gain

Receives premium Obligation to buy shares if exercised

Profits from rising prices or remaining

neutral

Potentially unlimited losses, limited gain

45


46/67

DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES

1) Both the parties are obligated to perform.

2) With futures premium is paid by either party.

3) The parties to futures contracts must perform atthe settlement date only. They are not obligated toperform before that date.

OPTIONS

1) Only the seller (writer) is obligated to perform.

2) With options, the buyer pays the seller a premium.

3) The buyer of an options contract can exercise anytime prior to expiration date.

46


47/67

4) The holder of the contract is exposed to theentire spectrum of downside risk and had thepotential for all upside return.

5) In futures margins to be paid. They areapproximate 15-20% on the current stock price.

4) The buyer limits the downside risk to the optionpremium but retain the upside potential.

5) In options premiums to be paid. But they are veryless as compared to the margins.

CONTRACT SPEEIFICATIONS

Parameter Index Futures Index Options Futures onIndividual

Securities

Options onIndividual

Securities

Underlying 5 indices 5 indices 230 securities 230 securities

SecurityDescriptor:Instrument

FUTIDX OPTIDX FUTSTK OPTSTK

47
http://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htm


48/67

UnderlyingSymbol

Symbol ofUnderlying Index

Symbol ofUnderlying Index

Symbol ofUnderlyingSecurity

Symbol ofUnderlying Security

Expiry Date DD-MMM-YYYY DD-MMM-YYYY DD-MMM-YYYY

DD-MMM-YYYY

Option Type - CE / PE - CE / PE

Strike Price - Strike Price - Strike Price

Trading Cycle 3 month trading cycle - the near month (one), the next month (two) and the far month(three)

Expiry Day Last Thursday of the expiry month. If the last Thursday is a trading holiday, then theexpiry day is the previous trading day.

Strike PriceIntervals

- Depending onunderlying price

- Depending onunderlying price

Permitted LotSize

Underlying specific Underlying specific Underlyingspecific

Underlying specific

Price Steps Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05

Price Bands Operating range of 10% of the baseprice

A contract specificprice range based onits delta value iscomputed andupdated on a dailybasis

Operating rangeof 20% of thebase price

A contract specificprice range basedon its delta value iscomputed andupdated on a dailybasis

48
http://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/sandp_cnx_nifty.htm?name=strikehttp://nseindia.com/products/content/derivatives/equities/sandp_cnx_nifty.htm?name=strikehttp://nseindia.com/products/content/derivatives/equities/individual_securities.htm?name=strikehttp://nseindia.com/products/content/derivatives/equities/individual_securities.htm?name=strikehttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/fo_underlying_home.htmhttp://nseindia.com/products/content/derivatives/equities/sandp_cnx_nifty.htm?name=strikehttp://nseindia.com/products/content/derivatives/equities/sandp_cnx_nifty.htm?name=strikehttp://nseindia.com/products/content/derivatives/equities/individual_securities.htm?name=strikehttp://nseindia.com/products/content/derivatives/equities/individual_securities.htm?name=strikehttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/content/fo/fo_mktlots.csvhttp://nseindia.com/content/fo/fo_mktlots.csv


49/67

BUSINESS GROWTH IN FO SEGMENT

Year

Index Futures Stock Futures Index Options Stock Options Total

Average

Daily

Turnover

( cr.)No. of

contracts

Turnover

( cr.)

No. of

contracts

Turnover

( cr.)

No. of

contracts

Notional

Turnover

( cr.)

No. of

contracts

Notional

Turnover

( cr.)

No. of

contracts

Turnover

( cr.)

2011-12

48883256 1274890.73 56657526 1496766.68 293007790 8193453.97 11701581 323075.82 410250153 11288187.08 121378.36

2010-11

165023653 4356754.53 186041459 5495756.70 650638557 18365365.76 32508393 1030344.21 1034212062 29248221.09 115150.48

2009-10

178306889 3934388.67 145591240 5195246.64 341379523 8027964.20 14016270 506065.18 679293922 17663664.57 72392.07

2008-09

210428103 3570111.40 221577980 3479642.12 212088444 3731501.84 13295970 229226.81 657390497 11010482.20 45310.63

2007-08

156598579 3820667.27 203587952 7548563.23 55366038 1362110.88 9460631 359136.55 425013200 13090477.75 52153.30

2006-07

81487424 2539574 104955401 3830967 25157438 791906 5283310 193795 216883573 7356242 29543

2005-06

58537886 1513755 80905493 2791697 12935116 338469 5240776 180253 157619271 4824174 19220

2004-05

21635449 772147 47043066 1484056 3293558 121943 5045112 168836 77017185 2546982 10107

2003-04

17191668 554446 32368842 1305939 1732414 52816 5583071 217207 56886776 2130610 8388

2002-03

2126763 43952 10676843 286533 442241 9246 3523062 100131 16768909 439862 1752

2001-02

1025588 21483 1957856 51515 175900 3765 1037529 25163 4196873 101926 410

2000-01

90580 2365 - - - - - - 90580 2365 11

1


50/67

PARTICIPANTS IN

THE DERIVATIVES MARKET

2


51/67

The participants in the derivatives market are as follows:

TRADING PARTICIPANTS:

1. HEDGERS

The process of managing the risk or risk management is called as hedging. Hedgers arethose individuals or firms who manage their risk with the help of derivative products.Hedging does not mean maximizing of return. The main purpose for hedging is to reducethe volatility of a portfolio by reducing the risk.

2. SPECULATORS

Speculators do not have any position on which they enter into futures and options Market

i.e., they take the positions in the futures market without having position in theunderlying cash market. They only have a particular view about future price of acommodity, shares, stock index, interest rates or currency. They consider various factorslike demand and supply, market positions, open interests, economic fundamentals,international events, etc. to make predictions. They take risk in turn from high returns.Speculators are essential in all markets commodities, equity, interest rates andcurrency. They help in providing the market the much desired volume and liquidity.

3. ARBITRAGEURS

Arbitrage is the simultaneous purchase and sale of the same underlying in two different

markets in an attempt to make profit from price discrepancies between the two markets.Arbitrage involves activity on several different instruments or assets simultaneously totake advantage of price distortions judged to be only temporary.

Arbitrage occupies a prominent position in the futures world. It is the mechanism thatkeeps prices of futures contracts aligned properly with prices of underlying assets. Theobjective is simply to make profits without risk, but the complexity of arbitrage activityis such that it is reserved to particularly well-informed and experienced professionaltraders, equipped with powerful calculating and data processing tools. Arbitrage may notbe as easy and costless as presumed.

INTERMEDIARY PARTICIPANTS:

4. BROKERS

For any purchase and sale, brokers perform an important function of bringing buyers andsellers together. As a member in any futures exchanges, may be any commodity or

3


52/67


53/67

7. BANK FOR FUND MOVEMENTS

Futures and options contracts are daily settled for which large fund movement frommembers to clearing house and back is necessary. This can be smoothly handled if abank works in association with a clearing house. Bank can make daily accounting entries

in the accounts of members and facilitate daily settlement a routine affair. This alsoreduces a possibility of any fraud or misappropriation of fund by any marketintermediary.

8. REGULATORY FRAMEWORK

A regulator creates confidence in the market besides providing Level playing field to allconcerned, for foreign exchange and money market, RBI is the regulatory authority so itcan take initiative in starting futures and options trade in currency and interest rates. Forcapital market, SEBI is playing a lead role, along with physical market in stocks, it willalso regulate the stock index futures to be started very soon in India. The approach and

outlook of regulator directly affects the strength and volume in the market. Forcommodities, Forward Market Commission is working for settling up national NationalCommodity Exchange.

5


54/67

REGULATORY FRAMEWORK

OF DERIVATIVES MARKET IN INDIA

6


55/67

With the amendment in the definition of 'securities' under SC(R)A (to include derivativecontracts in the definition of securities), derivatives trading takes place under the

provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities andExchange Board of India Act, 1992.

SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and itsClearing Corporation/House. The eligibility conditions have been framed to ensure thatDerivative Exchange/Segment & Clearing Corporation/House provide a transparenttrading environment, safety & integrity and provide facilities for redressal of investorgrievances. Some of the important eligibility conditions are-

o Derivative trading to take place through an on-line screen based Trading System.

o The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor

positions, prices, and volumes on a real time basis so as to deter market manipulation.o The Derivatives Exchange/ Segment should have arrangements for dissemination of

information about trades, quantities and quotes on a real time basis through atleast twoinformation vending networks, which are easily accessible to investors across thecountry.

o The Derivatives Exchange/Segment should have arbitration and investor grievances

redressal mechanism operative from all the four areas / regions of the country.o The Derivatives Exchange/Segment should have satisfactory system of monitoring

investor complaints and preventing irregularities in trading.o The Derivative Segment of the Exchange would have a separate Investor Protection

Fund.

o The Clearing Corporation/House shall perform full novation, i.e., the ClearingCorporation/House shall interpose itself between both legs of every trade, becoming thelegal counterparty to both or alternatively should provide an unconditional guarantee forsettlement of all trades.

7


56/67

o The Clearing Corporation/House shall have the capacity to monitor the overall position

of Members across both derivatives market and the underlying securities market forthose Members who are participating in both.

o The level of initial margin on Index Futures Contracts shall be related to the risk of loss

on the position. The concept of value-at-risk shall be used in calculating required level of

initial margins. The initial margins should be large enough to cover the one-day loss thatcan be encountered on the position on 99% of the days.

o The Clearing Corporation/House shall establish facilities for electronic funds transfer

(EFT) for swift movement of margin payments.o In the event of a Member defaulting in meeting its liabilities, the Clearing

Corporation/House shall transfer client positions and assets to another solvent Memberor close-out all open positions.

o The Clearing Corporation/House should have capabilities to segregate initial margins

deposited by Clearing Members for trades on their own account and on account of hisclient. The Clearing Corporation/House shall hold the clients margin money in trust forthe client purposes only and should not allow its diversion for any other purpose.

o The Clearing Corporation/House shall have a separate Trade Guarantee Fund for thetrades executed on Derivative Exchange / Segment.

Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE andthe F&O Segment of NSE.

Membership categories in the derivatives market

The various types of membership in the derivatives market are as follows:

o Trading Member (TM) A TM is a member of the derivatives exchange and can trade

on his own behalf and on behalf of his clients.o Clearing Member (CM) These members are permitted to settle their own trades as well

as the trades of the other non-clearing members known as Trading Members who haveagreed to settle the trades through them.

o Self-clearing Member (SCM) A SCM are those clearing members who can clear and

settle their own trades only.

Requirements to be a member of the derivatives exchange/ clearing corporation

o Balance Sheet Net worth Requirements: SEBI has prescribed a net worth requirement of

Rs. 3 crores for clearing members. The clearing members are required to furnish an

auditor's certificate for the net worth every 6 months to the exchange. The net worthrequirement is Rs. 1 crore for a self-clearing member. SEBI has not specified any networth requirement for a trading member.

o Liquid Net worth Requirements: Every clearing member (both clearing members and

self-clearing members) has to maintain at least Rs. 50 lakhs as Liquid Net worth with theexchange / clearing corporation.

8


57/67

o Certification requirements: The Members are required to pass the certification

programme approved by SEBI. Further, every trading member is required to appoint atleast two approved users who have passed the certification programme . Only theapproved users are permitted to operate the derivatives trading terminal.

Requirements for a Member with regard to the conduct of his business

The derivatives member is required to adhere to the code of conduct specified under theSEBI Broker Sub-Broker regulations. The following conditions stipulations have beenlaid by SEBI on the regulation of sales practices:

o Sales Personnel: The derivatives exchange recognizes the persons recommended by the

Trading Member and only such persons are authorized to act as sales personnel of theTM. These persons who represent the TM are known as Authorized Persons.

o Know-your-client: The member is required to get the Know-your-client form filled by

every one of client.

o Risk disclosure document: The derivatives member must educate his client on the risksof derivatives by providing a copy of the Risk disclosure document to the client.

o Member-client agreement: The Member is also required to enter into the Member-client

agreement with all his clients.

Lot size of a contract

Lot size refers to number of underlying securities in one contract. The lot size isdetermined keeping in mind the minimum contract size requirement at the time of

introduction of derivative contracts on a particular underlying.

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contractsize is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 =200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

9


58/67

CONCLUSION

10


59/67

Derivative securities markets play an important role by allowing investors who do notwant the risks associated with holding an asset to transfer it to those who do. However,

because they are markets for risk as opposed to physical assets, derivatives markets canbe very dangerous places for unsophisticated investors. People who reduce their risk byentering a derivative market are called hedgers, and those who increase their risk arecalled speculators.

The derivative securities markets play a vital role in the modern financial systems, andwithout them many common business transactions would be rendered much riskier orpractically impossible.

11


60/67

BIBLOGRAPHY

12


61/67

1.www.mbaknol.com/business-finance

2. www.nseindia.com

3. www.sebi.gov.in/

4. www.bseindia.com/

5. www.derivativesindia.com

6. www.theoptionsguide.com

7. www.lse.co.in

8. www.niftyoptionstrader.com

13
http://www.mbaknol.com/business-financehttp://www.mbaknol.com/business-financehttp://www.sebi.gov.in/http://www.derivativesindia.com/http://www.lse.co.in/http://www.mbaknol.com/business-financehttp://www.sebi.gov.in/http://www.derivativesindia.com/http://www.lse.co.in/


62/67

ANNEXURE

14


63/67

Glossary

Bears

Those who believe stock prices will decline. A bear market is one in which prices trenddownward.

Bid

The bid is the highest price a buyer will pay for a security; the offer is the lowest priceat which a security is offered by sellers.

Bulls

Those who believe the market will rise. A bull market is rising.

Exercise Price

The exercise price is the price at which a call's (put's) buyer can buy (or sell) theunderlying instrument

Spot price

The price in the cash market for delivery using the standard market convention

Strike Price

The price at which the holder of a derivative contract exercises his right if it is economicto do so at the appropriate point in time as delineated in the financial product's contract.

Primary Markets

The primary exchange on which a listed stock trades .

Derivative Security

15


64/67

A financial security whose value is determined in part from the value and characteristicsof another security, the underlying security .

Exercise

To implement the right under which the holder of an option is entitled to buy (in thecase of a call) or sell (in the case of a put) the underlying security.

Exercise Settlement Amount

The difference between the exercise price of the option and the exercise settlement valueof the index on the day an exercise notice is tendered, multiplied by the index multiplier.

Expiration Cycle

An expiration cycle relates to the dates on which options on a particular underlying

security expire. A given option, other than LEAPS, will be assigned to one of threecycles, the January cycle, the February cycle or the March cycle. At any point in time,an option will have contracts with four expiration dates outstanding, the two near-termmonths and two further-term months.

Expiration Date

The day in which an option contract becomes void . All holders of options must indicatetheir desire to exercise, if they wish to do so, by this date.

Expiration Time

The time of day by which all exercise notices must be received on the expiration date.

Hedge

A conservative strategy used to limit investment loss by effecting a transaction whichoffsets an existing position.

Holder

The purchaser of an option .

Clearing Member

Clearing Member means a Member of the Clearing Corporation.

Contract Month

16


65/67

Contract month means the month in which a contract is required to be finally settled.

Derivatives Contract

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

Expiration Day

The day on which the final settlement obligation are determined in a DerivativesContract .Futures Contract

Means a firm contractual agreement to buy or sell the underlying security in the future.

Last Trading Day

Means the day up to and on which a Derivatives Contract is available for trading.

Long Position

Long Position in a Derivatives contract means outstanding purchase obligations inrespect of a permitted derivatives contract at any point of time.

Open Position

Open position means the sum of long and short positions of the Member and his

constituent in any or all of the Derivatives Contracts outstanding with the ClearingCorporation.

Open Interest

Open Interest means the total number of Derivatives Contracts of an underlying securitythat have not yet been offset and closed by an opposite Derivatives transaction norfulfilled by delivery of the cash or underlying security or option exercise. For calculationof Open Interest only one side (either the long or the short) of the Derivatives Contract iscounted.

Options Contract

Options Contract is a type of Derivatives Contract, which gives the buyer/holder of thecontract the right (but not the obligation) to buy/sell the underlying security at apredetermined price within or at end of a specified period. The option contract that givesa right to buy is called a Call Option and the option contract that gives a right to sell is

17


66/67

called a Put Option.

Option Holder

Option Holder means a Trading Member who is the buyer of the Options Contracts.

Option Writer

Option Writer means a Trading Member who is the seller of the Options Contracts.

Outstanding Obligation

Means the obligation which has neither been closed out nor been settled.

Market Lot

Means the number of units that can be bought or sold in a specified derivatives contractand it is also termed as Contract Multiplier.

Settlement Date

Means the date on which the settlements of outstanding obligations in a permittedDerivatives contract are required to be settled.

Short Position

Short position in a derivatives contract means outstanding sell obligations in respect of apermitted derivatives contract at any point of time.

Trading cycle

Trading cycle means the period during which the derivatives contract will be availablefor trading.

Trading Member

Trading Member is a member of Derivative Exchange.

Underlying Securities

18


67/67

Means a security with reference to which a derivatives contract is permitted to be tradedon the Futures & Options segment of the Exchange from time to time

Contract Month

It is the month in which the contract will expire.

Volume

Number of contracts traded during a specific period of time - During a day, during aweek or during a month.

Documents

Derivatives Market in India(1)