Project - Abhi - Derivatives

8/6/2019 Project - Abhi - Derivatives

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Derivative in stock market

DERIVATIVE IN STOCK MARKET

At

India

Submitted in partial fulfillment of the requirements for the award of

The degree of

Master of Business Administration

Submitted to:

Punjab Technical University

Jalandhar

By:

Abhishek Kumar Srivastava

Regd No-9212400078

Under the guidance of

Dr. V.B. Padmanabhan

Ph.D (B&F),AICWA,CAIIB,AMFI,LL.B,,B.Sc.

#70, 2nd Main Road, 3rd Cross, Kanaka Nagar, Nagawara,

BANGALORE 560 032

International Institute Of Business Studies Page 1


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2009 - 11

DECLARATION

I hereby declared that this project titled derivative in stock market , is submitted to thePunjab Technical University as a partial requirement for the award of Degree of Master ofBusiness Administration, during the year 2010-2011.

It is the record of an original & independent study carried out by me, under the total guidanceand supervision ofDr.V.B Padmnabhan.This project report has not been submitted earlier byme or by anybody else for the award of any other degree in any University in India or abroad.

Date: Signature of the Student

Place: (Abhishek kumar srivastava)



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CERTIFICATE

This is to certify that Mr. Abhishek kumar srivastav of International Institute of BusinessStudies, Bangalore, has completed the Project titled Derivative in stock market under theguidance ofDr.V B Padmanabhan during the year 2010-2011.

During the stay in our organization, Mr. A bhishek kumar srivastava was very useful to our

organization, with her Managerial knowledge & has successfully completed the dissertation. Wewish him best of luck in all future endeavors.

For __________________Ltd,

(Name & Designation of the Signatory)

(Acknowledgement by the Student on Plain Paper)



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ACKNOWLEDGEMENT

I would like to express my sincere thanks to the Director & Management of InternationalInstitute of Business Studies, Bangalore, for their valuable guidance & support. I am extremely

thankful & grateful to Dr.V.B Padmnabhan for his constant guidance & encouragementthroughout the study.

I would also like to express my devoted thanks to my beloved parents & my friends for theirrelentless support & assistance to make this project a reality. Last but not the least; I would liketo thank all my respondents for their co-operation & participation in data collection, which hasenabled me to complete the project successfully.

Date: Signature of the Student

Place: (Abhishek kumar srivastava)



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EXECUTIVE SUMMARY

Firstly I am briefing the current Indian market and comparing it with it past. Derivatives tradingin the stock market have been a subject of enthusiasm of research in the field of finance the mostdesired instruments that allow market participants to manage risk in the modern securitiestrading are known as derivatives.The derivatives are defined as the future contracts whose value depends upon the underlyingassets. If derivatives are introduced in the stock market, the underlying asset may be anything ascomponent of stock market like, stock prices or market indices, interest rates, etc.The main logic behind derivatives trading is that derivatives reduce the risk by providing anadditional channel to invest with lower trading cost and it facilitates the investors to extend theirsettlement through the future contracts. It provides extra liquidity in the stockmarket. Derivatives are assets, which derive their values from an underlying asset. These

underlying assets are of various categories like Commodities including grains, coffee beans, etc. Precious metals like gold and silver. Foreign exchange rate.Bonds of different types, including medium to long-term negotiable debtsecurities issued by governments, companies, etc. Short-term debt securities such as T-bills. Over-The-Counter (OTC) money market products such as loans or deposits. EquitiesFor example, a dollar forward is a derivative contract, which gives the buyer a right & anobligation to buy dollars at some future date. The prices of the derivatives are driven by the spot

prices of these underlying assets. However, the most important use of derivatives is intransferring market risk, called Hedging, which is a protection against losses resulting fromunforeseen price or volatility changes. Thus, derivatives are a very important tool of riskmanagement.There are various derivative products traded. They are;1. Forwards2. Futures3. Options4. Swaps

AForward Contract is a transaction in which the buyer and the seller agree upon a delivery of

a specific quality and quantity of asset usually a commodity at a specified future date. The pricemay be agreed on in advance or in future.

A Future contract is a firm contractual agreement between a buyer and seller for a specified ason a fixed date in future. The contract price will vary according to the market place but it is fixedwhen the trade is made. The contract also has a standard specification so both parties knowexactly what is being done.



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An Options contract confers the right but not the obligation to buy (call option) or sell (putoption) a specified underlying instrument or asset at a specified price the Strike or Exercisedprice up until or an specified future date the Expiry date. The Price is called Premium and ispaid by buyer of the option to the seller or writer of the option.

A call option gives the holder the right to buy an underlying asset by a certain date for a certainprice. The seller is under an obligation to fulfill the contract and is paid a price of this, which iscalled "the call option premium or call option price".

A put option, on the other hand gives the holder the right to sell an underlying asset by a certaindate for a certain price. The buyer is under an obligation to fulfill the contract and is paid a pricefor this, which is called "the put option premium or put option price".

Swaps are transactions which obligates the two parties to the contract to exchange a series ofcash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)

payments, based on some notional principle amount is called as a SWAP. In case of swap, onlythe payment flows are exchanged and not the principle amount I had conducted this research tofind out whether investing in the derivative market is beneficial or not? You will be glad to knowthat derivative market in India is the most booming now days.

So the person who is ready to take risk and want to gain more should invest in the derivativemarket. On the other hand RBI has to play an important role in derivative market. Also SEBImust encourage investment in derivative market so that the investors get the benefit out of it.Sorry to say that today even educated persons are not willing to invest in derivative marketbecause they have the fear of high risk.

So, SEBI should take necessary steps for improvement in Derivative Market so that moreinvestors can invest in Derivative market. I am also giving brief data about foreign market.Then at the last I am giving my suggestions and recommendations. With over 25 million

shareholders, India has the third largest investor base in the world after USA and Japan. Over7500 companies are listed on the Indian stock exchanges (more than the number of companieslisted in developed markets of Japan, UK, Germany, France, Australia, Switzerland, Canada andHong Kong.).

The Indian capital market is significant in terms of the degree of development, volume oftrading, transparency and its tremendous growth potential. Indias market capitalization was thehighest among the emerging markets. Total market capitalization of The Bombay StockExchange (BSE), which, as on July 31, 1997, was US$ 175 billion has grown by 37.5% percentevery twelve months and was over US$ 834 billion as of January, 2007. Bombay StockExchanges (BSE), one of the oldest in the world, accounts for the largest number of listedcompanies transacting their shares on a nationwide online trading system.



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TABLE

CHAPTERS CONTENTS PAGE NOS.

1.

INTRODUCTION 8-29

2.

OBJECTIVE OF STUDY 30-31

3. R

ESEARCH METHODOLOGY 32-34

4.

REVIEW OF LITERATURE 35-36

5.

HISTORY OF THE DERIVATIVES 37-68

6. ANALYSIS & INTERPRETATION OF

DATA 69-77

7. SUMMARY OF FINDINGS, CONCLUSIONS

& RECOMMENDATIONS 78-82

8.

BIBLIOGRAPHY83



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Chapter -1

introduction

Introduction

What are derivatives



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Derivatives are financial instruments whose price is determined by some underlying variables.Derivatives can be traded directly between the two parties as well as through exchanges. Thereare different types of derivatives based on the type of assets that it deals in such as commodity,equity, bond, interest rate, index and so on. Mainly there are four types of derivatives that are

traded

Future, Forward, Options and Swaps. In case of stock market derivative trading essentiallymeans trading in future contracts and options. In derivative trading, stocks are bought in the formof contracts and in a lot.

The biggest advantage of derivative trading is that you can buy huge amount of stock by payingonly a part of the total value of the stock. As in derivative trading you have to buy the stocks in alot the price of the lot is relatively lower than the total amount stock you get. So, this means youhave a chance of making profit even by investing a comparatively less money.

Derivative trading also lets you short sell the stocks. That means you can sell the stocks evenbefore you actually own them. This is beneficial when you have an idea that the price of aparticular stock is going to reduce. In derivative trading you can first sell the stock at a higherprice and then buy the equal number of stocks when the price has gone down. In that way youcan make profit in derivative trading even if the price is going down.

There are newer derivatives that are becoming popular like weather derivatives and naturalcalamity derivatives. These are used as a hedge against any untoward happenings because ofnatural causes. In derivative trading the brokerage is relatively lower than the cash segment. Ifyou consider the number of stock that you purchase in the form of future contracts then you willfind that you have to pay less brokerage compared to the cash segment.

A derivative is not a stand-alone asset, since it has no value of its own. However, more commontypes of derivatives have been traded on marketsbefore their expiration date as if they wereassets. Among the oldest of these are rice futures, which have been traded on theDojima RiceExchange since the eighteenth century.

The emergence of the market for derivative products, most notably forwards, futures andoptions, can be traced back to the willingness of risk-averse economic agents to guardthemselves against uncertainties arising out of fluctuations in asset prices. By their very nature,the financial markets are marked by a very high degree of volatility. Through the use ofderivative products, it is possible to partially or fully transfer price risks by locking-in asset

prices. As instruments of risk management, these generally do not influence the fluctuations inthe underlying asset prices. However, by locking-in asset prices, derivative products minimizethe impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

The following factors have been driving the growth of financial derivatives: Increased volatilityin asset prices in financial markets, Increased integration of national financial markets with theinternational markets, Marked improvement in communication facilities and sharp decline in

http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Markethttp://en.wikipedia.org/wiki/Markethttp://en.wikipedia.org/wiki/Dojima_Rice_Exchangehttp://en.wikipedia.org/wiki/Dojima_Rice_Exchangehttp://en.wikipedia.org/wiki/Dojima_Rice_Exchangehttp://en.wikipedia.org/wiki/Markethttp://en.wikipedia.org/wiki/Dojima_Rice_Exchangehttp://en.wikipedia.org/wiki/Dojima_Rice_Exchangehttp://en.wikipedia.org/wiki/Asset


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their costs, Development of more sophisticated risk management tools, providing economicagents a wider choice of risk management strategies, and Innovations in the derivatives markets,which optimally combine the risks and returns over a large number of financial assets, leading tohigher returns, reduced risk as well as trans-actions costs as compared to individual financialassets.

The most common types of derivatives that ordinary investors are likely to come across arefutures, options, warrants and convertible bonds. Beyond this, the derivatives range is onlylimited by the imagination of investment banks. It is likely that any person who has fundsinvested an insurance policy or a pension fund that they are investing in, and exposed to,derivatives-wittingly or unwittingly.


Contracts agreement


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UNDERSTANDING DERIVATIVES

The primary objectives of any investor are to maximize returns and minimize risks. Derivativesare contracts that originated from the need to minimize risk. The word derivative' originatesfrom mathematics and refers to a variable, which has been derived from another variable.Derivatives are so called because they have no value of their own. They derive their value fromthe value of some other asset, which is known as the underlying. For example, a derivative of the


CASH

FORWARD

DERIVATIVES

OTHERS LIKE SWAPS,

FRAs etc.

MERCHANDISIN

g, CUSTOMIZED

FUTURES

(Standardized) OPTIONS

NTSD TSD


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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 theunderlying 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 dateof commencement of the contract. The value of the contract depends on the expiry period andalso on the price of the underlying asset.

For example, a farmer fears that the price of soybean (underlying), when his crop is ready fordelivery 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 theselling 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 (expiryperiod). In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the valueof this derivative contract will increase as the price of soybean decreases and vice-a-versa. If theselling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be morevaluable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomeseven more valuable.

This is because the farmer can sell the soybean he has produced at Rs .9000 per tone eventhough the market price is much less. Thus, the value of the derivative is dependent on the valueof 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 commodityderivative. If the underlying is a financial asset like debt instruments, currency, share priceindex, equity shares, etc, the derivative is known as a financial derivative. Derivative contractscan be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customized as per the needs of the user by negotiating with theother party involved.Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example ofthe farmer above, if he thinks that the total production from his land will be around 150 quintals,he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals ofsoybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities

exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standardcontract on soybean.

The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50quintals of soybean uncovered for price fluctuations. However, exchange traded derivatives havesome advantages like low transaction costs and no risk of default by the other party, which mayexceed the cost associated with leaving a part of the productionuncovered.



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TYPES OF DERIVATIVES:-

The most commonly used derivatives contracts are forwards, futures and options which we shalldiscuss in detail later. Here we take a brief look at various derivatives contracts that have cometo be used.

FORWARD CONTRACTS;-

A forward contract is a customized contract between two entities, where settlement takes placeon a specific date in the future at todays pre-agreed price a forward contract is an agreement tobuy or sell an asset on a specified date for a specified price. One of the parties to the contract


types

forword future option swaps


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BASIC FEATURES OF FUTURE CONTRACT

1. Standardization :

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

The underlying. This can be anything from a barrel of sweet crude oil to aShort term interest rate.The type of settlement, either cash settlement or physical settlement.The amountand units of the underlying asset per contract. This can be the notional amount of

bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of thedeposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted.The gradeof the deliverable. In case of bonds, this specifies which bonds

can be delivered. In case of physical commodities, this specifies not onlythe quality of the underlying goods but also the manner and location ofDelivery. The delivery month.

The last trading date.Other details such as the tick, the minimum permissible price fluctuation .

2. Margin :

Although the value of a contract at time of trading should be zero, its price constantly fluctuates.This renders the owner liable to adverse changes in value, and creates a credit risk to theexchange, who always acts as counterparty. To minimize this risk, the exchange demands thatcontract owners post a form of collateral, commonly known as Margin requirements are waived

or reduced in some cases for hedgers who have physical ownership of the covered commodity orspread traders who have offsetting contracts balancing the position.Initial Margin is paid byboth buyer and seller. It represents the loss on that contract, as determined by historical pricechanges, which is not likely to beexceeded on a usual day's trading. It may be 5% or 10% of total contract price.

Mark to market Margin:

Because a series of adverse price changes may exhaust the initial margin, a further margin,usually called variation or maintenance margin, is required by the exchange. This is calculated

by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" ormark-to-market price of the contract. To understand the original practice, consider that a futurestrader, when taking a position, deposits money with the exchange, called a "margin". This isintended to protect the exchange against loss. At the end of every trading day, the contract ismarked to its present market value. If the trader is on the winning side of a deal, his contract hasincreased in value that day, and the exchange pays this profit into his account. On the other hand,if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin isused as the collateral from which the loss is paid.



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3. Settlement

Settlement is the act of consummating the contract, and can be done in one oftwo ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is deliveredby the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Inpractice, it occurs only on a minority of contracts. Most are cancelled out by purchasing acovering position - that is, buying a contract to cancel out an earlier sale (covering a short), orselling a contract to liquidate an earlier purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying reference rate, such as ashort term interest rate index such as Euribor, or the closing value of a stock market index. Afutures contract might also opt to settle against an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many equity index andinterest rate futures contracts, this happens on the Last Thursday of certain trading month. Onthis day the t+2 futures contract becomes the t forward contract.

PRICING OF FUTURE CONTRACT:-

In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forwardprice) must be the same as the cost (including interest) of buying and storing the asset. In otherwords, the rational forward price represents the expected future value of the underlyingdiscounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of thefuture/forward(t) , will be found by discounting the present value S(t)at time t to maturity by therate of risk-free return r

F(t)=S(t)*(1+r)(T-t) .

This relationship may be modified for storage costs, dividends, dividend yields,and convenience yields. Any deviation from this equality allows for arbitrage asfollows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today(on the spot market) with borrowed money.2. On the delivery date, the arbitrageur hands over the underlying, andreceives the agreed forward price.3. He then repays the lender the borrowed amount plus interest.4. The difference between the two amounts is the arbitrage profit.In the case where the forward price is lower:1. The arbitrageur buys the futures contract and sells the underlying today



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(on the spot market); he invests the proceeds.2. On the delivery date, he cashes in the matured investment, which hasappreciated at the risk free rate.3. He then receives the underlying and pays the agreed forward price usingthe matured investment. [If he was short the underlying, he returns it now.]

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

What the terminologies used in a Futures contract?

Spot price:The price at which an asset trades in the spot market. Futures price:The price at which the futures contract trades in the futures market. Contract cycle:The period over which a contract trades. The index futures contracts on

the NSE have one-month, two-months and three-months expiry cycles, which expire on thelast Thursday of the month. Thus a January expiration contract expires on the last Thursday

of January and a February expiration contract ceases trading on the last Thursday ofFebruary. On the Friday following the last Thursday, a new contract having a three-monthexpiry is introduced for trading.

Expiry date:It is the date specified in the futures contract. This is the last day on whichthe contract will be traded, at the end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one contract. For in-stance, the contract size on NSEs futures market is 200 Nifties.

Basis:In the context of financial futures, basis can be defined as the futures price minus thespot price. There will be a different basis for each delivery month for each contract. In anormal market, basis will be positive. This reflects that futures prices normally exceed spot

prices. Cost of carry:The relationship between futures prices and spot prices can be summarized

in terms of what is known as the cost of carry. This measures the storage cost plus theinterest that is paid to finance the asset less the income earned on the asset.

Initial margin:The amount that must be deposited in the margin account at the time afutures contract is first entered into is known as initial margin.

Marking-to-market:In the futures market, at the end of each trading day, the margin ac-count is adjusted to reflect the investors gain or loss depending upon the futures closingprice. This is called markingtomarket.

Maintenance margin:This is somewhat lower than the initial margin. This is set to ensurethat the balance in the margin account never becomes negative. If the balance in the margin

account falls below the maintenance margin, the investor receives a margin call and is expectedto top up the margin account to the initial margin level before trading commences on the nextday.

How is a future useful for me to hedge my position?

One can hedge ones position by taking an opposite position in the futures



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market. For example, If you are buying in the spot price, the risk you carry is that of pricesfalling in the future. You can lock this by selling in the futures price.

Even if the stock continues falling, your position is hedged as you have firmed the price at whichyou are selling. Similarly, you want to buy a stock at a later date but face the risk of prices rising.

You can hedge against this rise by buying futures.

You can use a combination of futures too to hedge yourself. There is always a correlationbetween the index and individual stocks. This correlation may be negative or positive, but thereis a correlation. This is given by the beta of the stock.

In simple terms, what b indicates is the change in the price of a stock to thechange in index. For example, if b of a stock is 0.8, it means that if the indexgoes up by 10, the price of the stock goes up by 8. It will also fall by a similar level when theindex falls. A negative b means that the price of the stock falls when the index rises. So, if youhave a position in a stock, you can hedge the same by buying the index at b times the value of

the stock.

Example :-

The b of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I can hedge myposition by selling 8000 of Nifty. Ie I will sell 8 Nifties.

Scenario 1-

If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800 The value of mystock however goes up by 8 % ie it becomes Rs 10800 ie a gain of Rs 800.Thus my net position is zero and I am perfectly hedged.

Scenario 2-

If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800 But the value ofthe stock also falls by 8 %. The value of this stock becomes Rs 9200 a loss of Rs 800.Thus my net position is zero and I am perfectly hedged.But again, b is a predicted value based on regression models. Regression isNothing but analysis of past data. So there is a chance that the above position may not be fullyhedged if the b does not behave as per the predicted value.

DISTINCTION BETWEEN FUTURES AND FORWARDSCONTRACTS

FEATURES FORWARD CONTRACT FUTURE CONTRACT



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OperationalMechanism

Traded directly between two parties (not traded on the

exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized contracts.

Counter-party

risk

Exists. Exists. However, assumed by the clearing

corp., which becomes the counter party toall the trades or unconditionally guarantees

their settlement.

Liquidation

Profile

Low, as contracts are tailor

made contracts catering to the

needs of the needs of theparties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets are

scattered.

Efficient, as markets are centralized and all

buyers and sellers come to a commonplatform to discover the price.

Examples Currency market in India. Commodities, futures, Index Futures andIndividual stock Futures in India.

Price discoveryNot efficient, as markets are scattered. Efficient, as markets are centralizedand all buyers and sellers come to a common platform to discover the price.Examples Currency market in India. Commodities, futures, Index Futuresand Individual stock Futures in India.

OPTIONS



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A derivative transaction that gives the option holder the right but not the obligation to buy or sellthe underlying asset at a price, called the strike price, during a period or on a specific date inexchange for payment of a premium is known as option. Underlying asset refers to any assetthat is traded. The price at which the underlying is traded is called the strike price. There aretwo types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:A contract that gives its owner the right but not the obligation to buy an underlying asset-stockor any financial asset, at a specified price on or before a specified date is known as a Calloption. The owner makes a profit provided he sells at a higher current price and buys at a lowerfuture price.

PUT OPTION:A contract that gives its owner the right but not the obligation to sell an underlying asset-stock orany financial asset, at a specified price on or before a specified date is known as a Put option.The owner makes a profit provided he buys at a lower current price and sells at a higher future

price. Hence, no option will be exercised if the future price does not increase. Put and calls arealmost always written on equities, although occasionallypreference shares, bonds and warrants become the subject of options.

What are the options that are currently traded in the market?The options that are currently traded in the market are index options and stockoptions on the 30 stocks. The index options are European options. They aresettled on the last day. The stock options are American options.There are 3 options-1, 2,3 month options. There can be a series of option withinthe above time span at different strike prices.Another lingo in option is Near and Far options. A near option means the optionis closer to expiration date. A Far option means the option is farther fromexpiration date. A 1 month option is a near option while a 3 month option is a faroption. In option trading, what gets quoted in the exchange is the premium and all thatpeople buy and sell is the premium.

SWAPS -Swaps are transactions which obligates the two parties to the contract to exchange a series ofcash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)payments, based on some notional principle amount is called as a SWAP. In case of swap, onlythe payment flows are exchanged and not the principle amount. The two commonly used swapsare:

INTEREST RATE SWAPS:Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixedrate interest payments to a party in exchange for his variable rate interest payments. The fixed



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rate payer takes a short position in the forward contract whereas the floating rate payer takes along position in the forward contract.

CURRENCY SWAPS:

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

one currency are swapped for the principle and the interest payments on loan in anothercurrency. The parties to the swap contract of currency generally hail from two differentcountries. This arrangement allows the counter parties to borrow easily and cheaply in theirhome currencies. Under a currency swap, cash flows to be exchanged are determined at the spotrate at a time when swap is done. Such cash flows are supposed to remain unaffected bysubsequent changes in the exchange rates.

FINANCIAL SWAP:Financial swaps constitute a funding technique which permit a borrower to access one marketand then exchange the liability for another type of liability. It also allows the investors toexchange one type of asset for another type of asset with a preferred income stream.

The needs of the players and how currency swaps help meet these needs

To manage the exchange rate risk

Since the international trade implies returns and payments in a variety of currencies whoserelative values may fluctuate it involves taking foreign exchange risk. The players mentionedabove are facing this risk. A key question facing the players then is whether these exchange risksare so large as to affect their business. A related question is what, if any, special strategies shouldbe followed to reduce the impact of foreign exchange risk.One-way to minimize the long-term risk of one currency being worth more or less in the future isto offset the particular cash flow stream with an opposite flow in the same currency. Thecurrency swap helps to achieve this without raising new funds; instead it changes existing cashflows.

To lower financing cost Currency swaps can be used to reduce the cost of loan. The following example deals with such acase. Consider two Indian corporate A & B. Corporate A is an exporter with a rupee loan at 14%fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in the creditrating of the two companies, the rates at which the loans are available to them are different. Ahas access to 14% rupee loan and dollar loan at LIBOR + 0.25%. A would like to convert itsrupee loan into a dollar loan, to reverse its revenue in dollars and B would like to convert thedollar loan into a fixed rupee loan thus crystallizing its cost of borrowing. They can enter into aswap and reduce the cost compared to what it would have been if they had taken a direct loan in

the desired currencies.

OTHER KINDS OF DERIVATIVES:-



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

BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Optionsare most popular form of baskets.

LEAPS -Normally option contracts are for a period of 1 to 12 months. However, exchange may introduceoption contracts with a maturity period of 2-3 years. These long-term option contracts arepopularly known as Leaps or Long term Equity Anticipation Securities.

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

exchanges having a maximum maturity of nine months. Longer-dated options are called warrantsand are generally traded over-the-counter.

SWAPTIONS -Swaptions are options to buy or sell a swap that will become operative at the expiry of theoptions. Thus a swaption is an option on a forward swap. Rather than have calls and puts, theswaptions market has receiver swaptions and payer swaptions. A receiver swaption is an optionto receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Option Terminology:-

Index options : These options have the index as the underlying. Some options areEuropean while others are American. Like index futures contracts, index options contractsare also cash settled.

Stock options :Stock options are options on individual stocks. Options currently trade onover 500 stocks in the United States. A contract gives the holder the right to buy or sellshares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the optionpremium buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who receives the optionpremium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There aretwo basic types of options, call options and put options.Call option: A call option gives theholder the right but not the obligation to buy an asset by a certain date for a certain price. Putoption: A put option gives the holder the right but not the obligation to sell an asset by acertain date for a certain price.



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Expiration date : The date specified in the options contract is known as the expiration date,the exercise date, the strike date or the maturity.

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

exercise price.American options: American options are options that can be exercised at anytime upto the expiration date. Most exchange-traded options are American. In-the-moneyoption: An in-the-money (ITM) option is an option that would lead to a positive cash flow tothe holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price >strike price). If the index is much higher than the strike price, the call is said to be deep ITM.In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option : An at-the-money (ATM) option is an option that would lead to zerocash flow if it were exercised immediately. An option on the index is at-the-money when thecurrent index equals the strike price (i.e. spot price = strike price)._

Out-of-the-money option : An out-of-the-money (OTM) option is an option that would leadto negative cash flow it it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i.e.spot price < strike price). If the index is much lower than the strike price, the call is said to bedeep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium can be broken down into twocomponents - intrinsic value and time value. The intrinsic value of a call is the amount the optionis ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, theintrinsic value of a call isNP which means the intrinsic value of a call is Max [0, (S t K)]

which means the intrinsic value of a call is the (S t K). Similarly, the intrinsic value of a put isMax [0, (K -St)], i.e. the greater of 0 or (K - St). K is the strike price and St is the spot price.

Options undertakings:-

StocksForeignCurrenciesStockIndicesCommoditiesOthers - Futures Options, are options on the futures contracts or underlying assets are futures

contracts. The futures contract generally matures shortly after the options expiration

Options Classifications:-Options are often classified as

In the money - These result in a positive cash flow towards the investorAt the money - These result in a zero-cash flow to the investorOut of money - These result in a negative cash flow for the investor



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Example:

Calls

Reliance 350 Stock Series

Naked Options: These are options which are not combined with an offsetting contract to cover

the existing positions.

Covered Options: These are option contracts in which the shares are already owned by aninvestor (in case of covered call options) and in case the option is exercised then the offsetting ofthe deal can be done by selling these shares held.

OPTIONS PRICING:-

Prices of options are commonly depend upon six factors. Unlike futures which derives thereprices primarily from prices of the undertaking. Option's prices are far more complex. The tablebelow helps understand the affect of each of these factors and gives a broad picture of option

pricing keeping all other factors constant. The table presents the case of European as well asAmerican Options.

EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION

PRICES:-

EUROPEAN OPTIONSBuying

AMERICAN OPTIONSBuying

PARAMETERS CALL PUT CALL PUT

Spot Price (S)

Strike Price (Xt)

Time to Expiration (T) ? ?Volatility ()

Risk Free Interest Rates (r)

Dividends (D)

Favourable

Unfavourable

STRIKE PRICE: In case of a call option the payoff for the buyer is shown above. As

per this relationship a higher strike price would reduce the profits for the holder of thecall option.TIME TO EXPIRATION: More the time to Expiration more favorable is the option.This can only exist in case of American option as in case of European Options theOptions Contract matures only on the Date of Maturity.



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Futures Options

Exchange traded,with novation Same as futures.

Exchange defines the product Same as futures.

Price is zero, strike price moves Strike price is fixed, price moves.Price is zero Price is always positive.

Linear payoff Nonlinear payoff.

Both long and short at risk Only short at risk.

What are the options that are currently traded in the market?The options that are currently traded in the market are index options and stockoptions on the 30 stocks. The index options are European options. They aresettled on the last day. The stock options are American options. There are 3 options-1, 2,3 monthoptions. There can be a series of option within the above time span at different strike prices.Another lingo in option is Near and Far options. A near option means the option is closer to

expiration date. A Far option means the option is farther from expiration date. A 1 month optionis a near option while a 3 month option is a faroption. In option trading, what gets quoted in the exchange is the premium and all thatpeople buy and sell is the premium.

How do I use options in my trading strategy?Options are a great tool to use for trading. If you feel the market will go up. You should buy acall option at a level lower than what you expect the market to go up. If you think that the marketwill fall, you should buy a put option at a level higher than the level to which you expect themarket fall.

When we say market, we mean the index. The same strategy can be used forindividual stocks also.A combination of futures and options can be used too, to make profits.

We have seen that the risk for an option holder is the premium

amount. But what should be the strategy for an option writer to

cover himself?

An option writer can use a combination strategy of futures and options to protect his position.The risk for an option writer arises only when the option is exercised. This will be very clearwith an

Example:-Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium of Rs 20. Therisk arises only when the option is exercised. The option will be exercised when the priceexceeds Rs 300. I start making a loss only after the price exceeds Rs 320(Strike price pluspremium).



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More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver thestock to the other party and also make entire profit on premium,I buy a future of Reliance at Rs 300.This is just one leg of the risk. The earlier risk was of the call being exercised.The risk now is that of the call not being exercised. In case the call is not

Exercised, what do I do? I will have to take delivery as I have bought a future. So minimize thisrisk, I buy a put option on Reliance at Rs 300. But I also need to Pay a premium for buying theoption. I pay a premium of Rs 10.Now I am fully Covered and my net cash flow would bePremium earned from selling call option : Rs 20Premium paid to buy put option : (Rs 10) Net cash flow : Rs 10But the above pay off will be possible only when the premium I am paying for the put option islower than the premium that I get for writing the call.Similarly, we can arrive at a covered position for writing a put option too,Another interesting observation is that the above strategy in itself presents anopportunity to make money. This is so because of the premium differential in the put and the call

option. So if one tracks the derivative markets on a continuous basis, one can chance uponalmost risk less money making opportunities.

Different option series at various strike prices. How is this strike price

arrived at?The strike price bands are specified by the exchange. This band is dependent onthe market price.

Market Price Rs. Strike Price Intervals Rs.1000 50

Thus if a stock is trading at Rs. 100 then there can be options with strike price ofRs 105,110,115, 95, 90 etc.

Futures and options

An interesting question to ask at this stage is - when would one use options instead of futures?Options are different from futures in several interesting senses. At a practical level, the optionbuyer faces an interesting situation. He pays for the option in full at the time it is purchased.

After this, he only has an upside. There is no possibility of the options position generating anyfurther losses to him (other than the funds already paid for the option). This is different fromfutures, which is free to enter into, but can generate very large losses. This characteristic makesoptions attractive to many occasional market participants, who cannot put in the time to closelymonitor their futures positions. Buying put options is buying insurance. To buy a put option onNifty is to buy insurance, which reimburses the full extent to which Nifty drops below the strikeprice of the put option. This is attractive to many people, and to mutual funds creatingguaranteed return products. The Nifty index fund industry will find it very useful to make a



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bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund,which gives the investor protection against extreme drops in Nifty.

How can I arbitrage and make money in derivatives?

Arbitrage is making money on price differentials in different markets. Forexample, future is nothing but the future value of the spot price. This future value is obtained byfactoring the interest rate.But if there are differences in the money market and the interest rates change then the futureprice should correct itself to factor the change in interest. But if there is no factoring of thischange then it presents an opportunity to make money- an arbitrage opportunity.

Example:-A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005. The risk freeinterest rate is 12%. What should be the trading strategy?

Solution:The strategy for trading should be : Sell Spot and Buy FuturesSell the stock for Rs 1000. Buy the future at Rs 1005.Invest the Rs1000 at 12 %. The interest earned on this stock will be1000(1+.012)(1/12)=1009So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4Thus one can make a risk less profit of Rs 4 because of arbitrage But an important point is thatthis opportunity was available due to mix-pricing and the market not correcting itself. Normally,the time taken for the market to adjust to corrections is very less. So the time available forarbitrage is also less. As everyone rushes to cash in on the arbitrage, the market corrects itself.

Definition:-



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Derivatives defined:-

Derivative is a product whose value is derived from the value of one or more basic variables,called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying

asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wishto sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such atransaction is an example of a derivative. The price of this derivative is driven by the spot priceof wheat which is the underlying. In the Indian context the Securities Contracts (Regulation)Act, 1956 (SC(R) A) defines equity derivative to include A security derived from a debt instrument, share, loan whether secured or unsecured, riskinstrument or contract for differences or any other form of security.A contract, which derives its value from the prices, or index of prices, of underlying securities.

What are financial derivatives?

Financial derivatives are instruments that derive their value from financial assets.These assets can be stocks, bonds, currency etc. These derivatives can be forward rateagreements, futures, options swaps etc. As stated earlier, the most traded instruments are futuresand options. In derivative trading the brokerage is relatively lower than the cash segment. If youconsider the number of stock that you purchase in the form of future contracts then you will findthat you have to pay less brokerage compared to the cash segment.

ADVANTAGES:-

The use of derivatives also has its benefits: provide leverage (or gearing), such that a small movement in the underlying value can

cause a large difference in the value of the derivative;

Derivatives facilitate the buying and selling of risk, and many people consider this tohave a positive impact on the economic system. Although someone loses money whilesomeone else gains money with a derivative, under normal circumstances, trading inderivatives should not adversely affect the economic system because it is notzero sum inutility.

speculate and make a profit if the value of the underlying asset moves the way theyexpect (e.g., moves in a given direction, stays in or out of a specified range, reaches acertain level);

hedge or mitigate risk in the underlying, by entering into a derivative contract whosevalue moves in the opposite direction to their underlying position and cancels part or allof it out;

obtain exposure to the underlying where it is not possible to trade in the underlying (e.g.,weather derivatives);

create option ability where the value of the derivative is linked to a specific condition orevent (e.g., the underlying reaching a specific price level.

http://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Economic_systemhttp://en.wikipedia.org/wiki/Zero-sum_gamehttp://en.wikipedia.org/wiki/Zero-sum_gamehttp://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Option_(finance)http://en.wikipedia.org/wiki/Leverage_(finance)http://en.wikipedia.org/wiki/Economic_systemhttp://en.wikipedia.org/wiki/Zero-sum_gamehttp://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Hedge_(finance)http://en.wikipedia.org/wiki/Option_(finance)


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DISADVANTAGES:-

Because of their ability to provide leveraging, derivative disasters are pretty common in

international markets. Just as there is huge potential of earning higher returns, it also exposesindividuals and corporations alike to lose money in case the market moves against the positionsheld by them.

Does that mean derivatives are badla revisited?The derivative product that comes closest to Badla is futures. Futures is not badla, though a lot of people confuse it with badla. The fundamental difference is badlaconsisted of contango and backwardation (undha badla and vyaj badla) in the same market.Futures is a different market segment altogether. Hence Derivatives is not the same as badla,though it is similar.

How do I raise funds from the derivatives market?This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You have shares lyingwith you and are in urgent need of liquidity. Instead of pledging your shares and borrowing frombanks at a margin, you can sell the stock at Rs3000. Suppose you need this liquidity only for amonth and also do not want to part with Infosys. You can buy a 1 month future at Rs 3050. Aftera month you get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the financingcost for the liquidity.The other beauty about this is you have already locked in your purchase cost at Rs 3050. Thisfixes your liquidity cost also and you are protected against further price losses.

How do I lend into the market?The lending into the market is exactly the reverse of borrowing. You have money to lend. Youcan buy a stock and sell its future. Say, you buy Infosys at Rs 3000 and sell a 1 month future atRs 3100. In effect what you have done is lent Rs 3000 to the market for a month and earned Rs100 on it.

Suppose I dont want to lend/borrow money. I want to speculate and make

profits?When you speculate, you normally take a view on the market, either bullish or bearish. Whenyou take a bullish view on the market, you can always sell futures and buy in the spot market. Ifyou take a bearish view on the market, you can buy futures and sell in the spot market. Similarly,

in the options market, if you are bullish, you should buy call options. If you are bearish, youshould buy put options Conversely, if you are bullish, you should write put options. This is sobecause, in a bull market, there are lower chances of the put option being exercised and you canprofit from the premium.If you are bearish, you should write call options. This is so because, in a bear market, there arelower chances of the call option being exercised and you can profit from the premium.



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Chapter-2

Objective of

study

OBJECTIVE OF STUDY :-

The objective of the research means the purpose for which the research is being carried out. Theobjectives of this research are as follows:



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To understand the futures and options.

To know the RISK MANAGEMENT IN DERIVATIVES

To know the role of derivatives market in economic development.

To analyze the growth pattern in derivatives market

Chapter-3



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Research

methodology

Quantitative aspect:-

Primarily various books on derivative in stock market were read to know variousfeatures and principle used in working of the industry. Moreover, various magazines were readto know about the latest happening in this field.



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Websites were visited and information regarding different aspect, to get a betterknowledge on the topic was collected. Various websites were visited so as to study the importantof derivative in stock market in the ever rising competition in todays world.

Qualitative aspect:-

Dr.padmanabhan was approached and implementation and scope of derivative in stockas understood through his expertise in the field. Some analysis was done for different cases so asto understand different strategies in different situation,

He was also approached to give an insight on the future of derivative in stock in Indiaand the current scenario.

Method of data collection:-Secondary sources:-It is the data which has already been collected by some one or anorganization for some other purpose or research study .The data for study hasbeen collected from various sources:

BooksJournalsMagazinesInternet sources

Time:3 monthsStatistical Tools Used:.

LIMITAITONS OF STUDY

1. LIMITED TIME:

The time available to conduct the study was only 3 months. It being a wide topic, had alimited time..



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2. LIMITED RESOURCES:

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

3. VOLATALITY:

Share market is so much volatile and it is difficult to forecast anything about it whether youtrade through online or offline.4. ASPECTS COVERAGE:

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

SCOPE OF THE PROJECT:-

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

strategies with different situations and actions have been given. It includes the data collected inthe recent years and also the market in the derivatives in the recent years. This study extends tothe trading of derivatives done in the National Stock Markets.



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CHAPTER-4

REVIEW OF

LITERATURE

LITERATURE REVIEW:-



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The emergence of the market for derivative products, most notably forwards, futures andoptions, can be traced back to the willingness of risk-averse economic agents to guardthemselves against uncertainties arising out of fluctuations in asset prices. By their very nature,the financial markets are marked by a very high degree of volatility. Through the use ofderivative products, it is possible to partially or fully transfer price risks by locking-in asset

prices. As instruments of risk management, these generally do not influence the fluctuations inthe underlying asset prices. However, by locking-in asset prices, derivative products minimizethe impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in commodityprices and commodity-linked derivatives remained the sole form of such products for almostthree hundred years.

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

the financial markets. However, since their emergence, these products have become very popularand by 1990s, they accounted for about two-thirds of total transactions in derivative products.In recent years, the market for financial derivatives has grown tremendously both in terms of

variety of instruments available,

their complexity and also turnover. In the class of equity derivatives, futures and options onstock indices have gained more popularity than on individual stocks, especially amonginstitutional investors, who are major users of index-linked derivatives. Even small investors findthese useful due to high correlation of the popular indices with various portfolios and ease ofuse.The lower costs associated with index derivatives vis-vis derivative products based on individual

securities is another reason for their growing use. As in the present scenario, Derivative Tradingis fast gaining momentum, I have chosen this topic.



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CHAPTER -5

HISTORY OF

DERIVATIVES

HISTORY OF DERIVATIVES:-

The history of derivatives is surprisingly longer than what most people think. Some texts



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even find the existence of the characteristics of derivative contracts in incidents ofMahabharata. Traces of derivative contracts can even be found in incidents that date back to theages before Jesus Christ. However, the advent of modern day derivative contracts is attributed tothe need for farmers to protect themselves from any decline in the price of their crops due todelayed monsoon, or overproduction.

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around1650. 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, 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, aswe know them today.

Derivatives have had a long presence in India. The commodity derivative market has beenfunctioning in India since the nineteenth century with organized trading in cotton through theestablishment 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 twomajor stock exchanges, NSE and BSE. There are various contracts currently traded on theseexchanges. The National Stock Exchange of India Limited (NSE) commenced trading inderivativeswith the launch of index futures on June 12, 2000. The futures contracts are based onthepopular 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 individual securitiesfrom July 2, 2001. Futures on individual securities were introduced on November 9, 2001.

Futures and Options on individual securities are available on 227 securities stipulated by SEBI.The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTYJUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing miniderivative (futures and options) contracts on S&P CNX Nifty index. National Commodity &Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide aplatform for commodities trading. The derivatives market in India has grown exponentially,especially at NSE. Stock Futures are the most highly traded contracts.

The size of the derivatives market has become important in the last 15 years or so. In 2007 thetotal world derivatives market expanded to $516 trillion. With the opening of the economy tomultinationals and the adoption of the liberalized economic policies, the economy is driven more

towards the free market economy.

The complex 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. With the integration of thefinancial markets and free mobility of capital, risks also multiplied. For instance, when countriesadopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates.Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk



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of default or counter party risk. Apart from it, every assetwhether commodity or metal orshare or currencyis subject to depreciation in its value. It may be due to certain inherentfactors and external factors like the market condition, Governments policy, economic andpolitical condition prevailing inthe 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 to those whoare able to bear and manage them.Thus, risk management becomes a must for survival since there is a high volatility in the presentfinancial 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 financialservice companies can play a very dynamic role in dealing with such risks. They can ensure thatthe above risks are hedged by using derivatives like forwards, future, options, swaps etc.Derivatives, thus, enable the clients to transfer their financial risks to the financial service

companies. This really protects the clients from unforeseen risks and helps them to get there dueoperating profits or to keep the project well within the budget costs. To hedge the various risksthat one faces in the financial market today, derivatives are absolutely essential.

What are the other strategies using derivatives?

The other strategies are also various permutations of multiple puts, calls andfutures. They are also called by exotic names , but if one were to observe them closely, they arerelatively simple instruments.Some of these instruments are: Butter fly spread: It is the strategy of simultaneous buying of put and call

Calendar Spread - An option strategy in which a short-term option is sold and a longer-termoption is bought both having the same striking price. Either puts or calls may be used. Double option An option that gives the buyer the right to buy and/or sell a futures contract, ata premium, at the strike price Straddle The simultaneous purchase and sale of option of the sameSpecification to different periods. Tandem Options A sequence of options of the same type, with variablestrike price and period. Bermuda Option Like the location of the Bermudas, this option is located somewherebetween a European style option which can be exercised only at maturity and an American styleoption which can be exercised any time the option holder chooses. This option can be

exercisable only on predetermined dates

What kind of people will use derivatives?



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Derivatives will find use for the following set of people: Speculators: People who buy or sell inthe market to make profits. For example, if you will the stock price of Reliance is expected to goupto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay

US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer canminimize his losses by buying a currency future at Rs 49/$ Arbitrageurs: People who buy orsell to make money on price differentials in Different markets. For example, a futures price issimply the current price plus the interest cost. If there is any change in the interest, it presents anarbitrage Opportunity. We will examine this in detail when we look at futures in a Separatechapter. Basically, every investor assumes one or more of the above roles and derivatives Are avery good option for him.

How has this market developed over time?

Derivatives have been a recent development in the Indian financial markets. But there have beenderivatives in the commodities market. There is Cotton and Oilseed futures in Mumbai, Soyafutures in Bhopal, Pepper futures in Cochin,Coffee futures in Bangalore etc. But the players inthese markets are restricted to big farmers and industries, who need these as an input to protectthemselves from the vagaries of agriculture sector. Globally too, the first derivatives started withthe commodities, way back in 1894. Financial derivatives are a relatively late development,coming into existence only in the 1970s. The first exchange where derivatives were traded is theChicago Board of Trade (CBOT).In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000.The first derivatives were index futures. The index used was Nifty. Option trading was started inJune 2001, for index as well as stocks. In November 2001, futures on stocks were allowed.

Currently, there are 30 stocks on which derivative trading is allowed The 30 stocks on whichtrading is allowed currently are:

IMPACT OF DERIVATIVE MARKET ON FINANCIAL MARKETS:



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Derivatives are becoming increasingly popular, so the obvious question is whether, and how,they affect the stability of financial markets. Generally, derivatives improve the overallallocation of risks within financial systems.They do so in two ways: Derivatives make risk management more efficient and flexible especially at banks.

Derivatives allow a more efficient distribution of individual risks and a related reduction ofaggregate risk within an economy. Nevertheless, a number of risk factors must be taken intoaccount:

Poor market transparency makes it difficult at present to give an adequate assessment ofrisk distribution. Initiatives to gain additional market information and set appropriate reportingrules which reflect the interests of both the supervisory bodies and the market participants aretherefore to be welcomed.

Risks attributable to poor contract wording (documentation risk) have already been largelyovercome thanks to the steadily ongoing development of standardized rules (ISDA). A high market concentration currently hinders the economically optimal allocation of risks,

although it does not directly endanger the stability of the financial markets. But the highdegree of concentration is expected to last only temporarily.

There is no clear evidence so far that credit derivatives have systematically been wronglypriced. However, this cannot be ruled out entirely at present Especially given the inexperience of some of the participants entering the market.Systematically wrong pricing would result primarily in a misallocation of resources. The use of derivatives may change traditional incentive structures. This is mainly a theoreticalphenomenon. In practice, various mechanisms help to deal with the incentive problems whichcould potentially increase risk. Risks associated with the use of credit derivatives will meritspecial attention until The market has matured. Banks and financial markets will then benefit

additionally from their use and become more stable.While derivatives are being used more and more in operative financial and risk management,their long-term implications for the credit and financial markets are only beginning toemerge. For the overall economy, the growing use of derivatives affects the stability ofFinancial markets.

ROLE OF DERIVATIVES;-



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Derivative markets help investors in many different ways:

RISK MANAGEMENT

Derivatives are high-risk instruments and hence the exchanges have put up a lot of measures to

control this risk. he most critical aspect of risk management is the daily monitoring of price andposition and the margining of those positions. NSE uses the SPAN (Standard Portfolio Analysisof Risk). SPAN is a system that has origins at the Chicago Mercantile Exchange, one of theoldest derivative exchanges in the world. The objective of SPAN is to monitor the positions anddetermine the maximum loss that a stock can incur in a single day. This loss is covered by theexchange by imposing mark to market margins. SPAN evaluates risk scenarios, which arenothing but market conditions.

The specific set of market conditions evaluated, are called the risk scenarios, and these aredefined in terms of: (a) how much the price of the underlying instrument is expected to changeover one trading day, and (b) how much the volatility of that underlying price is expected to

change over one trading day. Based on the SPAN measurement, margins are imposed and riskcovered. Apart from this, the exchange will have a minimum base capital of Rs 50 lacs andbrokers need to pay additionalbase capital if they need margins above the permissible limits

Futures and options contract can be used for altering the risk of investing in spot market. Forinstance, consider an investor who owns an asset. He will always be worried that the price mayfall before he can sell the asset. He can protect himself by selling a futures contract, or by buyinga Put option. If the spot price falls, the short hedgers will gain in the futures market, as you willsee later. This will help offset their losses in the spot market. Similarly, if the spot price fallsbelow the exercise price, the put option can always be exercised.

Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk,can transfer some of that risk to a person who wants to take more risk. Consider a risk averseindividual. He can obviously reduce risk by hedging. When he does so, the opposite position inthe market may be taken by a speculator who wishes to take more risk. Since people can altertheir risk exposure using futures and options, derivatives markets help in the raising of capital.As an investor, you can always invest in an asset and then change its risk to a level that is moreacceptable to you by using derivatives.

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 in disseminating suchinformation. As we have seen, futures markets provide a low cost trading mechanism. Thus



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information pertaining to supply and demand easily percolates into such markets. Accurateprices are essential for ensuring the correct allocation of resources in a free market. economy.Options markets provide information about the volatility or risk of the underlying asset.

OPERATIONAL ADVANTAGES As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, theyoffer greater liquidity. Large spot transactions can often lead to significant price changes.However, futures markets tend to be more liquid than spot markets, because herein you can takelarge positions by depositing relatively small margins. Consequently, a large position inderivatives markets is relatively easier to take and has less of a price impact asopposed to a transaction of the same magnitude in the spot market. Finally, it is easier to takea short position in derivatives markets than it is to sell short in spot markets.

MARKET EFFICIENCYThe availability of derivatives makes markets more efficient; spot, futures and optionsmarkets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it ispossible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence thesemarkets help to ensure that prices reflect true values.

EASE OF SPECULATION Derivative markets provide speculators with a cheaper alternative to engaging in spottransactions. Also, the amount of capital required to take a comparable position is less in thiscase. This is important because facilitation of speculation is critical for ensuring free andfairmarkets. Speculators always take calculated risks. A speculator will accept a level of riskonlyif he is convinced that the associated expected return, is commensurate with the risk that he istaking.

The derivative market performs a number of economic functions.The prices of derivatives converge with the prices of the underlying at theexpiration of derivative contract. Thus derivatives help in discovery offuture as well as current prices.

An important incidental benefit that flows from derivatives trading is that itacts as a catalyst for new entrepreneurial activity.

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

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

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA:-



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The first step towards introduction of derivatives trading in India was the promulgation of theSecurities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options insecurities.

The market for derivatives, however, did not take off, as there was no regulatory framework to

govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship ofDr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework forderivatives trading in India. The committee submitted its report on March 17, 1998 prescribingnecessary preconditions for introduction of derivatives trading in India.

The committee recommended that derivatives should be declared as securities so thatregulatory framework applicable to trading of securities could also govern trading of securities.SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, torecommend measures for risk containment in derivatives market in India. The report, which wassubmitted in October 1998, worked out the operational details of margining system,methodology for charging initial margins, broker net worth, deposit requirement and realtime

monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended inDecember 1999 to include derivatives within the ambit of securities and the regulatoryframework were developed for governing derivatives trading.

The act also made it clear that derivatives shall be legal and valid only if such contracts aretraded on a recognized stock exchange, thus precluding OTC derivatives. The government alsorescinded in March 2000, the three decade old notification, which prohibited forward trading insecurities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval tothis effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE

and BSE, and their clearing house/corporation to commence trading and settlement in approvedderivatives contracts. To begin with, SEBI approved trading in index futures contracts based onS&P CNX Nifty and BSE30 (Sense) index. This was followed by approval for trading inoptions based on these two indexes and options on individual securities.The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options onindividual securities commenced in July 2001. Futures contracts on

individual stocks were launched in November 2001. The derivatives trading on NSE commencedwith S&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 options contract

on NSE are based on S&P CNX Trading and settlement in derivative contracts is done inaccordance with the rules, byelaws, and regulations of the respective exchanges and theirclearing house/corporation duly approved by SEBI and notified in the official gazette. ForeignInstitutional 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 reporton the futures and options (F&O):



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SETTLEMENT OF DERIVATIVES:-

How are futures settled on the stock exchange?

Mark to market settlement:-

There is a daily settlement for Mark to Market .The profits/ losses are computed as the differencebetween the trade price or the previous days settlement price, as the case may be, and thecurrent days settlement price. The party who have suffered a loss are required to pay the mark-to-market loss amount to exchange which is in turn passed on to the party who has made a profit.This is known as daily mark-to-market settlement.Theoretical daily settlement price for unexpired futures contracts, which are not traded duringthe last half an hour on a day, is currently the price computed as per the formula detailed below:

F = S * e rt where :F = theoretical futures priceS = value of the underlying index/ stockr = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as maybe Specified.After daily settlement, all the open positions are reset to the daily settlement price.The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =Trade day). The mark to market losses or profits are directly debited or credited to the brokeraccount from where the broker passes to the client account

Final Settlement:-

On the expiry of the futures contracts, exchange marks all positions to the final settlement priceand the resulting profit / loss is settled in cash.The final settlement of the futures contracts is similar to the daily settlement process except forthe method of computation of final settlement price. The final settlement profit / loss iscomputed as the difference between trade price or the previous days settlement price, as the casemay be, and the final settlement price of the relevant futures contract. Final settlement loss/profit amount is debited/ credited to the relevant brokers clearing bank account on T+1 day (T=expiry day). This is then passed on the client from the broker. Open positions in futures contractscease to exist after their expiration day



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How are options settled on the stock exchange?

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The premium payableposition and premium receivable positions are netted across all option contracts for each brokerat the client level to determine the net premium payable or receivable amount, at the end of eachday. The brokers who have a premium payable position are required to pay the premium amountto exchange which is in turn passed on to the members who have a premium receivable position.This is known as daily premium settlement.The brokers in turn would take this from their clients.The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day). Thepremium payable amount and premium receivable amount are directly debited or credited to the

broker, from where it is passed on to the client.

REGULATORY AND TAXATION ASPECTS OF DERIVATIVES

Since derivatives are a highly risky market, as experience world over has shown, there are tightregulatory controls in this market. The same is true of India. In India, a committee was set upunder Dr L CGupta to study the introduction of the derivatives market in India.

This committee formulated the guidelines and framework for the derivatives market and pavedthe way for the derivatives market in India. There other committee that has far reaching

implications in the derivatives market is the J R Verma Committee. This committee hasrecommended norms for trading in the exchange. A lot of emphasis has been laid on marginingand surveillance so as to provide a strong backbone in systems and processes and ensurestringent controls in a risky market. As for the taxation aspect, the CBDT is treating gains fromderivative transactions as profit from speculation. Similarly losses in derivative transactions canbe treated as speculation losses for tax purpose.

India has started the innovations in financial markets very late. Some of the recentdevelopments initiated by the regulatory authorities are very important in this respect.Futures trading have been permitted in certain commodity exchanges. Mumbai StockExchange has started futures trading in cottonseed and cotton under the BOOE and under t

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Project - Abhi - Derivatives