Project on derivaties

8/7/2019 Project on derivaties

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Project report submitted towards fulfillment

of

PGDM

LBSIMT, Bareilly

Academic Session

[2008-2010]

Submitted by

Sarang Mani

UNDER THE GUIDANCE OF

Mr. Rahul Kumar AgarwalArea Sales Manager

IL & FS InvestSmart Securities Ltd.

Submitted by:

Name Sarang Mani

Indian Derivative Market


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July 5, 2009

TO WHOMSOEVER IT MAY CONCERN

On behalf of IL&FS InvestSmart Securities Ltd., I take the privilege of recognizing

the efforts put in by Mr. Sarang Mani to carry out her Project on Indian

Derivative Marketfrom 5th May to 5th July 2009. Sarang has not only carried

out this study as a part of his curriculum but he has proven to be a key member

in bringing positive contribution in our Sales strategies.

The project carried out by Sarang has given us some focused reasons toimprove our people practices, focus on employee satisfaction level as well

contribute to our sales. In fact we are considering adapting a few suggestions

given by him in the above context.

Lastly, I would like to thank your esteemed institution for providing your students

such a platform; for them to learn from their experiences while carrying out these

studies.

Warm regards,

(Rahul Kumar Agarwal)Area Sales Manager


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TABLE OF CONTENTS

S.No.

TOPICSPAGENO.

1. Executive Summary ...... 062. Company Profile................... 103. Introduction ................... 164.5.6.7.8.9.

Need of the Study............................................................................Literatural Review............................................................................Objective of the Study.....................................................................Scope of the Study..........................................................................Research Methodology....................................................................Limitations of Study.........................................................................

171819202122

10. Main Topics of Study

1) Introduction to Derivative............................................................. 232) Derivative Defined......................................................................... 243) Types of Derivatives Market.......................................................... 254) Types of Derivatives...................................................................... 25

i) Forward Contracts...................................................................... 26ii) Future Contracts........................................................................ 27iii)iv)

Options.......................................................................................Swap.......................................................................................

3233

5) Other Kinds of Derivatives......................................................... 3411. History of Derivatives......................................................................... 3512. Indian Derivative Market ......... 38

1)2)i)

ii)3)4)5)

Need of Derivatives in India today................................Myths and realities about derivatives.................Derivatives increase speculation and do not serve anyeconomic purpose .....................................................................Indian Market is not ready for derivative trading........................

Comparison of New System with Existing System.........Exchange-traded vs. OTC derivatives markets...............................Factors Contributing To The Growth Of Derivatives........................

3939

4041434547

i) Price Volatility............................................................................. 47ii)iii)

Globalisation of Markets..............................................................Technological Advances.............................................................

4849

iv) Advances in Financial Theories....................................... 4913. Development of Derivative Markets in India....... 5014.

1)2)3)4)5)

Benifits of Derivatives...................................Risk Management............................................................................Price Discovery..............................................................................Operational Advantages.................................................................Market Efficiency............................................................................Easy to Speculation.........................................................................

545454545555


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EXECUTIVE SUMMARY

Firstly I am briefing the current Indian market and compairing it with it past. 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. Over 7500 companies are listed on the Indian stock

exchanges (more than the number of companies listed in developed markets of

Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.).

The Indian capital market is significant in terms of the degree of development,

volume of trading, transparency and its tremendous growth potential.

Indias market capitalization was the highest among the emerging markets. Total

market capitalization of The Bombay Stock Exchange (BSE), which, as on July

31, 1997, was US$ 175 billion has grown by 37.5% percent every twelve months

and was over US$ 834 billion as ofJanuary, 2007. Bombay Stock Exchanges

(BSE), one of the oldest in the world, accounts for the largest number of listed

companies transacting their shares on a nationwide online trading system. The

two major exchanges namely the National Stock Exchange (NSE) and theBombay Stock Exchange (BSE) ranked no. 3 & 5 in the world, calculated by the

number of daily transactions done on the exchanges.

The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006

An increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years

only. Turnover in the Spot and Derivatives segment both in NSE & BSE was

higher by 45% into 2006 as compared to 2005. With daily average volume of US

$ 9.4 billion, the Sensex has posted excellent returns in the recent years.

Currently the market cap of the Sensex as on July 4th, 2009 was Rs 48.4

Lakh Crore with a P/E ofmore than 20.

Derivatives trading in the stock market have been a subject of enthusiasm of

research in the field of finance the most desired instruments that allow market


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participants to manage risk in the modern securities trading are known as

derivatives. The derivatives are defined as the future contracts whose value

depends upon the underlying assets. If derivatives are introduced in the stock

market, the underlying asset may be anything as component 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 an additional

channel to invest with lower trading cost and it facilitates the investors to extend

their settlement through the future contracts. It provides extra liquidity in the stock

market.

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 debt

securities 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.

Equities

For example, a dollar forward is a derivative contract, which gives the buyer a

right & an obligation 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 in transferring market risk,

called Hedging, which is a protection against losses resulting from unforeseen

price or volatility changes. Thus, derivatives are a very important tool of risk

management.


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There are various derivative products traded. They are;

1. Forwards

2. Futures

3.Options

4. Swaps

A Forward 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 price may be agreed on in advance or in future.

A Future contract is a firm contractual agreement between a buyer and seller

for a specified as on a fixed date in future. The contract price will vary according

to the market place but it is fixed when the trade is made. The contract also has a

standard specification so both parties know exactly what is being done.

An Options contractconfers the right but not the obligation to buy (call option)

or sell (put option) a specified underlying instrument or asset at a specified price

the Strike or Exercised price up until or an specified future date the Expiry

date. The Price is called Premium and is paid 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 certain price. The seller is under an obligation to fulfill the contract and

is paid a price of this, which is called "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 certain date for a certain price. The buyer is under an obligation tofulfill the contract and is paid a price for this, which is called "the put option

premium or put option price".


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

exchange a series of cash flows at specified intervals known as payment or

settlement dates. They can be regarded as portfolios of forward's contracts. A

contract whereby two parties agree to exchange (swap) payments, based on

some notional principle amount is called as a SWAP. In case of swap, only the

payment flows are exchanged and not the principle amount

I had conducted this research to find out whether investing in the

derivative market is beneficial or not? You will be glad to know that

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 derivative market.

On the other hand RBI has to play an important role in derivative market.

Also SEBI must 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 market because they have the

fear ofhigh risk.

So,SEBIshould take necessary steps for improvement in Derivative Market

so that more investors can invest in Derivative market.


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COMPANY PROFILE

A Briefabout IL&FS Investsmart Limited:

IL&FS Investsmart Limited (IIL) is one of Indias leading financial services

organizations providing individuals and corporates with customized financial

management solutions.

At IIL, we believe in "Realizing your goals together". You will find in us - a trusted

investment partner to help you work towards achieving your financial goals. Our

institutional expertise, combined with a thorough understanding of the financial

markets results in appropriate investment solutions for you.

Our strong team of Relationship Managers, Customer Service Executives,

Advisory Managers and Research Analysts offers efficient execution backed by

in-depth research, knowledge and expertise to customers across the country.

Vision

To become a long term prefferd long term financial to a wide base of customer

whilst optimizing Stake holder value.

Mission

To establish a base of 1 million satisfied customer by 2010

We will crest this by being a responsible trustworthy partner.

Corporate action

An approach to business that reflects responsibility, transparency and ethical

behaviour.

Respect for employee client and stake holder group.


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Retail Business

Retail offerings of IIL seek to cover all financial

planning requirements of individuals, which include

providing personalised investment managementservices including planning, advisory, execution

and monitoring of the full range of investment

services. Broadly the retail services are divided into

two broad categories.

y Advisory Services:

Portfolio Management Services, Mutual

Funds, Insurance.

y Trading Services:

Equities, Derivatives, IPOs

These services are offered across our network of

over 300 offices across the country. You can also

enjoy the convenience of availing these services

online through our trading platformwww.investsmartonline.com


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Institutional Business

IILs Institutional business thrives on the strong relationships we have built among

domestic mutual funds, banks, financial institutions, insurance companies and private

sector funds over the past few years. Efficient execution, quality research and highdegree of compliance with stock exchange regulations and ethical business standards

back IILs services to institutional investors.

Our Institutional services can be broadly categorized as follows.

Merchant Banking

We offer financial advisory and capital-raising services to corporates. Having

successfully managed IPOs, Follow-on offerings, Open Offers, Mergers, etc, IILs

Merchant Banking business has been growing from strength-to-strength.

Institutional Equity & Debt

Combining the efforts of a top-drawer research team & dynamic sales professionals, we

are committed to offer timely & proactive investing & trading strategies. We are

presently empanelled with more than 100 institutions and service customers across

geographies.

PromotersIL&FS Investsmart Limited (IIL) is one of Indias leading companies in the Financial

Services industry. It was promoted in 1997 by Infrastructure Leasing & Financial

Services (IL&FS), one of India's leading infrastructure development and finance

companies.

The company is now held by HSBC, one of the worlds largest banking and financial

services organisations.

In India, The HSBC Group offers a range of financial services including corporate,

commercial, retail and private banking, insurance, asset management, investment

banking, equities and capital markets, institutional brokerage, custodial services. It also

provides software development expertise and global services facilities for the HSBC

Groups operations worldwide.


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Value Added Products for You!

"Value Added Products for You" - Investsmart Online continually strives to

provide the services and support that our clients need to thrive in the market.

We pride ourselves on offering almost limitless customization possibilities; sothat you can truly "own the trade" We also realize that every trader has unique

and complex needs that sometimes require special attention. With this in mind,

we created Value Added products.

SmartChartTools to plot Profitable Investments

Our Charting Tools

Provides you a wealth of charting capabilities andtiming indicators, which allow you to go right intothe action with real-time daily and intra-day charts.

SmartExposureIncrease your Market Exposure

Limit Against Shares

Margin is offered against the securities you have inyour Demat for trading.

SmartCallConvenience to trade over the phone

Phone Trading Services

Call & Trade is a service offered by Investsmartonline for its customers, which provides customerswith a facility to trade over the phone.

SmartSecureState-of-the-art Security Platforms

State-of-the-Art Security Platforms

At IL&FS Investsmart, we place a very high onuson security and realize that it is one of the vitalcomponents of any e-business venture. Our onlineproducts are developed on state-of-the-art securityplatforms.

SmartAlertSmart Alert Service

Smart Alert Services

Whether you are day trader or a serious investor,wewill deliver stock information (Short term and Long

term calls) to your cell phone daily.

SmartNextSell Receivable Shares

Sell Receivable Shares

SRS is a facility offered by Investsmart onlinewherein the customer will be able to sell the sharesthat he has purchased even before he receives thedelivery of the shares from the Exchange. He willnot have to wait till the time he receives the deliveryfrom the Exchange thus increasing his liquidity.


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INTRODUCTION

A Derivative is a financial instrument whose value depends on other, more

basic, underlying variables. The variables underlying could be prices of traded

securities and stock, prices of gold or copper.

Derivatives have become increasingly important in the field of finance,

Options and Futures are traded actively on many exchanges, Forward

contracts, Swap and different types of options are regularly traded outside

exchanges by financial intuitions, banks and their corporate clients in what

are termed as over-the-counter markets in other words, there is no single

market place or organized exchanges.


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NEED OF THE STUDY

The study has been done to know the different types of derivatives and also

to know the derivative market in India. This study also covers the recent

developments in the derivative market taking into account the trading in past

years.

Through this study I came to know the trading done in derivatives and their

use in the stock markets.


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LITERATURE REVIEW

The emergence of the market for derivative products, most notably forwards,

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

economic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative

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

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

fluctuations in the underlying asset prices. However, by locking-in asset prices,

derivative products minimize the impact of fluctuations in asset prices on theprofitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in

commodity prices and commodity-linked derivatives remained the sole form of

such products for almost three hundred years. The financial derivatives came

into spotlight in post-1970 period due to growing instability in the financial

markets. However, since their emergence, these products have become very

popular and by 1990s, they accounted for about two-thirds of total transactions in

derivative products. In recent years, the market for financial derivatives has

grown tremendously both in terms of variety of instruments available, their

complexity and also turnover. In the class of equity derivatives, futures and

options on stock indices have gained more popularity than on individual stocks,

especially among institutional investors, who are major users of index-linked

derivatives.

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

indices with various portfolios and ease of use. The lower costs associated with

index derivatives vis-vis derivative products based on individual securities is

another reason for their growing use.

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

I have chosen this topic.


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OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives

To know the role of derivatives trading in India.

To analyse the performance of Derivatives Trading since 2001with special

reference to Futures & Options


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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 in the recent years and also the

market in the derivatives in the recent years. This study extends to the trading

of derivatives done in the National Stock Markets.


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RESARCH METHODOLOGY

Method of data collection:-

Secondary sources:-

It is the data which has already been collected by some one or an

organization for some other purpose or research study .The data for study has

been collected from various sources:

Books

Journals

Magazines

Internet sources

Time:

2 months

Statistical Tools Used:

Simple tools like bar graphs, tabulation, line diagrams have been used.


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LIMITAITONS OF STUDY

1. LIMITED TIME:

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

topic had a limited time.

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 any thing about itwhether you trade through online or offline

4. ASPECTS COVERAGE:

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


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MAIN TOPICS OF STUDY

1. INTRODUCTION TO DERIVATIVE

The origin of derivatives can be traced back to the need of farmers to protectthemselves against fluctuations in the price of their crop. From the time it was

sown to the time it was ready for harvest, farmers would face price uncertainty.

Through the use of simple derivative products, it was possible for the farmer to

partially or fully transfer price risks by locking-in asset prices. These were simple

contracts developed to meet the needs of farmers and were basically a means of

reducing risk.

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

would receive for his harvest in September. In years of scarcity, he would

probably obtain attractive prices. However, during times of oversupply, he would

have to dispose off his harvest at a very low price. Clearly this meant that the

farmer and his family were exposed to a high risk of price uncertainty.

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

would face a price risk that of having to pay exorbitant prices during dearth,

although favourable prices could be obtained during periods of oversupply.

Under such circumstances, it clearly made sense for the farmer and the

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

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

negotiate happened to be futures-type contract, which would enable both parties

to eliminate the price risk.

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

farmers and merchants together. A group of traders got together and created the

to-arrive contract that permitted farmers to lock into price upfront and deliver the

grain later. These to-arrive contracts proved useful as a device for hedging and


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speculation on price charges. These were eventually standardized, and in 1925

the first futures clearing house came into existence.

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

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also

exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

2. DERIVATIVE DEFINED

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

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

be equity, forex, commodity or any other asset. In our earlier discussion, we saw

that wheat farmers may wish to sell their harvest at a future date to eliminate the

risk of change in price by that date. Such a transaction is an example of a

derivative. The price of this derivative is driven by the spot price of wheat which

is the underlying in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the Forward

Markets Commission (FMC) continues to have jurisdiction over commodity

futures contracts. However when derivatives trading in securities was introducedin 2001, the term security in the Securities Contracts (Regulation) Act, 1956

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

Consequently, regulation of derivatives came under the purview of Securities

Exchange Board of India (SEBI). We thus have separate regulatory authorities

for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of

derivatives is governed by the regulatory framework under the SCRA. The

Securities Contracts (Regulation) Act, 1956 defines derivative to include-

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

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

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

underlying securities.


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Derivatives

Future Option Forward Swaps

3. TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock National Commodity &Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Figure.2 Types of Derivatives


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(ii) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in the

future, at a pre-set price. The future date is called the delivery date or final

settlement date. The pre-set price is called the futures price. The price of the

underlying asset on the delivery date is called the settlement price. The

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

date.

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

which differs from an options contract, which gives the buyer the right, but not theobligation, and the option writer (seller) the obligation, but not the right. To exit

the commitment, the holder of a futures position has to sell his long position or

buy back his short position, effectively closing out the futures position and its

contract obligations. Futures contracts are exchange traded derivatives. The

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

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:

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

specifying:

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

short term interest rate.

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

y 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 the deposit over which the short term

interest rate is traded, etc.


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y The currency in which the futures contract is quoted.

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

can be delivered. In case of physical commodities, this specifies not only

the quality of the underlying goods but also the manner and location of

delivery. The delivery month.

y The last trading date.

y 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 the exchange, who always acts as counterparty. Tominimize this risk, the exchange demands that contract owners post a form of

collateral, commonly known as Margin requirements are waived or reduced in

some cases for hedgers who have physical ownership of the covered commodity

or spread traders who have offsetting contracts balancing the position.

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

contract, as determined by historical price changes, which is not likely to be

exceeded on a usual day's trading. It may be 5% or 10% of total contract price.

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

exhaust the initial margin, a further margin, usually called variation or

maintenance margin, is required by the exchange. This is calculated by the

futures contract, i.e. agreeing on a price at the end of each day, called the

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

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

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

to protect the exchange against loss. At the end of every trading day, the contract

is marked to its present market value. If the trader is on the winning side of a

deal, his contract has increased in value that day, and the exchange pays this

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


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

collateral from which the loss is paid.

3. Settlement

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

two ways, as specified per type of futures contract:

y Physical delivery - the amount specified of the underlying asset of the

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

exchange to the buyers of the contract. In practice, it occurs only on a

minority of contracts. Most are cancelled out by purchasing a covering

position - that is, buying a contract to cancel out an earlier sale (covering a

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

y Cash settlement - a cash payment is made based on the underlying

reference rate, such as a short term interest rate index such as Euribor, or

the closing value of a stock market index. A futures contract might also opt to

settle against an index based on trade in a related spot market.

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

equity index and interest rate futures contracts, this happens on the Last

Thursday of certain trading month. On this day the t+2 futures contract becomes

the t forward contract.

PRICING OF FUTURE CONTRACT

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

(the forward price) must be the same as the cost (including interest) of buying

and storing the asset. In other words, the rational forward price represents the

expected future value of the underlying discounted at the risk free rate. Thus, for

a simple, non-dividend paying asset, the value of the future/forward, , willbe found by discounting the present value at time to maturity by the rate

of risk-free return .


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

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

follows.

In the case where the forward price is higher:

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

(on the spot market) with borrowed money.

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

receives the agreed forward price.

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

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

In the case where the forward price is lower:

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

(on the spot market); he invests the proceeds.

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

appreciated at the risk free rate.

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

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

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


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TABLE 1-

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs ofthe needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

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

and Individual stock Futures in India.


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OPTIONS -

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

obligation to buy or sell the underlying asset at a price, called the strike price,

during a period or on a specific date in exchange for payment of a premium isknown as option. Underlying asset refers to any asset that is traded. The price

at which the underlying is traded is called the strike price.

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

CALL OPTION:

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

underlying asset-stock or any financial asset, at a specified price on or before a

specified date is known as a Call option. The owner makes a profit provided he

sells at a higher current price and buys at a lower future price.

PUT OPTION:

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

asset-stock or any financial asset, at a specified price on or before a specified

date is known as a Put option. The owner makes a profit provided he buys at a

lower current price and sells at a higher future price. Hence, no option will be

exercised if the future price does not increase.

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

preference shares, bonds and warrants become the subject of options.


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SWAPS -

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

exchange a series of cash flows at specified intervals known as payment or

settlement dates. They can be regarded as portfolios of forward's contracts. A

contract whereby two parties agree to exchange (swap) payments, based onsome notional principle amount is called as a SWAP. In case of swap, only the

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

used swaps are:

INTEREST RATE SWAPS:

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

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

rate interest payments. The fixed rate payer takes a short position in the forward

contract whereas the floating rate payer takes a long position in the forwardcontract.

CURRENCY SWAPS:

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

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

payments on loan in another currency. The parties to the swap contract of

currency generally hail from two different countries. This arrangement allows the

counter parties to borrow easily and cheaply in their home currencies. Under a

currency swap, cash flows to be exchanged are determined at the spot rate at atime when swap is done. Such cash flows are supposed to remain unaffected by

subsequent changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to

access one market and then exchange the liability for another type of liability. It

also allows the investors to exchange one type of asset for another type of asset

with a preferred income stream.

5. OTHER KINDS OF DERIVATIVES


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

BASKETS -

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

are most popular form of baskets.

LEAPS -

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

exchange may introduce option contracts with a maturity period of 2-3 years.These long-term option contracts are popularly known as Leaps or Long term

Equity Anticipation Securities.

WARRANTS -

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

options exchanges having a maximum maturity of nine months. Longer-datedoptions are called warrants and are generally traded over-the-counter.

SWAPTIONS -

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

expiry of the options. Thus a swaption is an option on a forward swap. Rather

than have calls and puts, the swaptions market has receiver swaptions and payer

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

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


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trading link between two exchanges, was formed between the Singapore

International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient Greece

and Rome. Options are very popular with speculators in the tulip craze of

seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol

of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers

and dealers traded in tulip bulb options. There was so much speculation that

people even mortgaged their homes and businesses. These speculators were

wiped out when the tulip craze collapsed in 1637 as there was no mechanism to

guarantee the performance of the option terms.

The first call and put options were invented by an American

financier, Russell Sage, in 1872. These options were traded over the counter.

Agricultural commodities options were traded in the nineteenth century in

England and the US. Options on shares were available in the US on the over the

counter (OTC) market only until 1973 without much knowledge of valuation. A

group of firms known as Put and Call brokers and Dealers Association was set

up in early 1900s to provide a mechanism for bringing buyers and sellers

together.

On April 26, 1973, the Chicago Board options Exchange

(CBOE) was set up at CBOT for the purpose of trading stock options. It was in

1973 again that black, Merton, and Scholes invented the famous Black-Scholes

Option Formula. This model helped in assessing the fair price of an option which

led to an increased interest in trading of options. With the options markets

becoming increasingly popular, the American Stock Exchange (AMEX) and the

Philadelphia Stock Exchange (PHLX) began trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and

nineties. The collapse of the Bretton Woods regime of fixed parties and the

introduction of floating rates for currencies in the international financial markets


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paved the way for development of a number of financial derivatives which served

as effective risk management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on

which futures contracts are traded. The CBOT now offers 48 futures and option

contracts (with the annual volume at more than 211 million in 2001).The CBOE is

the largest exchange for trading stock options. The CBOE trades options on the

S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the

premier exchange for trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones

Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the

Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago

Mercantile Exchange.


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12. INDIAN DERIVATIVES MARKET

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

prices fluctuate every day. The introduction of risk management instruments in

India gained momentum in the last few years due to liberalisation process andReserve Bank of Indias (RBI) efforts in creating currency forward market.

Derivatives are an integral part of liberalisation process to manage risk. NSE

gauging the market requirements initiated the process of setting up derivative

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

Table 2. Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade index futures.18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy

framework for index futures.

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

7 July 1999 RBI gave permission forOTC forward rate agreements

(FRAs) and interest rate swaps.

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

Indian index.

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

futures trading.

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

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives


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(1) Need for derivatives in India today

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

become the most important markets in the world. Today, derivatives have

become part and parcel of the day-to-day life for ordinary people in major part of

the world.

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

trading methods and was using traditional out-dated methods of trading. There

was a huge gap between the investors aspirations of the markets and the

available means of trading. The opening of Indian economy has precipitated the

process of integration of Indias financial markets with the international financial

markets. Introduction of risk management instruments in India has gained

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

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

large market.

(2) Myths and realities about derivatives

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

become the most important markets in the world. Financial derivatives came into

the spotlight along with the rise in uncertainty of post-1970, when US announced

an end to the Bretton Woods System of fixed exchange rates leading to

introduction of currency derivatives followed by other innovations including stock

index futures. Today, derivatives have become part and parcel of the day-to-day

life for ordinary people in major parts of the world. While this is true for many

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

There are many myths about derivatives but the realities that are different

especially for Exchange traded derivatives, which are well regulated with all the

safety mechanisms in place.

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

y Indian Market is not ready for derivative trading

y Disasters prove that derivatives are very risky and highly leveraged

instruments.


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y Derivatives are complex and exotic instruments that Indian investors will

find difficulty in understanding

y Is the existing capital market safer than Derivatives?

(i) Derivatives increase speculation and do not serve any

economicpurpose:

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

the private and public sectors that derivatives provide numerous and substantial

benefits to the users. Derivatives are a low-cost, effective method for users to

hedge and manage their exposures to interest rates, commodity prices or

exchange rates. The need for derivatives as hedging tool was felt first in the

commodities market. Agricultural futures and options helped farmers and

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

agreement, the financial markets in the world started undergoing radical

changes. This period is marked by remarkable innovations in the financial

markets such as introduction of floating rates for the currencies, increased

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

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

risk factors grew in gigantic proportions. This situation led to development

derivatives as effective risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities through

instruments like stock index futures and options. An equity fund, for example, can

reduce its exposure to the stock market quickly and at a relatively low cost

without selling off part of its equity assets by using stock index futures or index

options.

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

managing risks and raising capital, derivatives improve the allocation of credit

and the sharing of risk in the global economy, lowering the cost of capital


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formation and stimulating economic growth. Now that world markets for trade and

finance have become more integrated, derivatives have strengthened these

important linkages between global markets, increasing market liquidity and

efficiency and facilitating the flow of trade and finance

(ii) Indian Market is not ready for derivative trading

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

capital market is not ready for derivatives trading. Here, we look into the pre-

requisites, which are needed for the introduction of derivatives, and how Indian

market fares:

TABLE 3.

PRE-REQUISITES INDIAN SCENARIOLarge marketCapitalisation

India is one of the largest market-capitalisedcountries in Asia with a market capitalisation ofmore than Rs.765000 crores.

High Liquidity in theunderlying

The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which meanson an average every month 14% of the countrysMarket capitalisation gets traded. These are clearindicators of high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing tradeshas become fully functional from July 1996 in theform of National Securities Clearing Corporation(NSCCL). NSCCL is responsible for guaranteeingall open positions on the National Stock Exchange(NSE) for which it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL)which started functioning in the year 1997 hasrevolutionalised the security settlement in ourcountry.

A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital marketenjoys a strong, independent, and innovative legalguardian who is helping the market to evolve to ahealthier place for trade practices.


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(3) Comparison of New System with Existing System

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

and banning of Badla is disadvantageous and introduced early, but I feel that this

new system is very useful especially to retail investors. It increases the no of

options investors for investment. In fact it should have been introduced much

before and NSE had approved it but was not active because of politicization in

SEBI.

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

June 20001) v/s the old system i.e. before June 2001

New System Vs Existing System for Market Players

Figure 3.3a

Speculators

Existing SYSTEM New

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

Advantages

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


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Figure 3.3b

Arbitrageurs

Existing SYSTEM New

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

y Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Difficultto 1) No Leverage 1)Fix pricetodayto buy 1) Additional

offloadholding availablerisk latterby paying premium. costisonlyduringadverse rewarddependant 2)ForLong, buy ATM Put premium.

marketconditions onmarket prices Option. Ifmarketgoesup,ascircuitfilters long position benefitelse

limittocurtaillosses. exercisetheoption.

3)Selldeep OTM calloptionwithunderlyingshares,earnpremium + profitwithincrease prcie

Advantages

y Availability of Leverage


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Figure 3.3d

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) IfBullish buy 1) Plain Buy/Sell 1) Buy Call/Putoptions 1) Downsidestockselsesellit. impliesunlimited basedonmarketoutlook remains

profit/loss. 2) Hedge positionif protected &holdingunderlying upside

stock unlimited.

Advantagesy Losses Protected.


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4. Exchange-traded vs. OTC derivatives markets

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

few years, which has accompanied the modernization of commercial and

investment banking and globalisation of financial activities. The recent

developments in information technology have contributed to a great extent to

these developments. While both exchange-traded and OTC derivative contracts

offer many benefits, the former have rigid structures compared to the latter. It has

been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in

1998. These episodes of turbulence revealed the risks posed to market stability

originating in features ofOTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-

traded derivatives:

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

located within individual institutions,

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

margining,

3. There are no formal rules for risk and burden-sharing,4. There are no formal rules or mechanisms for ensuring market stability and

integrity, and for safeguarding the collective interests of market

participants, and

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

and the exchanges self-regulatory organization, although they are

affected indirectly by national legal systems, banking supervision and

market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.


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The following features ofOTC derivatives markets can give rise to instability in

institutions, markets, and the international financial system: (i) the dynamic

nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of

OTC derivative activities on available aggregate credit; (iv) the high concentration

ofOTC derivative activities in major institutions; and (v) the central role ofOTC

derivatives markets in the global financial system. Instability arises when shocks,

such as counter-party credit events and sharp movements in asset prices that

underlie derivative contracts, occur which significantly alter the perceptions of

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

the size and configuration of counter-party exposures can become unsustainably

large and provoke a rapid unwinding of positions.

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

However, the progress has been limited in implementing reforms in risk

management, including counter-party, liquidity and operational risks, and OTC

derivatives markets continue to pose a threat to international financial stability.

The problem is more acute as heavy reliance on OTC derivatives creates the

possibility of systemic financial events, which fall outside the more formal

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

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

inherent risks associated with OTC derivatives, and their dependence on

exchange traded derivatives, Indian law considers them illegal.


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5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

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

globalisation of the markets, technological developments and advances in the

financial theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects

having value maybe commodities, local currency or foreign currencies. The

concept of price is clear to almost everybody when we discuss commodities.

There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc.

the price one pays for use of a unit of another persons money is called interest

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

is called as an exchange rate.

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

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

of demand and supply in the market determines the price. These factors are

constantly interacting in the market causing changes in the price over a short

period of time. Such changes in the price are known as price volatility. This has

three factors: the speed of price changes, the frequency of price changes and the

magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The break down of the

BRETTON WOODS agreement brought and end to the stabilising role of fixed

exchange rates and the gold convertibility of the dollars. The globalisation of the

markets and rapid industrialisation of many underdeveloped countries brought a

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

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


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C.} TECHNOLOGICAL ADVANCES

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed

processors, network systems and enhanced method of data entry. Closely

related to advances in computer technology are advances in

telecommunications. Improvement in communications allow for instantaneous

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

were significant advances in software programmes without which computer and

telecommunication advances would be meaningless. These facilitated the more

rapid movement of information and consequently its instantaneous impact on

market price.

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

whole resources are rapidly relocated to more productive use and better rationed

overtime the greater price volatility exposes producers and consumers to greater

price risk. The effect of this risk can easily destroy a business which is otherwise

well managed. Derivatives can help a firm manage the price risk inherent in a

market economy. To the extent the technological developments increase

volatility, derivatives and risk management products become that much more

important.

D.} ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward contracts

in its traditional form, was the only hedging tool available. Option pricing models

developed by Black and Scholes in 1973 were used to determine prices of call

and put options. In late 1970s, work of Lewis Edeington extended the early work

ofJohnson and started the hedging of financial price risks with financial futures.

The work of economic theorists gave rise to new products for risk management

which led to the growth of derivatives in financial markets.

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

instruments


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13. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. 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 of

Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory

framework for derivatives trading in India. The committee submitted its report on

March 17, 1998 prescribing necessary preconditions for introduction of

derivatives trading in India. The committee recommended that derivatives should

be declared as securities so that regulatory framework applicable to trading of

securities could also govern trading of securities. SEBI also set up a group in

June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures

for risk containment in derivatives market in India. The report, which was

submitted 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 in December 1999 to include derivativeswithin the ambit of securities and the regulatory framework were developed for

governing derivatives trading. The act also made it clear that derivatives shall be

legal and valid only if such contracts are traded on a recognized stock exchange,

thus precluding OTC derivatives. The government also rescinded in March 2000,

the three decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final

approval to this 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 approved derivatives contracts. To begin

with, SEBI approved trading in index futures contracts based on S&P CNX Nifty

and BSE30 (Sense) index. This was followed by approval for trading in options

based on these two indexes and options on individual securities.


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The trading in BSE Sensex options commenced on June 4, 2001 and the trading

in options on individual securities commenced in July 2001. Futures contracts on

individual stocks were launched in November 2001. The derivatives trading on

NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The

trading in index options commenced on June 4, 2001 and trading in options on

individual securities commenced on July 2, 2001. Single stock futures were

launched on November 9, 2001. The index futures and options contract on NSE

are based on S&P CNX Trading and settlement in derivative contracts is done in

accordance with the rules, byelaws, and regulations of the respective exchanges

and their clearing house/corporation duly approved by SEBI and notified in the

official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all

Exchange traded derivative products.

The following are some observations based on the trading statistics provided in

the NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the

F&O segment. It constituted 70 per cent of the total turnover during June 2002. A

primary reason attributed to this phenomenon is that traders are comfortable with

single-stock futures than equity options, as the former closely resembles the

erstwhile badla system.

On relative terms, volumes in the index options segment continue to

remain poor. This may be due to the low volatility of the spot index. Typically,

options are considered more valuable when the volatility of the underlying (in this

case, the index) is high. A related issue is that brokers do not earn high

commissions by recommending index options to their clients, because low

volatility leads to higher waiting time for round-trips.


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Put volumes in the index options and equity options segment have

increased since January 2002. The call-put volumes in index options have

decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes

ratio suggests that the traders are increasingly becoming pessimistic on the

market.

Farther month futures contracts are still not actively traded. Trading in

equity options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as

a less risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. If calls and puts are not looked as just substitutes for spot

trading, the intra-day stock price variations should not have a one-to-one impact

on the option premiums.

y The spot foreign exchange market remains the most important segment

but the derivative segment has also grown. In the derivative market foreign

exchange swaps account for the largest share of the total turnover ofderivatives in India followed by forwards and options. Significant

milestones in the development of derivatives market have been (i)

permission to banks to undertake cross currency derivative transactions

subject to certain conditions (1996) (ii) allowing corporates to undertake long

term foreign currency swaps that contributed to the development of the

term currency swap market (1997) (iii) allowing dollar rupee options (2003)

and (iv) introduction of currency futures (2008). I would like to emphasise

that currency swaps allowed companies with ECBs to swap their foreign

currency liabili ties into rupees. However, since banks could not carry open

positions the risk was allowed to be transferred to any other resident

corporate. Normally such risks should be taken by corporates who have

natural hedge or have potential foreign exchange earnings. But often


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corporate assume these risks due to interest rate differentials and views on

currencies.

This period has also witnessed several relaxations in regulations relating to

forex markets and also greater liberalisation in capital account regulations

leading to greater integration with the global economy.

y Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any underlying

need or exposure a n d on a leveraged basis on the recognized stock

exchanges with credit risks being assumed by the central counterparty

Since the commencement of trading of currency futures in all the three

exchanges, the value of the trades has gone up steadily from Rs 17, 429

crores in October 2008 to Rs 45, 803 crores in December 2008. The average

daily turnover in all the exchanges has also increased from Rs871 crores to

Rs 2,181 crores during the same period. The turnover in the currency

futures market is in line with the international scenario, where I understand

the share of futures market ranges between 2 3 per cent.

Table 4.1ForexMarketActivity

April05-

Mar06

April06-

Mar07

April07-

Mar08

April08-

Dec08Total turnover (USD billion) 4,404 6,571 12,304 9,621

Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1

Spot/Total Turnover (%) 50.5 51.9 49.7 45.9

Forward/Total Turnover (%) 19.0 17.9 19.3 21.5

Swap/Total Turnover (%) 30.5 30.1 31.1 32.7

Source: RBI


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14. BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot

market. For instance, consider an investor who owns an asset. He will always be

worried that the price may fall before he can sell the asset. He can protect

himself by selling a futures contract, or by buying a Put option. If the spot price

falls, the short hedgers will gain in the futures market, as you will see later. This

will help offset their losses in the spot market. Similarly, if the spot price falls

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

2.] PRICE DISCOVERY

Price discovery refers to the markets ability to determine true equilibrium prices.

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

help in disseminating such information. As we have seen, futures markets

provide a low cost trading mechanism. Thus information pertaining to supply and

demand easily percolates into such markets. Accurate prices are essential for

ensuring the correct allocation of resources in a free market economy. Options

markets provide information about the volatility or risk of the underlying asset.

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

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

significant price changes. However, futures markets tend to be more liquid than

spot markets, because herein you can take large positions by depositing

relatively small margins. Consequently, a large position in derivatives markets is

relatively easier to take and has less of a price impact as opposed to a

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

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


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4.] MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot, futures and

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

derivatives, it is possible to exploit arbitrage opportunities quickly and to keep

prices in alignment. Hence these markets help to ensure that prices reflect true

values.

5.] EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in

spot transactions. Also, the amount of capital required to take a comparable

position is less in this case. This is important because facilitation of speculation is

critical for ensuring free and fair markets. Speculators always take calculated

risks. A speculator will accept a level of risk only if he is convinced that the

associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

y

The prices of derivatives converge with the prices of the underlying at theexpiration of derivative contract. Thus derivatives help in discovery of

future as well as current prices.

y An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

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

Transfer of risk enables market participants to expand their volume of

activity.

15. National Exchanges


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In enhancing the institutional capabilities for futures trading the idea of

setting up of National Commodity Exchange(s) has been pursued since 1999.

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,

(NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX),

Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become

operational. National Status implies that these exchanges would be

automatically permitted to conduct futures trading in all commodities subject to

clearance of byelaws and contract specifications by the FMC. While the NMCE,

Ahmedabad commenced futures trading in November 2002, MCX and NCDEX,

Mumbai commenced operations in October/ December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised multi commodity exchange has permanent recognition from

Government of India for facilitating online trading, clearing and settlement

operations for commodity futures markets across the country. Key shareholders

of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank,

State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI

Life Insurance Co. Ltd., Union Bank of India, Bank of India, Bank ofBaroda, Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team

with deep domain knowledge of the commodity futures markets. Today MCX is

offering spectacular growth opportunities and advantages to a large cross section

of the participants including Producers / Processors, Traders, Corporate,

Regional Trading Canters, Importers, Exporters, Cooperatives, Industry

Associations, amongst others MCX being nation-wide commodity exchange,

offering multiple commodities for trading with wide reach and penetration and

robust infrastructure.


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MCX, having a permanent recognition from the Government of India, is

an independent and demutualised multi commodity Exchange. MCX, a state-of-

the-art nationwide, digital Exchange, facilitates online trading, clearing and

settlement operations for a commodities futures trading.

NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted

by Central Warehousing Corporation (CWC), National Agricultural Cooperative

Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation

Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National

Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).

While various integral aspects of commodity economy, viz., warehousing,

cooperatives, private and public sector marketing of agricultural commodities,

research and training were adequately addressed in structuring the Exchange,

finance was still a vital missing link. Punjab National Bank (PNB) took equity of

the Exchange to establish that linkage. Even today, NMCE is the only Exchange

in India to have such investment and technical support from the commodity

relevant institutions.

NMCE facilitates electronic derivatives trading through robust and testedtrading platform, Derivative Trading Settlement System (DTSS), provided by

CMC. It has robust delivery mechanism making it the most suitable for the

participants in the physical commodity markets. It has also established fair and

transparent rule-based procedures and demonstrated total commitment towards

eliminating any conflicts of interest. It is the only Commodity Exchange in the

world to have received ISO 9001:2000 certification from British Standard

Institutions (BSI). NMCE was the first commodity exchange to provide trading

facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The

contracts are marked to market on daily basis. The system of upfront margining

based on Value at Risk is followed to ensure financial security of the market. In


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the event of high volatility in the prices, special intra-day clearing and settlement

is held. NMCE was the first to initiate process of dematerialization and electronic

transfer of warehoused commodity stocks. The unique strength of NMCE is its

settlements via a Delivery Backed System, an imperative in the commodity

trading business. These deliveries are executed through a sound and reliable

Warehouse Receipt System, leading to guaranteed clearing and settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology

driven commodity exchange. It is a public limited company registered under the

Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai

on April 23,2003. It has an independent Board of Directors and professionals nothaving any vested interest in commodity markets. It has been launched to

provide a world-class commodity exchange platform for market participants to

trade in a wide spectrum of commodity derivatives driven by best global

practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures

trading in commodities. Besides, NCDEX is subjected to various laws of the land

like the Companies Act, Stamp Act, Contracts Act, Forward Commission

(Regulation) Act and various other legislations, which impinge on its working. It is

located in Mumbai and offers facilities to its members in more than 390 centres

throughout India. The reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm

Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking

bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard

Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,

Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow

Peas, Yellow Red Maize & Yellow Soybean Meal.


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TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN

INDIA WITH RESPECT TO THE VARIOUS EXCHANGES IN INDIA:-


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16. The Present Status:

Presently futures trading is permitted in all the commodities. Trading is

taking place in about 78 commodities through 25 Exchanges/Associations as

given in the table below:-

TABLE 4 Registered commodity exchanges in India

No. Exchange COMMODITY

1. India Pepper & Spice Trade

Association, Kochi (IPSTA)

Pepper (both domestic and

international contracts)

2. Vijai Beopar Chambers Ltd.,

Muzaffarnagar

Gur, Mustard seed

3. Rajdhani Oils & Oilseeds Exchange

Ltd., Delhi

Gur, Mustard seed its oil &

oilcake

4. Bhatinda Om & Oil Exchange Ltd.,

Bhatinda

Gur

5. The Chamber of Commerce, Hapur Gur, Potatoes and Mustard

seed

6. The Meerut Agro Commodities

Exchange Ltd., Meerut

Gur

7. The Bombay Commodity Exchange

Ltd., Mumbai

Oilseed Complex, Castor

oil international contracts

8. Rajkot Seeds, Oil & Bullion

Merchants Association, Rajkot

Castor seed, Groundnut,

its oil & cake, cottonseed,

its oil & cake, cotton

(kapas) and RBD

palmolein.

9. The Ahmedabad Commodity

Exchange, Ahmedabad

Castorseed, cottonseed, its

oil and oilcake

10. The East India Jute & Hessian

Exchange Ltd., Calcutta

Hessian & Sacking


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11. The East India Cotton Association

Ltd., Mumbai

Cotton

12. The Spices & Oilseeds Exchange

Ltd., Sangli.

Turmeric

13. National Board of Trade, Indore Soya seed, Soyaoil and

Soya meals,

Rapeseed/Mustardseed its

oil and oilcake and RBD

Palmolien

14. The First Commodities Exchange of

India Ltd., Kochi

Copra/coconut, its oil &

oilcake

15. Central India Commercial

Exchange Ltd., Gwalior

Gur and Mustard seed

16. E-sugar India Ltd., Mumbai Sugar

17. National Multi-Commodity

Exchange of India Ltd., Ahmedabad

Several Commodities

18. Coffee Futures Exchange India

Ltd., Bangalore

Coffee

19. Surendranagar Cotton Oil &

Oilseeds, Surendranagar

Cotton, Cottonseed, Kapas

20. E-Commodities Ltd., New Delhi Sugar (trading yet to

commence)

21. National Commodity & Derivatives,

Exchange Ltd., Mumbai

Several Commodities

22. Multi Commodity Exchange Ltd.,

Mumbai

Several Commodities

23. Bikaner commodity Exchange Ltd.,

Bikaner

Mustard seeds its oil &

oilcake, Gram. Guar seed.Guar Gum

24. Haryana Commodities Ltd., Hissar Mustard seed complex

25. Bullion Association Ltd., Jaipur Mustard seed Complex


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17. STATUS REPORT OF THE DEVELOPMENTS IN THE

DERIVATIVE MARKET

1. The Board at its meeting on November 29, 2002 had desired that a quarterly

report be submitted to the Board on the developments in the derivative market. Accordingly, this memorandum presents a status report for the quarterJuly-

September 2008-09 on the developments in the derivative market.

2. Equity Derivatives Segment

A. Observations on the quarterly data forJuly-September, 2008-09

During July-September 2008-09, the turnover at BSE was Rs.1,510 crore,

which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.

Refer Table 1

Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while

turnover increased by 24.77% to Rs. 3,317 thousand crore in July-

September 2008-09 over April-June 2008-09.

Futures (Index Future + Stock Future) constituted 67.20% of the total

number of contracts traded in the F&O Segment. Stock Future and Index

Future accounted for 35.26% and 31.94% respectively.

Options constituted 32.80% of the total volumes. This mainly

comprised of trading in IndexOption (30.68%).

Turnover at F&O segment was 4.19 times that of its cash segment.

Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India

and ICICI Bank Ltd were the most actively traded scrips in thederivatives segment. Together they contributed 25.12% of derivatives

turnover in individual stocks.

Client trading constituted 60.17%, Propriety trading constituted 31.07%

and FII trading constituted remaining 8.76% of the total turnover.


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Refer Table 2

Volume in longer dated derivative contracts (contracts with maturity of

more than three months and up to 3 years) was 3.99 lakh and total

turnover was Rs. 9870 crore.

Total volume in shorter dated derivative contracts (contracts with maturity

up to 3months) was 1,695 lakh and total turnover was Rs. 3,307 thousand

crore.

Refer Table 3

Volume in Mini Nifty (contracts with minimum lot size of Rs.1 lakh) was

44 lakh and total turnover was Rs. 37 thousand crore.

Refer Table 4

During July-September, 2008, S&P CNX Nifty futures recorded highest

average daily volatility of 2.85% in July 2008.

Refer Table 5

The volume (in terms of no. of contracts traded) of Nifty Future at

SGX as a percentage of the volume of Nifty Future at NSE was

8.55% during July- September 2008-09.

Refer Table 6

India stands 2nd in Stock Futures, 2nd in Index Futures, 16th in StockOption and

4th in Index Options (as on November 10, 2008) in World Derivatives

Market (in terms of volume) at the end of September 2008.

Derivative contracts were launched on 38 securities at National Stock

Exchange during July-September 2008-09.


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Table-5: Fact file of July-September 2008-09 with respect to the

previous quarter

MarketDepth

PRODUCT

APRIL-JUNE 2008-09 JULY-SEPTEMBER2008-09

No. ofContracts(Lakh)

Turnover(Rs. 000)

No. ofContracts(Lakh)

Turnover(Rs. 000)

VOLUME & TURNOVER

Index Future 415.7 935.6 542.6 1,077.5

Index Option 240.1 571.3 521.2

Documents

Project on derivaties