indian derivatives market

The Growth of Derivatives Market in India1

A C K N O W L E D G E M E N T

The success of any project is never limited to individual undertaking project;

it is a collective efforts of people around, that spell success. This

acknowledgement is humble attempt of earnestly thanking all those who

were directly or indirectly involved in this project.

I would like to extend my sincere, heartfelt gratitude to our Head of the

Department, Prof. Shruti Charvarkar and our internal guide Prof. Arun

under whose guidance I had the privilege of working and learning and whose

constant inspiration at all faces of the project lead to the successful

completion of my work.

Last but not the least I express my deepest regards to all staff members, for

helping me by giving me their time and providing all required facilities.


EXECUTIVE SUMMARY

Firstly I am briefing the current Indian market and comparing 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.

India’s 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 of January, 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 the Bombay 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

Capitalisation of the Sensex as on July 4th, 2009 was Rs 48.4 Lakh Crore with a

P/E of more than 20.


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

LIMITATIONS OF STUDY


1. LIMITED RESOURCES :

Limited resources are available to collect the information about the commodity

trading.

2. VOLATALITY :

Share market is so much volatile and it is difficult to forecast any thing about it

whether you trade through online or offline.

3. ASPECTS COVERAGE :

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

INDEXPage 1 /

2CHAPTER Topic Page


NO. From To1 Introduction To Derivatives ( 8 - 18 )

1.1 Meaning & Underlying Assets

9 - 9

1.2 History of Derivatives

10 - 12

1.3 Need of the Study

13 - 13

1.4 Literature Review

14 - 14

1.5 Objectives of the Study

15 - 15

1.6 Scope of the Project

16 - 16

1.7 Products

17 - 18

2 Derivatives Markets in India ( 20 - 22 )

2.1

Introduction 20 - 21

2.2

Definitions 21 - 21

2.3

Types 22 - 22

3 Contracts in Derivatives Markets in India ( 24 - 32 )

3.1

Forward Contracts 24 - 25

3.2

Future Contracts 25 - 29

3.3

Option Contracts 30 - 30

3.4

Swap Contracts 31 - 31

3.5

Other Types of Contracts 32 - 32

4 Growth & Development of Derivatives Market

( 34 - 43 ) in India

4.1

Indian Derivatives Market 34 - 34

4.2

Needs for Derivative Markets in India Today 35 - 35


4.3

Myths & Realities of Derivatives 36 - 43

INDEX Page 2 / 2

CHAPTERTopic

Page

NO. From To5 Factors Contributing to the Growth

( 45 - 51 )

& Development of Derivatives Market in India

5.1

Price Volatility 45 - 46

5.2

Globalisation of Markets 46 - 46

5.3

Technological Advances 46 - 47

5.4

Advances in Finanacial Theory 47 - 47

5.5

Development of Derivatives Market 47 - 51

6Benefits, Types of National Exchanges &

Reports( 53 - 60 )

of Developments in Derivative Markets in

India

6.1

Risk Management 53 - 53

6.2

Price Discovery 53 - 53

6.3

Operational Advantages 53 - 54

6.4

Market Efficiency 54 - 54

6.5

Ease of Speculations 54 - 54

6.6

Types of National Exchanges 55 - 59

6.7

Reports of Developments 60 - 60


7 Case Study on IL&FS Investsmart 62 - 67 8 Findings & Conclusions 69 - 70 9 Recommendations & Suggestions 72 - 72

Ώ Bibliography 73 - 73

Ώ Abbrevations 73 - 75

CHAPTER 1

Introduction to Derivatives

1.1 Meaning & Underlying Assets

1.2 History of Derivatives

1.3 Need of the Study

1.4 Literature Review

1.5 Objectives of the Study

1.6 Scope of the Project

1.7 Products


INTRODUCTION TO DERIVATIVES

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.


1.1 MEANING & UNDERLYING ASSETS

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

in the field of finance, the most desired instruments that allow market participants to

manage risk in the modern securities trading are known as Derivatives. The Derivatives

are defined as “the future contracts whose value depends upon the underlying assets ”.

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.

1.2 HISTORY OF DERIVATIVES :

The history of derivatives is quite colourful and surprisingly a lot longer than most

people think. Forward delivery contracts, stating what is to be delivered for a fixed price

at a specified place on a specified date, existed in ancient Greece and Rome. Roman

emperors entered forward contracts to provide the masses with their supply of Egyptian

grain. These contracts were also undertaken between farmers and merchants to

eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts

have existed for centuries for hedging price risk.

The first organized commodity exchange came into existence in the early 1700’s in

Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT),

was formed in 1848 in the US to deal with the problem of ‘credit risk’ and to provide

centralised location to negotiate forward contracts. From ‘forward’ trading in

commodities emerged the commodity ‘futures’. The first type of futures contract was

called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT

listed the first ‘exchange traded’ derivatives contract, known as the futures contracts.

Futures trading grew out of the need for hedging the price risk involved in many

commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT,

was formed in 1919, though it did exist before in 1874 under the names of ‘Chicago

Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first

financial futures to emerge were the currency in 1972 in the US. The first foreign

currency futures were traded on May 16, 1972, on International Monetary Market (IMM),

a division of CME. The currency futures traded on the IMM are the British Pound, the


Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian

Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures.

Interest rate futures contracts were traded for the first time on the CBOT on October 20,

1975. Stock index futures and options emerged in 1982. The first stock index futures

contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of

the several networks, which offered a 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 Dealer’s

Association was set up in early 1900’s 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 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.


1.3 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.


1.4 LITERATURE REVIEW

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

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

guard themselves against uncertainties arising out of fluctuations in asset prices. By

their very nature, the financial markets are marked by a very high degree of volatility.

Through the use of derivative products, it is possible to partially or fully transfer price

risks by locking-in asset prices. As instruments of risk management, these generally do

not influence the fluctuations in the underlying asset prices. However, by locking-in

asset prices, derivative products minimize the impact of fluctuations in asset prices on

the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in

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

products for almost three hundred years. The financial derivatives came into spotlight in

post-1970 period due to growing instability in the financial markets. However, since their

emergence, these products have become very popular and by 1990s, they accounted

for about two-thirds of total transactions in derivative products. In recent years, the

market for financial derivatives has grown tremendously both in terms of variety of

instruments available, their complexity and also turnover. In the class of equity

derivatives, futures and options on stock indices have gained more popularity than on

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

linked derivatives.

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

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

vis-vis derivative products based on individual securities is another reason for their

growing use.

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

this topic .

1.5 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 2001 with special

reference to Futures & Options

1.6 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.

1.7 PRODUCTS


There are various derivative products traded. They are;

1.7.1 Forwards

1.7.2 Futures

1.7.3 Options

1.7.4 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 Contract confers 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 to fulfill the


contract and is paid a price for 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 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 of high risk.

So, SEBI should take necessary steps for improvement in Derivative Market so that

more investors can invest in Derivative market.


CHAPTER 2

Derivatives Markets in India

2.1 Introduction

2.2 Definitions

2.3 Types

DERIVATIVE MARKET IN INDIA

2.1 INTRODUCTION

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

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

the time it was ready for harvest, farmers would face price uncertainty. Through the use

of simple derivative products, it was possible for the farmer to partially or fully transfer

price risks by locking-in asset prices. These were simple contracts developed to meet

the needs of farmers and were basically a means of reducing risk.


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

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

prices. However, during times of oversupply, he would have to dispose off his harvest at

a very low price. Clearly this meant that the farmer and his family were exposed to a

high risk of price uncertainty.

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

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

prices could be obtained during periods of oversupply. Under such circumstances, it

clearly made sense for the farmer and the merchant to come together and enter into

contract whereby the price of the grain to be delivered in September could be decided

earlier. What they would then negotiate happened to be Futures-Type Contract, which

would enable both parties to eliminate the price risk.

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

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

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

arrive contracts proved useful as a device for hedging and speculation on price charges.

These were eventually standardized, and in 1925 the first futures clearing house came

into existence.

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

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

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

2.2 DEFINITION OF DERIVATIVE

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

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

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

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


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

of this derivative is driven by the spot price of wheat which is the “underlying” in this

case.

The Forwards Contracts (Regulation) Act, 1952, regulates the Forward / Futures

Contracts in commodities all over India. As per this the Forward Markets Commission

(FMC) continues to have jurisdiction over commodity Futures Contracts. However when

Derivatives Trading in securities was introduced in 2001, the term “Security” in the

Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative

contracts in securities. Consequently, regulation of derivatives came under the purview

of Securities Exchange Board of India (SEBI). We thus have separate Regulatory

Authorities for Securities and Commodity Derivative Markets.

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

governed by the regulatory framework under the SCRA. The Securities Contracts

(Regulation) Act, 1956 defines “Derivative” to include -

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

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

derives its value from the prices, or index of prices, of underlying securities.

2.3 TYPES OF DERIVATIVES MARKET

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


CHAPTER 3

Contracts in Derivatives Markets in India

3.1 Forward Contracts

3.2 Future Contracts

3.3 Option Contracts

3.4 Swap Contracts

3.5 Other Types of Contracts

3.1 FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a

specified price. One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specified future date for a certain

specified price. The other party assumes a short position and agrees to sell the

asset on the same date for the same price. Other contract details like delivery

date, price and quantity are negotiated bilaterally by the parties to the contract.

The forward contracts are n o r m a l l y traded outside the exchanges.


BASIC FEATURES OF FORWARD CONTRACT

• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• On the expiration date, the contract has to be settled by delivery of the

asset.

• If the party wishes to reverse the contract, it has to compulsorily go to the same

counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market. Forward contracts

are often confused with futures contracts. The confusion is primarily because both

serve essentially the same economic funct ions of allocating risk in the presence

of future price uncertainty. However futures are a significant improvement over

the forward contracts as they eliminate counterparty risk and offer more

liquidity.

3.2 FUTURE CONTRACT

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

to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set

price. The future date is called the delivery date or final settlement date. The pre-set

price is called the futures price. The price of the underlying asset on the delivery date is

called the settlement price. The settlement price, normally, converges towards the

futures price on the delivery date.

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

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


and the option writer (seller) the obligation, but not the right. To exit the commitment,

the holder of a futures position has to sell his long position or buy back his short

position, effectively closing out the futures position and its contract obligations. Futures

contracts are exchange traded derivatives. The exchange acts as counterparty on all

contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization :

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

specifying:

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

term interest rate.

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

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

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

currency, the notional amount of the deposit over which the short term interest

rate is traded, etc.

The currency in which the futures contract is quoted.

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

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

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

month.

The last trading date.

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

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

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

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

exchange demands that contract owners post a form of collateral, commonly known as


Margin requirements are waived or reduced in some cases for hedgers who have

physical ownership of the covered commodity or spread traders who have offsetting

contracts balancing the position.

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

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

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

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

initial margin, a further margin, usually called variation or maintenance margin, is

required by the exchange. This is calculated by the futures contract, i.e. agreeing on a

price at the end of each day, called the "settlement" or mark-to-market price of the

contract.

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

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

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

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

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

account. On the other hand, if he is on the losing side, the exchange will debit his

account. If he cannot pay, then the margin is used as the collateral from which the loss

is paid.

3. Settlement :Settlement is the act of consummating the contract, and can be done in one of two

ways, as specified per type of futures contract:

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

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

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

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

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

purchase (covering a long).


Cash Settlement - a cash payment is made based on the underlying reference

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

a stock market 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.

3.2.1 PRICING OF FUTURE CONTRACTIn a futures contract, for no arbitrage to be possible, the price paid on delivery (the

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

the asset. In other words, the rational forward price represents the expected future

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

paying asset, the value of the future/forward, , will be found by discounting the

present value at time to maturity by the rate of risk-free return .

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

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

In the case where the forward price is higher :

1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money.

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

3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower :

1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds.


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

3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.]

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

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.


Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs of

the needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

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

and Individual stock Futures in India.


3.3 OPTIONS -

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

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

specific date in exchange for payment of a premium is known as ‘option’. Underlying

asset refers to any asset that is traded. The price at which the underlying is traded is

called the ‘strike price’.

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

CALL OPTION:

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

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

known as a ‘Call option’. The owner makes a profit provided he sells at a higher current

price and buys at a lower future price.

PUT OPTION:

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

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

as a ‘Put option’. The owner makes a profit provided he buys at a lower current price

and sells at a higher future price. Hence, no option will be exercised if the future price

does not increase.

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

shares, bonds and warrants become the subject of options.


3.4 SWAPS -

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

INTEREST RATE SWAPS :

Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS :

Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.

FINANCIAL SWAP :

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


3.5 OTHER KINDS OF DERIVATIVES

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

BASKETS -

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

most popular form of baskets.

LEAPS -

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

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

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

WARRANTS -

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

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

warrants and are generally traded over-the-counter.

SWAPTIONS -

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

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

and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver

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

pay fixed and receive floating.


CHAPTER 4

Growth & Development of Derivatives Markets in India

4.1 Indian Derivatives Market

4.2 Need for Derivatives in India Today

4.3 Myths & Realities of Derivatives

GROWTH & DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

4.1 INDIAN DERIVATIVES MARKET


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

every day. The introduction of risk management instruments in India gained momentum in the

last few years due to liberalisation process and Reserve Bank of India’s (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

Chronology of instruments

1991 Liberalisation process initiated

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

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

framework for index futures.

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

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

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

Indian index.

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

futures trading.

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

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

4.2 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 India’s

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 India’s efforts in allowing forward contracts, cross currency options etc.

which have developed into a very large market.

4.3 Myths and Realities about Derivatives

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

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

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

Bretton Woods System of fixed exchange rates leading to introduction of currency

derivatives followed by other innovations including stock index futures. Today,


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

major parts of the world. While this is true for many countries, there are still

apprehensions about the introduction of derivatives. There are many myths about

derivatives but the realities that are different especially for Exchange traded derivatives,

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

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

Indian Market is not ready for derivative trading

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

Derivatives are complex and exotic instruments that Indian investors will find

difficulty in understanding

Is the existing capital market safer than Derivatives?

4.3.1 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 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

4.3.2 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


4.3.3 Comparison of New System with Existing System

PRE-REQUISITES INDIAN SCENARIOLarge market Capitalisation

India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores.

High Liquidity in the underlying

The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all 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 has revolutionalised the security settlement in our country.

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


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

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) 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 premium hold till expiry.

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

Arbitrageurs


Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) 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 settlement forward transactions. 2) Cash &Carry 2) If Future Contract arbitrage continuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages Availability of Leverage

Small Investors


Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains profit/loss. 2) Hedge position if protected & holding underlying upside stock unlimited.Advantages Losses Protected.


4.3.4 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 of OTC derivative instruments and

markets.

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

derivatives:

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

individual institutions,

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

margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and

integrity, and for safeguarding the collective interests of market participants, and

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

exchange’s self-regulatory organization, although they are affected indirectly by

national legal systems, banking supervision and market surveillance.

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

stability.

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

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

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


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

activities in major institutions; and (v) the central role of OTC derivatives markets in the

global financial system. Instability arises when shocks, such as counter-party credit

events and sharp movements in asset prices that underlie derivative contracts, occur

which significantly alter the perceptions of current and potential future credit exposures.

When asset prices change rapidly, the size and 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.


CHAPTER 5

Factors Contributing to the Growth & Development of

Derivatives Markets in India

5.1 Price Volatility

5.2 Globalisation of Markets

5.3 Technological Advances

5.4 Advances in Financial Theories

5.5 Development of Derivative

Markets

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.


5.1 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 one’s 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-Asian currency crisis of 1990’s has also brought the price volatility

factor on the surface. The advent of telecommunication and data processing bought

information very quickly to the markets. Information which would have taken months to

impact the market earlier can now be obtained in matter of moments.

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

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

increasingly as these instruments can be used as hedge to protect against adverse

price changes in commodity, foreign exchange, equity shares and bonds.


5.2 GLOBALISATION OF MARKETS –

Earlier, managers had to deal with domestic economic concerns; what happened in

other part of the world was mostly irrelevant. Now globalisation has increased the size

of markets and as greatly enhanced competition .it has benefited consumers who

cannot obtain better quality goods at a lower cost. It has also exposed the modern

business to significant risks and, in many cases, led to cut profit margins

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

competitiveness of our products vis-à-vis depreciated currencies. Export of certain

goods from India declined because of this crisis. Steel industry in 1998 suffered its

worst set back due to cheap import of steel from south East Asian countries. Suddenly

blue chip companies had turned in to red. The fear of china devaluing its currency

created instability in Indian exports. Thus, it is evident that globalisation of industrial and

financial activities necessitates use of derivatives to guard against future losses. This

factor alone has contributed to the growth of derivatives to a significant extent.

5.3 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.

5.4 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 1970’s, work of Lewis Edeington extended the early work of Johnson and started

the hedging of financial price risks with financial futures. The work of economic theorists

gave rise to new products for risk management which led to the growth of derivatives in

financial markets.

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

instruments

5.5 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 24–member

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 pre–conditions 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 real–time monitoring

requirements. The Securities Contract Regulation Act (SCRA) was amended in

December 1999 to include derivatives within 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 BSE–30 (Sense) index.

This was followed by approval for trading in options 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 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.

• 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.

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 of derivatives 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

liabilities 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 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.

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.

Forex Market Activity


April’05-

Mar’06

April’06-

Mar’07

April’07-

Mar’08

April’08-

Dec’08Total 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


CHAPTER 6

Benefits , Types of National Exchanges & Reports of

Developments in Derivatives Markets in India

6.1 Risk Management

6.2 Price Discovery

6.3 Operational Advantages

6.4 Market Efficiency

6.5 Ease of Speculations

6.6 Types of National Exchanges

6.7 Reports of Developments

BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways :

6.1 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.

6.2 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.

6.3 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.

6.4 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.

6.5 EASE OF SPECULATION –


Derivative markets provide speculators with a cheaper alternative to engaging in spot

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

in this case. This is important because facilitation of speculation is critical for ensuring

free and fair markets. Speculators always take calculated risks. A speculator will accept

a level of risk only if he is convinced that the associated expected return is

commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

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

expiration of derivative contract. Thus derivatives help in discovery of future as

well as current prices.

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

a catalyst for new entrepreneurial activity.

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

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

6.6 Types of National Exchanges

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.

6.6.1 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 of Baroda, Canara 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.

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.

6.6.2 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 tested trading

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 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.

6.6.3 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 not having 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.

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:-

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

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

6.7 REPORT OF THE D E V E LO P M ENTS IN THE D E RIVATIVE 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 quarter July - September

2008-09 on the developments in the derivative market.

2. Equity Derivatives Segment

Observations on the quarterly data for July-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.


CHAPTER 7

CASE STUDY

http://www.investsmartindia.com/


COMPANY PROFILE

A Brief about IL&FS Investsmart Limited :

IL&FS Investsmart Limited (IIL) is one of India’s 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 preffered financial to a wide base of customer whilst optimizing

Stake holder value.

Mission To establish a base of 1 million satisfied customer by the end of 2011

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.


Institutional Business

IIL’s 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

Retail Business

Retail offerings of IIL seek to cover all financial planning requirements of

individuals, which includes providing Personalised Investment Management

Services including planning, advisory, execution and monitoring of the full

range of investment services. Broadly the retail services are divided into two

broad categories.

Advisory Services :

Portfolio Management Services, Mutual Funds, Insurance.

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 platform www.investsmartonline.com

http://www.investsmartonline.com/



high degree of compliance with Stock Exchange Regulations and Ethical Business

Standards back IIL’s 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, IIL’s

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.

Promoters

IL&FS Investsmart Limited (IIL) is one of India’s 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 world’s 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 Group’s operations worldwide.


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; so

that 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.

Smart ChartTools to plot Profitable Investments

Our Charting Tools

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

Smart Alert

Smart Exposure

Increase your Market Exposure

Smart CallConvenience to trade over the phone

Smart SecureState-of-the-art Security Platforms

Limit Against Shares

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

Phone Trading Services

Call & Trade is a service offered by Investsmart online for its customers, which provides customers with a facility to trade over the phone.State-of-the-Art Security Platforms

At IL&FS Investsmart, we place a very high onus on security and realize that it is one of the vital components of any e-business venture. Our online products are developed on state-of-the-art security platforms.

Sell Receivable Shares

SRS is a facility offered by Investsmart online wherein the customer will be able to sell the shares that he has purchased even before he receives the delivery of the shares from the Exchange. He will not have to wait till the time he receives the delivery from the Exchange thus increasing his liquidity.

Smart NextSell Receivable Shares

Smart Alert Service

Smart Alert Services

Whether you are day trader or a serious investor,we will deliver stock information (Short term and Long term calls) to your cell phone daily.


CHAPTER 8

Findings & Conclusions

FINDINGS & CONCLUSION

From the above analysis it can be concluded that:

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

Derivative Market is increasing year by year in the India’s largest stock exchange

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

contracts. But whereas the turnover is declined considerably. In the case of stock

future there was a slow increase observed in the number of contracts whereas a

decline was also observed in its turnover. In the case of index option there was a

huge increase observed both in the number of contracts and turnover.


2. After analyzing data it is clear that the main factors that are driving the growth of

Derivative Market are Market improvement in communication facilities as well as

long term saving & investment is also possible through entering into Derivative

Contract. So these factors encourage the Derivative Market in India.

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

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

entrepreneurship. Derivative Market is more regulated & standardized so in this

way it provides a more controlled environment. In nutshell, we can say that the

rule of High risk & High return apply in Derivatives. If we are able to take more

risk then we can earn more profit under Derivatives.

Commodity derivatives have a crucial role to play in the price risk management process

for the commodities in which it deals. And it can be extremely beneficial in agriculture-

dominated economy, like India, as the commodity market also involves agricultural

produce. Derivatives like forwards, futures, options, swaps etc are extensively used in

the country. However, the commodity derivatives have been utilized in a very limited

scale. Only forwards and futures trading are permitted in certain commodity items.

RELIANCE is the most active future contracts on individual securities traded with 90090

contracts and RNRL is the next most active futures contracts with 63522 contracts

being traded.


CHAPTER 9

Recommendations & Suggestions

RECOMMENDATIONS & SUGGESTIONS

RBI should play a greater role in supporting derivatives.

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

derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.


After study it is clear that Derivative influence our Indian Economy up to much

extent. So, SEBI should take necessary steps for improvement in Derivative

Market so that more investors can invest in Derivative market.

There is a need of more innovation in Derivative Market because in today

scenario even educated people also fear for investing in Derivative Market

Because of high risk involved in Derivatives.


BIBLIOGRAPHY

Books Referred:

Options Futures, and other Derivatives by John C Hull

Derivatives FAQ by Ajay Shah

NSE’s Certification in Financial Markets: - Derivatives Core module

Financial Markets & Services by Gordon & Natarajan

Reports:

Report of the RBI-SEBI standard technical committee on exchange traded

Currency Futures

Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.ncdex.com

www.google.com

www.derivativesindia.com

http://www.derivativesindia.com/

http://www.google.com/

http://www.ncdex.com/

http://www.sebi.gov.in/

http://www.bseindia.com/

http://www.nse-india.com/


ABBREVATIONS

A

AMEX- America Stock Exchange

B

BSE- Bombay Stock Exchange

BSI- British Standard Institute

C

CBOE - Chicago Board options Exchange

CBOT - Chicago Board of Trade

CEBB - Chicago Egg and Butter Board

CME - Chicago Mercantile Exchange

CNX- Crisil Nse 50 Index

CPE - Chicago Produce Exchange

CWC- Central Warehousing Corporation

D

DTSS- Derivative Trading Settlement System

F

FIIs- Foreign Institutional Investors

F & O – Future and Options

FMC- Forward Markets Commission

FRAs- Forward Rate Agreements

G

GAICL-Gujarat Agro Industries Corporation Limited

GSAMB- Gujarat State Agricultural Marketing Board

I

IMM - International Monetary Market

IPSTA- India Pepper & Spice Trade Association


M

MCX – Multi Commodity Exchange

N

NAFED-National Agricultural Co-Operative Marketing Federation Of India

NCDEX – National Commodities and Derivatives Exchange

NIAM- National Institute Of Agricultural Marketing

NMSE- National Multi Commodity Exchange

NOL- Neptune Overseas Limited

NSCCL- National Securities Clearing Corporation

NSDL- National Securities Depositories Limited

NSE - National Stock Exchange

O

OTC- Over The Counter

P

PHLX - Philadelphia Stock Exchange

PNB- Punjab National Bank

R

RBI- Reserve Bank Of India

S

SC(R) A - Securities Contracts (Regulation) Act, 1956

SEBI- Securities Exchange Board Of India

SGX- Singapore Stock Exchange

SIMEX - Singapore International Monetary Exchange

V

VPN- Virtual Private Network

indian derivatives market

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