RESEARCH PROJECT REPORT

ON TRENDS AND FUTURE OF DERIVATIVES IN INDIA

Submitted in partial fulfillment of the requirement for the award of Degree of Master of Business Administration From Gautam BuddhTechnical University, Lucknow

Submitted by

SURENDRA KUMAR SHUKLA

Roll no: 1112470148 MBA (Batch 2011-13), 4th Semester

Under the guidance of

Dr. NAMITA SRIVASTAVA

Associate Professor ICCMRT

INSTITUTE OF CO-OPERATIVE & CORPORATE MANAGEMENT, RESEARCH AND TRAINING

21/467, RING ROAD, INDIRA NAGAR, LUCKNOW-226016

Phone: 2716431, 2716092 Fax: (0522) 2716092 esy iccmrt@satyam.net.in osclkbV www.iccmrt.ac.in

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CERTIFICATE
This is to certify that SURENDRA KUMAR SHUKLA, a student of Master of Business Administration (MBA) Programme (batch 2011-13) at this institute has conducted a research project titled TRENDS AND FUTURE OF DERIVATIVES IN INDIA. under my guidance during the 4th semester. The report has been prepared towards partial fulfillment for the award of MBA degree from Gautam Buddh Technical University. The research project report is the original contribution of the student. The research project report is hereby recommended and forwarded for evaluation.

Dr. NAMITA SRIVASTAVA Associate Professor ICCMRT

DECLARATION

I, SURENDRA KUMAR SHUKLA, a student of Master of Business Administration (MBA) Programme from the Institute of Co- operative & Corporate Management Research and Training, Lucknow hereby declare that all the information, facts and figures used in this research project titled TRENDS AND FUTURE OF DERIVATIVES IN INDIA. have been collected by me. I also declare that this project report has been prepared by me and the same has never been submitted by the undersigned either in part or in full to any other University or Institute or published earlier. This information is true to the best of my knowledge and belief.

Date:

(SURENDRA KUMAR SHUKLA) Semester IV Roll No: 1112470148 ICCMRT

ACKNOWLEDGEMENT

Perseverance, inspiration and motivation have always played a key role in the success of any venture, but one ingredient which is also very important than other and at times, more important that other is corporation and guidance of experts and experienced person. A successful and satisfactory completion of any research is the outcome of the invaluable aggregate contribution of different persons fully in radical direction, explicitly or implicitly. Whereas vast, varied and valuable reading efforts leads to substantial acquisition of knowledge through books and allied informational sources. True expertise excludes from collateral practical works and experiences. Words have never seemed as inadequate as now, when we are endeavoring to express our heartfelt gratitude at the culmination of the research, to all those made it possible. Even the best effort is waste without proper guidance and advice. I highly solicit to Dr. Namita Srivastava (Associate Professor) ICCMRT for her unreserved cooperation, encouragement and sincere advice throughout the research. At the outset I would like to thanks Prof. Ajay Prakash (Principal) ICCMRT for his valuable advice and guidance during my research completion. Last, but not the least, I would like to express my faith in the Almighty, who has given me strength at every phase of life to stand and excel.

PREFACE
MBA is a stepping-stone to the management carrier and to develop good manager it is necessary that the theoretical must be supplemented with exposure to the real environment. Theoretical knowledge just provides the base and its not sufficient to produce a good manager thats why practical knowledge is needed. Therefore the research product is an essential requirement for the student of MBA. This research project not only helps the student to utilize his skills properly learn field realities but also provides a chance to the organization to find out talent among the budding managers in the very beginning. In accordance with the requirement of MBA course I have prepare research report on the topic Trends and future of Derivatives in India. The main objective of the research study is to study the various trends that come in the way of Derivatives market and to find out the future and market potential of derivative market in India. For conducting the research project sample size of 60 customers, brokers, dealers and investors were selected. The information regarding the project research was collected through the questionnaire formed by me which was filled by customers, brokers, dealers and investors there. In my research report, I have studied various trends that come in the way of Derivatives market. Because impression is usually given that losses arose from derivatives are extremely complex and difficult to understand financial strategies. So after interviewing with different brokers, investors and dealers, I have tried to give a solution to these complexities

TABLE OF CONTENT
PAGE NO.

1. CERTIFICATES 2. DECLARATION 3. ACKNOWLEDGEMENT 4. PREFACE 5. CHAPTER 1 INTRODUCTION 6. CHAPTER 2 REVIEW OF LITERATURE 7. CHAPTER 3 OBJECTIVE & RESEARCH METHODOLOGY 8. CHAPTER 4 DATA ANALYSIS 9. CHAPTER 5 FINDINGS & RECOMMENDATION 10.CONCLUSION 11. ANNEXURE QUESTIONNAIRE 74-81 69-73 64-68 1 (I) (II) (III)

82-84 85-86 89-90

Chapter 1
Introduction

INTRODUCTION TO THE STOCK EXCHANGE

A stock exchange is the place where securities, shares, debentures and bonds of joint stock companies, central & state govt., semi govt. organizations, local bodies and foreign govt. are bought and sold. A stock exchange is the nerve center of capital market. Changes in the capital market are brought about by a complex set of factors, all operating on the market simultaneously. Such changes are subject to secular trends set by the economic progress of the nation, and governed by the factors like general economic situation, financial and monetary policies, tax changes, political environment, international economic and financial development etc. A stock exchange provides necessary mobility to capital and directs the flow of capital into profitable and successful enterprises.

The Securities Contract (Regulation) Act 1956 defines stock exchange as:
A body of individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling, & dealing in securities. A stock exchange is a platform for the trade of already issued securities through primary market. It is the essential pillar of the private sector and corporate economy. It is the open auction market where buyers and sellers meet and involve a competitive price for the securities. It reflects hopes aspiration and fears of people regarding the performance of the economy. It exerts a powerful and significant influence as a depressant or stimulant of business activity. So, stock exchange mobilizes savings, canalizes them as securities into those enterprises which are favored by the investors on the basis of such criteria as - Future growth prospects. - Good returns. - Appreciation of capital. \

The stock exchange serves the role of barometer, not only of the state of health of individual companies, but also of the nations economy as a whole (it measures of all the pull and pressure of securities in the market). The trade in market is through the authorized members who have duly registered with concerned stock exchange and SEBI.

HISTORY OF STOCK EXCHANGE

The trading of securities in India was started in early 1973. The only stock exchange operating in the 19th century were those of Bombay set up in 1875 and in Ahemdabad set up in 1894. These were organized as voluntary non-profit making associations of brokers to regulate and protect their interests. Before the control on securities trading became a central subject under the constitution in 1950. It was a state subject and Bombay securities contract (control) act of 1925 used to regulate trading in securities. Under this act, Bombay stock exchange was recognized in 1927 and Ahemdabad stock exchange were organized at Bombay, Ahemdabad and other centers but they were not recognized soon after it became a central subject, central legislation was proposed and a committee headed by sh. A.D.GORWALA went into bill for security regulation. On the basis securities contract act became law in 1956. At present there were 23 recognized stock exchanges in India. From these BSE & NSE are the two major stock exchanges and rest 21 are the regional stock exchanges. Daily turnover of all the stock exchange is app. 20,000cr. BSE is 129 years old. NSE is 11 years old and it brought the screen based trading system in India

FEATURES OF THE STOCK EXCHANGE

It is a place where listed securities are bought and sold. It is an association of persons known as members. Trading in securities is allowed under rules and regulations of stock exchange. Membership is must for transacting business. Investors and speculators, who want to buy and sell securities, can do so through members of stock exchange i.e. brokers. There are mainly three participants in stock exchange i.e. Issuer of security (company). Investor of security (Individual, HUF). Intermediaries and products (broker, merchant bankers and shares, bonds, warrants, derivatives products etc.). It is the market as well as source for the capital. Corporate and govt. raise resource from the market.

FUTURE PLANS OF STOCK EXCHANGE

The current market scenario in the capital market is not very encouraging, however, in the future; the business model of Indian Stock Exchange would be the most preferred method of accessing multiple markets with low cost and high credibility of an Exchange. Indian Stock Exchange is considering several value added services or new products which may help ISE and ISS in fulfilling the demands of low cost users. We are considering derivative segment through NSE and DP services initially for the participants and later for clients through CDSL and NSDL. This futuristic concept of consolidation being pursued by ISE is now being also explored by the Developed Countries. We think such consolidation enables optimal utilization of existing resources, enhanced due to economies of scale and permit product innovation, a

sign o any dynamic market. On account of this philosophy we are proposing to implement most of the new products centrally on ISE, like, Internet trading, IPO segment, Distribution of mutual funds units, Information dissemination, etc. We are also planning to provide trading support to the commodities Exchanges and also consider providing hem entry into the securities industries. The creation of a national market has provided the brokers of the RSEs and individual investors in the regions and opportunity approach the liquid national level market. This market is expected to provide liquidity in small capital companies as the other National Level markets have a higher entry norm and may not cater to this market.

FUNCTIONS OF STOCK EXCHANGE

Stock Exchange Performs The Following Functions: The stock exchange provides appropriate conditions where by purchase and sale of securities takes place at reasonable and fair prices. People having surplus funds invest in the securities and these funds used for industrialization and economic development of country that leads to capital formation. The stock exchange provides a ready market for the conversion of existing securities into cash and vice-versa. The stock exchange acts as the center of providing business information relating to enterprise whose securities are traded as the listed companies are to present their financial and other statements to it. Stock exchange protects the interest of the investors through strict enforcement of rules and regulations with respect to dealings. Punishments (including fine, suspension or even expulsion of membership) may be there if broker make any malpractice in dealing with investors like charging high commissions etc. Stock exchange acts as the barometer of the country as it measures all the pulls and pressures of the securities in the market. The stock exchange provides the linkage between the savings in the household sector and the investment in corporate economy.

STOCK EXCHANGES OF INDIA

Name of Stock Exchange Year of Establishme nt
1. 2. 3. 4. 5. 6. 7. The Stock Exchange Mumbai Ahmedabad Stock Exchange Calcutta Stock Exchange Madhya Pradesh Stock Exchange Madras Stock Exchange Ltd. Hyderabad Stock Exchange Ltd. Delhi Stock Exchange Association 1875 1897 1908 1930 1937 1943 1947 1957 1978 1982 1982 1983 1984 1986 1983 1989 1989 1990 1994 Voluntary Non profit org. Voluntary Non profit org. Public ltd. Company Voluntary Non profit org. Company ltd. By guarantee Company ltd. By guarantee Public ltd. Company Pvt. Converted into public ltd. Company Public ltd. Company Public ltd. Company Company ltd. By guarantee Public ltd. Company Public ltd. Company Company ltd. By guarantee Public ltd. Company Company ltd. By guarantee Company ltd. By guarantee N.D N.D N.D N.D N.D N.D

Type of Organization

Ltd. 8. Bangalore Stock Exchange 9. Cochin Stock Exchange 10. U.P. Stock Exchange Ltd. 11. Pune Stock Exchange Ltd. 12. Ludhiana Stock Exchange 13. Guwahati Stock Exchange 14. Magadh Stock Exchange Ass. (Patna) 15. Jaipur Stock Exchange Ltd. 16. Bhubaneshwar Stock Exchange 17. SaurashtraKutch Stock Exchange Ltd. 18. Vadodara Stock Exchange Ltd. 19. National Stock Exchange of India

Ltd. 20. Coimbatore Stock Exchange Ltd. 1996 21. OTC Stock Exchange of India 22. Mangalore Stock Exchange Ltd. 23. Interconnected Stock Exchange (ICSE)

WHO BENEFITS FROM STOCK EXCHANGE

1. 2.

Investors: - It provides them liquidity, marketability, safety etc. of invstments. Company: - It provides them access to market funds, higher rating and public
interest.

3. 4.

Brokers: - They receive commission in lieu of services to investors. Economy and Country: - There is large flow of saving, better growth more
industries and higher income.

INTRODUCTION OF DERIVATIVES
Primary market is used for raising money and secondary market is used for trading in the securities, which have been used in primary market. But derivative market is quite different from other markets as the market is used for minimizing risk arising from underlying assets. The word "derivative" originates from mathematics. It refers to a variable, which has been derived from another variable. i.e. X = f (Y) WHERE X (dependent variable) = DERIVATIVE PRODUCT Y (independent variable) = UNDERLYING ASSET A financial derivative is a product that derives value from the market of another product. Hence derivative market has no independent existence without an underlying asset. The price of the derivative instrument is contingent on the value of underlying assets. As a tool of risk management we can define it as, "a financial contract whose value is derived from the value of an underlying asset/derivative security". All derivatives are based on some cash product. The underlying assets can be: a. Any type of agriculture product of grain (not prevailing in India)

b. c. d. e.

Price of precious and metals gold Foreign exchange rates Short term as well as long-term bond of securities of different type issued by govt. and companies etc. O.T.C. money instruments for example loan & deposits.

Example: Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. The price of these derivatives is driven from spot price of wheat.

DEFINITION OF DERIVATIVEIn the Indian context the Securities contracts (Regulation), Act 1956 defines "Derivative" to include: (1) A security derived from a debt instrument, Share, Loan whether secured or unsecured, Risk instrument or contract for difference or any other form of security. A contract, which derives its value from the prices of underlying securities.

HISTORICAL ASPECT OF DERIVATIVES:

The need for derivatives as hedging tool was first felt in the commodities market. Agricultural FUTURE & OPTIONS helped farmers and PROCESSORS hedge against commodity price risk. After the fallout of BRITAIN WOOD AGREEMENT, the financial markets in the world started undergoing radical changes, which give rise to the risk factor. This situation led to development of derivatives as effective "Risk Management tools". Derivative trading in financial market started in 1972 when "Chicago Mercantile Exchange opened its International Monetary Market Division (IIM). The IMM provided an outlet for currency speculators and for those looking to reduce their currency risks. Trading took place on currency. Futures, which were contracts for specified quantities of given currencies, the exchange rate was fixed at time of contract later on commodity future contracts was introduced then followed by interest rate futures. Looking at the liquidity market, derivatives allow corporate and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund e.g. can reduce its exposure to the stock market and

at a relatively low cost without selling of part of its equity assets by using stock index futures or index options. Therefore the stock index futures first emerged in U.S.A. in 1982.

PRODUCTS, PARTICIPANTS AND FUNCTIONSDerivative contracts have several variants. The most common are FORWADS, FUTURES, and OPTIONS AND SWAPS. The following three categories of Participants-Hedgers, Speculators, and Arbitrageurs.

(1) HEDGER:Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce the risk. Thus, they are operation who wants to eliminate the risk composing of their portfolio. (2) SPECULATORS: They wish to be on future movements in the price of an asset. A speculator may buy securities in anticipation of rise in price. If this expectation comes true he sells the securities at a higher price and makes a profit. Usually the speculator does not take delivery of securities sold by him. He only receives and pays the difference between the purchase and sale prices. (3) ARBITRAGEURS: They are in business to take advantage of discrepancy between prices in two different markets. If for example, they see the future price of an asset getting out of line with the cash price, they will take off setting positions in two markets to lock in profit.

TYPES OF DERIVATIVES

The most commonly used derivative contract is forwards, futures and options:

(1) FORWARDS:A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the futures at today's preagreed price.

(2) FUTURES:A future contract is an agreement between two parties to buy or sell an asset at a certain time the future at the certain price. Futures contracts are the special types of forward contracts in the sense that are standardized exchange traded contracts.

(3) OPTIONS:It is of two types: call and put options. Underlying asset, at a given price on or before a given future date. PUTS give the buyer the right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

(4) 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.

(5) BASKETS:
Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets. (6) SWAPS: These are private agreements between two parties to exchange cash flows in the future according to a prearrange formula. They can be regarded as portfolios of forward's contracts. The two commonly used swaps are:

a) INTEREST RATE SWAPS:

These entail swapping both Principal and interest between the parties, with the cash flow in one direction being in a different currency than those in the opposite direction.

b) CURRENCY SWAPS:
These entail swapping both Principal and interest between the parties, with the cash flow in one direction being in a different currency than those in the opposite direction.

Cash Vs Derivative Market

The basis differences between these two may be noted as follows. a) In cash market tangible asset are traded whereas in derivatives market contract based on tangible assets or intangible like index or rates are traded. b) The value of derivative contract is always based on and linked to the underlying asset. Though, this linkage may not be on point-to point basis. c) Cash market contracts are settled by delivery and payment or through an offsetting contract. The derivative contracts on tangible may be settled through payment and delivery, offsetting contract or cash settlement, whereas derivative contracts on intangibles are necessarily settled in cash or through offsetting contracts. d) The cash market always has a net long position, whereas the net position in derivative market is always zero. e) Cash asset may be meant for consumption or investment. Derivatives are used for hedging, arbitration or speculation. f) Derivative markets are highly leveraged and therefore could be much more risky.

THE DERIVATIVE MARKETS PERFORM A NUMBER OF ECONOMIC FUNCTIONS:(1) Prices in organized derivative markets reflect the perception of market participants about the future and lead the prices of underlying to perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well current prices. (2) The derivative market helps to transfer the risks from those who have them but may like them those who have an appetite for them. (3) Derivatives due to their inherent nature are linked to the underlying cash markets. With the introduction of derivative, the underlying market, witness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. (4) Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new business, new products and new employment opportunities, the benefits of which are immense. (5) Derivatives market helps increase savings and investments in the long run Transfer of risk enables market participants to expand their volume of activities.

PARTICIPANTS IN DERIVATIVE MARKET

Exchange, trading members, clearing members. Hedgers, arbitrageurs, speculators. Clearing, clearing bank. Financial institutions. Stock lenders and borrowers.

OBJECTIVES OF DERIVATE TRADING

(1) HEDGING:
You own a stock and you are confident about the prospects of the company. However at the same time you feel that overall market may not perform as good and therefore price of your stock may also fall in line with overall marked trend. You expect that some adverse economic or political event might affect the market sentiments, though fundamentals of the company will remain good, therefore, it is good to retain the stock. In both these situations you would like to insure your portfolio against any such market fall. Such insurance is known as hedging. Hedging is a tool to reduce the inherent risk in an investment. Various strategies designed to reduce investment risk using call option, put options, short selling, and futures are used for hedging. The basic purpose of a hedge is to reduce the risk of loss.

(2) ARBITRAGE:
The future price of an underlying asset is function of spot price and cost of carry adjusted for any return on investment. However, due to uncertainty about interest rates, distortions in spot prices, or uncertainty about future income stream, prices in futures market may not truly reflect the expected spot price in future. This imbalance in future and spot price gives rise to arbitrage opportunities. Transactions made to take advantage of temporary distortions in the market are known as arbitrage transactions.

(3) SPECULATION:
You may have very strong opinion about the future market price of a particular asset based on past trends, current information and future expectation. Likewise you may also have an opinion about the overall market trend. To take advantage of such opinion, individual asset or the entire market (index) could be sold or purchased. Position taken either in cash market of derivative market on the basis of personal opinion is known as speculation.

DERIVATIVE TERMINOLOGY
ASSIGNMENT:
It means allocation of an option contract, which is exercised, to a short position in the same opinion contract, at the same strike price, for fulfillment of the obligation, in accordance with the procedure specified in by the relevant authority from time to time.

BADLA:
It is an indigenous mechanism of postponing the settlement of trade. This product is peculiar to India markets. This involves Badla financiers, stock lenders and stock traders. The long buyers and short sellers may postpone settlement of their trade by making payments and giving delivery by using the services of Badla financiers and stock lenders who assume their positions for Badla charges. Counterparty risk, unpredictable charges and high risk due to inadequate margining are inherent limitations of Badla.

BASIS:
It is difference between spot price and future price of the same asset. In normal markets this basis is always negative, i.e. spot price is always less than future price. A positive basis provides for arbitrage opportunity.

BETA
It is a measure of the sensitivity of returns on scrip to return on the market index. It shows how the price of scrip would move with every percentage point change in the market index.

CONTRACT VALUE-

It is the value arrived at by multiplying the strike price of the

option contract with the regular/market lot size.

EXERCISE:

It is defined as the number of future or option contracts required be buying or selling per unit of the spot underlying position to completely hedge against the market risk of the underlying.

MARGIN:
It is the money collected from parties to trade to insure against the default risk. Some amount of margins is collected upfront and some are collected shortly after the trade. Failure to pay margins may result in mandatory closure of position.

OFFSETTING CONTRACT:
New matching contract, which offsets an existing contract, is known as offsetting contract.

OPTION PREMIUM:
It is consideration paid by the option buyer to option writer. The premium has two components intrinsic value and time value. Intrinsic value is the difference between the spot price of the underlying and exercise price of the contract. Time value represents the cost of carrying the underlying for the option period, adjusted for any dividend and option premium.

RISK TRANSFER:
It refers to hedging against the price risk through futures. The holder of an asset, which he intender to sell in near future, may transfer the inherent risk by selling futures today. The counterparty assumes the risk in anticipation of making gain

REASON FOR STARTING DERIVATIVES

2

1. Counter party risk on the part of broker, in case it asks money from us but before giving
delivery of shares goes bankrupt. 2. Liquidity risk in the form that the particular scrip might not be traded on exchange. 3. Unsystematic risk in the form that the price of scrip may go up or down due to Company Specific Reasons. 4. Mutual funds may find it difficult to invest the funds raised by them properly as the scrip in which they want to invert might not be available at the right price. 6. Systematic risk in the form that the price of scrip may go up or affecting the sentiment of whole market. down due to reason

THE REQUIREMENTS FOR SETTING UP FUTURE AND OPTION TRADING IS OUTLINED BELOW:1. Creation of an Options Clearing Corporation (OCC) as the single guarantor of every traded option. In case of default by a party to a contract, the clearing house has to bear the cost necessary to carry out the contract. 2. Creation of a strong cash market (secondary market). This is because after the exercise of an option contract, the investors move to the secondary market to book profits. 3. Creation of paper-less trading and a book-entry transfer system. 4. Careful selection of the securities may be listed on a National securities exchange, have a wider capital base, be actively traded, and so on. 5. Uniformity of rules and regulation in all the stock exchanges. 6. Standardization of the terms governing the options contracts. This would decrease the transaction costs, for a given underlying security, all contracts on the options exchange should have an expiry date, a strike price, and a contract price, only the premium should be negotiated on the floor of the exchange. 7. Large, financially sound institutions, members and a number of market makers, who can write the options contracts. Strict capital adequacy norms to be laid out and followed.

STRENGTH OF INDIAN CAPITAL MARKET FOR INTRODUCTION OF DERIVATIVES

1. LARGE MARKET CAPITALIZATION:
India is one of the largest market capitalized country in Asia with a market capitalization of more than 7,65,000 corers.

2. HIGH LIQUIDITY:
In the underlying securities the daily average traded volume in Indian capital market today is around 7,500 crores. Which means on an average every month 14% of the country market capitalization gets traded, shows high liquidity.

3. TRADER GUARANTEE:
The first "clearing corporation" (CCL) guaranteeing trades has become fully functional from July 1996 in the form of NATIONAL SECURITIES CLEARING CORPORATION Ltd. for which it does the clearing.

4. STRONG DEPOSITORY:
A strong depository National Securities Depositories Ltd.(NSDL), which started functioning in the year 1997, has strengthen the securities settlement in our country. 5. A GOOD LEGAL GUARDIAN: SEBI is acting as a good legal guardian for Indian Capital market.

IMPORTANCE OF DERIVATIVE TRADING

1. Reduction of borrowing cost. 2. Enhancing the yield on assets. 3. Modifying the payment structure of assets to correspond to investor market view. 4. No physical delivery of share certificate so reduction in cost by stamp duty. 5. Increase in hedger, speculator and arbitrageurs. 6. It does not totally eliminate speculation, which is basic need of Indian investors.

INSTRUMENTS OF DERIVATIVE TRADING:-

FORWARD Derivative FUTURE OPTION SWAPS

FORWARD CONTRACT:-

"It is an agreement to buy/sell an asset on a certain future date at an agreed price". The two parties are: Who takes a long position agreeing to buy Who takes a short positionagreeing to sell The mutually agreed price is known as "delivery price" or "forward price". The delivery price is chosen in such a way that the value of contract for both parties is zero at the time of entering the contract, but the contract takes a positive or negative value for parties as the price of underlying asset moves. It removes the future price risk. If a speculator has information or analysis, which forecast an upturn in price, and then be can go long on the forward market instead of cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculator may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of assets underlying the forward contract.

EFFECT OF CHANGE IN PRICE:

As mentioned above the value of such a contract in zero for both the parties. But later as the price & the underlying asset changes, it gives positive or negative value for contract. PRICE & UNDERLYING ASSETS INCREASE DECREASE HOLDER POSITION POSITIVE & LONG HOLDER POSITION VALUE NEGATIVE POSITIVE VALUE & SHORT VALUE

NEGATIVE VALUE

E.g.

A agrees to deliver 100 equity shares of Reliance to B on Sept. 30, 2002 at a Rate of Rs. 120 per share. Now if the price of share on that date is Rs. 140 per share, than a who has short position would stand to loss of Rs. (20*200) = 4000, long position would gain the same amount or vise versa if price quoted is less than delivery price. Profit/Loss = ST-E ST = spot price on maturity date E = delivery price

LIMITATIONS OF FORWARD CONTRACT:1. No standardization. 2. One party can breach its obligation. 3. Lack of centralization of trading. 4. Lack of liquidity. To overcome this other type of derivation instrument known as "Future Contracts" were introduced.

VALUATION OF FORWARD CONTRACTThe forward contract can be put under three categories for the purpose & valuation:

VALUATION OF THOSE SECURITIES PROVIDING NO INCOMEShares, which neither expects to do not pay any, dividend in future nor having arbitrage opportunities. E.g. Here Price (F) = S0e rt Where F = Future Price S0 = spot price of asset R = risk free rate of interest p.a. with continuous compounding T = time of maturity. If F>S0ert

In this case the investor will buy asset and take a short position in the forward contract. "Short position is not position of investor is of seller means contract sold is greater then contract bought". Investor may buy the assets, borrowing an amount equal to * * for "t" period at risk free rate. At the time of maturity, the assets will be delivered for price F and repayment will be equal to S0ert and there is net profit equal to F- S0ert If F< S0ert He will long his position in forward contract. When contract matures: the assets would be purchased for "F" Here profit is S0ert F E.g. Consider a forward contract were non-dividend shares available at Rs, 70 mature in 3 months, Risk free rate 8% p.a. compounded continuously. S0ert = 70 x [e] 0.25x0.08 = 70 x 0202 = Rs. 71.41 If F = 73 Then an arbitrageur will short a contract, borrow an amount of Rs. 70 & buy share at Rs, Repay the loan of Rs. 70. At maturity sell it as Rs. 73 (forward contract price) and 71.40, thus profit is (73- 71.40) 1.60 Thus he shorts his forward contract position.

SECURITIES PROVIDING A CERTAIN CASH INCOMEIf there is certain cash income to be generated on securities in future to the investor, we will determine present value of income e.g. in case of preference share. Present Value of Dividend = Rate & Interest (continuously compounded) ~If there is no arbitrage Then F = (So I) ert ~If F> (So I)ert Arbitrageur can short a forward contract, borrow money and buy the asset at present and at maturity asset is sold and earns profit. Profit = F (So I) ert If F <(So-I) ert Arbitrageur can long a forward contract, short the asset a present and invest the proceeding Profit (at maturity) E.g. Let us consider a 6-month forward contract on 100 shares at Rs. 38 each risk free of interest (compounding continuously) earn is 10% p.a. dividend is expected to a yield of Rs. 1.50 in 4 months. Solution: divided receivable after 4 months = 100x1.50=Rs.1.50 = resent Value & dividend = Rs 50x0.9672=RS 145.88 (3800-145.8) e(0.5)(0.10) = 3654.92x1.05127 F = 3842.31 = 150xe (4/12)(0.10)50 (So-I) ert F

VALUATION & FORWARD CONTRACT PROVIDING A KNOWN YIELD:In case of share included in portfolio companies the index, as underlying assets, are expected to give dividend in course of time, which may be percentage 0 their prices. It is assumed to be paid continuously at a rate of "Y" p.a. F = Soert E.g. Stock underlying an under provide a, dividend yield of 4.1% p.a., current value of index is 520 and risk free rate of interest is 10% p.a. r=0.10, y = 0.04, * * = 520 T =3/12 =0.25 F = 520xe(0.10-0.40) (0.25) = 520x01512 = Rs. 527.85

FUTURE CONTRACT
'It is an agreement between buyer and seller for the purchase and sale of a particular assets at a specific future date; specific size, date of delivery, place and alternative asset. It takes obligation on both parties to fulfill the contract.

FEATURES OF FUTURE CONTRACT:1. Standardized contracts e.g. contract size. 2. Between two parties who do not necessarily know each other. 3. Guarantee for performance by a clearing corporation or clearing house. Clearinghouse is associated with matching, processing, registering, confirming setting, reconciling and guaranteeing the trades on the future exchanges. Clearinghouse tries to eliminate risk of default by either party. 4. It has some features of Badla also.

FUTURE TERMINOLOGY

SPOT PRICE:
The price at which an asset trades in the spot market.

FUTURES PRICE:
The price at which the futures contract trades in the futures market.

CONTRACT CYCLE:
The period over which the contract trades. The index futures contracts on the NSE have one month, and three-month expiry Cycles, which expires on the last Thursday of the month? Thus a January expiration contract expires on the last Thursday of the January. On the Friday following the last Thursday, a new contract having three-month expiry is introduced of trading.

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

CONTRACT SIZE:
The amount of asset that has to be delivered less than one contract. For instance, the contract size on NSE's futures market is Nifties.

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

COST OF CARRY:
The relation between futures price and spot price can be summarized in terms of what is known as cost of carry. This measures the storage cost plus the interest that is paid to finance the assets less the incomes earned on the asset.

INITIAL MARGIN:
The amount that must be deposited in the margin account at a time a future contract is first entered into is known as initial margin.

MARKING-TO-MARKET:
In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's margin gain or loss depending upon the future's closing price.

MAINTENANCE MARGIN:
This is somewhat lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance amount falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

INSTRUMENTS OF FUTURE CONTRACTS

COMMODITY FUTURES1. Trader in American Exchanges like CBOT, New York: Commodity Exchange, Chicago Mercantile Exchange (CLEARING MEMBERSE), New York Mercantile Exchange Includes: Wheat, Natural Gas, Platinum, Gold, and Cattle etc. 2. Contract Life: Mostly for 90 days or less. 3. Maturity date is mostly non-standardized. 4. Quality specified

FINANCIAL FUTURES
1. Introduced by IMM (a division of CLEARING MEMBERSE) It Includes: 10 or 5 year treasury notes (in 1976 by I:M:M), S & P 5000, Nikkie 225, Euro Dollars, British Pound, Canadian Dollars, Mini Value line Stock Index, Russell 2000, Russell 3000, etc. 2. Mostly Longer time e.g. US Treasury Bond Futures are of even more than 2 years 3. Maturity date is standardized. 4. There cannot be any quality variations into these assets.

TYPE OF FUTURE CONTRACTS:

INDEX FUTURES & STOCK FUTURES

INDEX FUTURES:
Of the financial futures, Index future contracts are key contracts, introduced in U.S. A, in 1982 by the "Commodity Futures Trading Commission" (CFTC) by approving the Kansas Board proposal. Index Futures began trading in India in June 2000 of Trade (KSBT)'s Futures derive its value from the underlying index-e.g. NSE's futures. Contracts are based on "S & P CNX NIFTY" At present it has become the most liquid contract in the country, the arbitrage between the futures equity market is further expected to reduce impact cost. 80-90% of retail participation is expected in India because. 1. Brokerage cost is lower. 2. Savings in cost is possible thorough reduced bid-ask spreads where stocks are trade in package forms.

3. Impact cost will be much lower than dealing in individual scrip. 4. Institutional and large equity holders need portfolios hedging facility. Index derivatives are more suited to them and more cost effective than in individual stocks. Pension funds in the US are known-to use stock index futures for risk hedging purpose. 5. Stock Index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. 6. Stock index, being an average is much less volatile than individual stock prices. This implies lower capital adequacy and margin requirements. 7. Index derivatives are cash settled, and hence don't suffer from settlement delays and problems related to bad delivery & forged certificates.

INDIVIDUAL STOCK FUTURES

The high level committee on capital market on 2001 decided to permit FII's to participate in "Individual Stock Futures" trading e.g. in Reliance SEBI Frame guidelines for its trading stock futures can be effectively used for hedging: speculation and arbitrage At present there are 31 scrips in which stock derivatives are trading. E.g. the Reliance stock traders at Rs. 1000 and the two month futures trade at 1006. Assume that the minimum contract value is Rs. 1,00,000. He buys 100 Individual stock futures for which he buys a margin of Rs. 20,000. 2 months later the stock closes at Rs. 010. OR expiration date, he makes a profit of Rs. 400 on an investment of Rs. 20,000 works out annual return of 12%.

VALUATION OF FUTURES CONTRACTS

It can be made possible on following basis: 1. Valuation of financial futures 2. Valuation of commodity futures I. II. Carry type commodities Non-Carry type commodities

VALUATION OF FINANCIAL FUTURES:

Valuation of financial futures is based on following assumptions 1. The markets are perfect. 2. There is no transaction cost. 3. All the assets are infinitely divisible. 4. Bid-asks spreads do not exit so that it is assumed that only one price prevails.There is no restriction on short selling. Also short selling gets to use the full proceeds of the sales valuations. This includes stock index futures. The value of futures contract on a stock index may be obtained by using the "cost of carry model". In this case Price of the contract is = spot price+ Carry cost-carry returns i.e. (s + C R)

Here: SPOT PRICE: Current Price of One Unit of Deliverable asset in the Market. CARRY COST: Holding cost i.e. interest Charges etc. + opportunity cost of using
funds.

CARRY RETURNS: Dividends etc.

Valuation of Stock Index futures is F = S0e(r-y) t

COMMODITY FUTURE'S VALUATION

1) CARRY TYPE OR INVESTRADING MEMBERSENT PURPOSE
These types of commodities are held by significant number. Of investor for futures safety as investment alone. ~If storage cost is zero then F = Soert ~If any storage cost or opportunity cost then it is regarded as negative income. If S is the present value. of all the storage costs that may be incurred during the life of a future contract then F = (So + s)ert ~If the storage cost were proportional to price of commodity then would be the same as in case of Providing a negative yield. If S represents the storage costs p.a. proportion of spot prices, we have F = Soe(r+s) t E.g. Let us consider a 6 months gold futures contract of 100 gm.

COMMODITIES VALUATION-

Assume that the spot price is Rs. 480 per gram and that it cost Rs. 3 per gram for the 6 monthly period to store gold and that the cost is incurred at the end of the period. If the risk free rate of Interest is 12% p.a. compounded continuously then R=0.12, s=480 x 100= 48000, e = 6/12 = 0.5 S=3 x 100 e-(0.12 x 0.5) = Rs. 282.53 Then F (48000 282.53)e-0.12 = Rs. 54,438.40

2)

NON CARRY TYPE COMMODITITES:

Consumable goods like agricultural product's

futures price will not exceed the sum of spot price + Caring Cost-Caring Returns, in these arbitrage arguments doesn't work investor stores these on because of its consumption value

only not for investment. Valuation of non-carry commodity futures requires another concept. i.e. "Convenience return" or "Convenience yield", which is the returns (in terms of money) that the investor realizes for carrying commodity over his short term needs. The financial assets have no convenience return. This is different or different investor. F= (So +s) e (r-c) t S= P.V. C=convenience cost So=Spot price

PAY OFF FOR FUTURES: (a) Payoff for buyers of futures contract-long futures
Its payoff is same as payoff of a person who holds assets. Result of holding an asset may be unlimited upside or unlimited downside. Profit 1220 Nifty (underlying) Assets Loss

INTERPRETATIONThe figure shows P/L for a long futures position. The investor bought futures when THE INDEX WAS AT 1220. If Index If Index His futures position shows profits His futures position shows losses

(b) Payoff for seller of futures contract-short futuresIt can be explained by taking an example: A speculator who sells a 2 months Nifty Index futures contracts when the nifty stands at 1220 (Nifty an underlying assets) Profit Nifty (underlying assets)

Loss

INTERPRETATION:
When Index moves Seller start making Profits.

When index movers. Seller starts making Loss.

FORWARD VS. FUTURES

Features -Operational
Mechanism -Contract Specifications -Counter party Risks -Liquidity -Price Discovery -Example -Settlement Not Efficient Currency Market At end of period

Forward
Traded between two parties Differ from traded to trade exists such risk Low

Future
Trade on Exchange Standardized contracts No such risk High Highly Efficient Future Market daily

COBOT WHEAT FUTURES CONTRACT SPECIFICATIONS

Trading Unit Deliverable Grades 5000 Bushels No. 1 Northern Spring wheat at par and No. 2 Soft. Red, No. 2 Hard Red Winter, No. 2 Dark Northern Spring and substitution at different established by the exchange. Cents and quarter-cents bushel ($12.50 per Price Quotation Tick Size Daily Price Limit contract.) One-quarter cent per bushel ($12.50 per contract) 20 cent per bushel ($1000 per contract) above or below the previous day's settlement price (expandable to 30 cent per bushel) No limit in the spot month (limit are lifted two business day before the spot month begins.) March, May, July, September and December. Starts in July and ends in May Seventh business day preceding the last Contract Months Contract Year Last Trading day business day of the delivery month. Last business day of the delivery month 9.30 to 1.15 p.m (Chicago time!, Monday through Friday, Only the last trading day of an expiring contract, trading that contract closes in noon. Last Delivery Day Trading Hours W

Ticker Symbol

OPTIONS
Options are fundamentally different from forward and futures. An option gives the holder/buyers of the option the right to do something. The holder does not have committed himself to doing something. In contrast, in a forward or futures contract, the two parties have committed them self to doing something. Whereas it nothing (expect margin requirement) to enter in to a futures he purchases of an option require an up front payment.

HISTORICAL BACKGROUND OF OPTION:

Although options have exercised for a long time, they were traded OTD, without much knowledge of valuation. Today exchange-traded options are actively traded on stocks, stock indices, foreign currencies and futures contracts.

The first trading is options began in Europe and U.S. as early as the century. It was only in early, 1900s that a group of firms set up what is known as the "put and call brokers and dealers association" with the aim of providing a mechanism for bringing buyers and sellers together. It someone wanted to buy an option, he or she would contract one of the member firms. The firm would then attempt to find a seller or writer of option either from its own client of those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return of price. The two deficiencies in above markets were 1. 2. No secondary market No mechanism to guarantee the writer of option would honor it

In 1973, Black, Marton, Scholes invented the Black-Scholes formula. In April 1973, CBOE was set up specially for the purpose of trading options. The market for options develop so rapidly that by early 80's number of share underlying the options contract sold each day exceed the daily volume of share traded on the NYSE. Since then, there has been no looking back.

What is option?
An options is the right, but not the obligation to buy or sell a specified amount (and quality) of a commodity, currency, index or financial instruments a to buy or sell a specified number of underlying futures contracts, at a specified price on a before a give date in the future. Thus, option like futures, also provide a mechanism by which one can acquire a certain commodity on other assets, or take position in order to make profits or cover risk for a price. In this type of contract as well, there are two parties: (a) The buyer (or the holder, or owner of options) (b) The seller (or writer of options) While the buyer takes "long position" the seller take "short position" So every option contract can either be "call option" or "put option" options are created by selling and buying and for every option that is buyer and seller.

OPTION

BUYER

SELLER

RIGHT

OBLIGATION

TO BUY (CALL)

TO SELL (PUT)

TO SELL (CALL)

TO BUY (PUT)

OPTION TERMINOLOGY
Buyer of an option: the buyer of an option is the one who by paying the option premium buys the right but not the obligation exercise his option on the seller/writer. Writer of an option: the writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. Option price: option price is the price, which the option buyer pays to the option seller. It is also referred as option premium. Expiration date: the date specified in the options contract is known as expiration date, the exercise date, the strike date or the maturity. Strike price: the price specified in the options contract is knows as strike price or the exercise price. American options: these are the options that can be exercised at any time up to the expiration date. Most exchange-traded options are Americans. European options: these are the options that can be exercised only on the expiration date itself. These are easier or analyze than American option, and properties of American options are frequently deducted from those of its European counterpart. In the money option: an in the money option is an option that would lead to a positive cash flow to the holder if it will exercise immediately. A call option in the index is set to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price>strike price). If the index is much higher than the strike price, The call is set to deep I TRADING MEMBERS. In the case of a put, the put is ITRADING MEMBERS if the index is below the strike price. At-money option: (ATRADING MEMBERS) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price. Out-of-the money option :( OTRADING MEMBERS) option is an option that would lead to a negative cash flow it was exercised immediately. A call option on the index is OTRADING MEMBERS when the current index stands at a level, which is less than the strike price (spot price<strike price). If the index is much lower than the strike price,

the call is set to be deep OTRADING MEMBERS. In the case of a put, the put is OTRADING MEMBERS if the index is above the strike price.

Intrinsic value of an option: the option premium can be broken into two componentsintrinsic values and time value. The intrinsic value of a call is the amount the option is ITRADING MEMBERS, if it is ITRADING MEMBERS. If the call is OTRADING MEMBERS, its intrinsic value is zero. Time value of an option: it is a difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTRADING MEMBERS or ATRADING MEMBERS has only time value. Usually the maximum time value exists when the options is ATRADING MEMBERS. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

TYPES OF OPTIONS
Thus the options are of two types: CALL OPTION AND PUT OPTION.

CALL OPTION:
It gives an owner the write to buy a specified quantity of the underling assets at a predetermined price i.e. the exercise price, or the specific date i.e. is the date of maturity.

EXAMPLE
Suppose it is January now and the investor buys a March option contract on Reliance Industries (RIL) Share with an exercise price/strike price Rs. 210. With this he get a right to buy share on a particular date in March, of course he is under no obligation. Obviously, if at the expiry date the price in market (spot price on expiry date) is above the exercise price he'll exercise his option and reverse is also true.

PUT OPTION:
It gives the holder the right to sell a specific quantity of underlying assets at an agreed price on date of maturity he gets the right to sell.

EXAMPLE
If an investor buys a March Put Option on RIL shares with an exercise price of Rs. 210 per share the investor get the right to sell 100 share @ 210 per share. The investor would naturally exercise his right if on maturity date price were below 210 and stand to gain and vice-versa. Buying out options is buying insurance. To buy a put option on Nifty is to buy insurance: which reimburses the full extent to which-Nifty drops below the strike price of the put option. This is attractive to many people.

AMERICAN Vs EUROPEAN OPTION:Its owner can exercise an American option at any time on or before the expiration date. A European style option gives the owner the right to use the option only on expiration date and not before.

OPTION PREMIUM:A glance at the rights and obligation of buyer and seller reveals that option contracts are skewed. One way naturally wonders as to why the seller (writer) of an option would always be obliged to sell/buy an asset whereas the other party gets the right? The answer is that writer of an option receives, a consideration for Undertaking the obligation. This is known as the price or premium to the seller for the option. The buyer pays the premium for the option to the seller whether he exercise the option is not exercised, it becomes worthless and the premium becomes the profit of the seller. Premium/Price of an option = Intrinsic Value + Time Value Do Nothing Option to option holder Close out the position by write a, matching call option or it in case of writer. Exercise the option.

IN-THE-MONEY AND OUT-THE-MONEY OPTIONS:Condition So>E So<E So=E So =spot price Call In the money Out of the money At the money E = exercise price Put Out of the money In the money At the money

Consideration for selling the option/Option Pricing/Option Premium Assumption Not transaction cost likes brokerage or commission on buying or selling.

FACTORS AFFECTING PRICING:1. Supply and demand in secondary market 2. Exercise price 3. Risk free interest rate, 4. Volatility of underlying 5. Time to expiration 6. Dividend on underlying

Option-to-option holder in case ofHe opt for expiry date.

i.e How Option Work:CALL OPTION WORK Spot Nifty: 1200 Buyer exercise the option Profit: No. of option x price Differential-Premium paid=Rs. (200x (1200-1150)2000=Rs.8000)

Day 1

Spot Nifty: 1100 Strike Price: 1150 Duration: 3 months No. of option bought=200 Premium per option: 10 Total premium paid=2000

Day 90

Spot Nifty: 1000 Buyer foregoes the option Loss premium paid Rs. 2000

PRICING OF OPTION

AT EXPIRATION

BEFORE EXPIRATION

Call option At expiration

Put option Before expiration

Put option At expiration Before expiration

Call option

1- AT EXPIRATION (a) Call option pricing at expiration:

If the price of the underlying asset were lower than the exercise price on the expiration date, the call would expire unexercised. This is because no one would like to buy an asset, which is available in the market at a lower price. If an out of money call did actually sell for a certain price, the investor can make an arbitrage profit by selling it and earning premium. The buyer is unlikely to exercise option, the allowing seller to retain premium. In even of (irrational) exercise of such a call, writer can purchase asset as S 1 and give it at making a profit of (E+S1) + premium. On the other hand, if the call happens to be in the money, it'll, be worth its intrinsic value, equal to excess of asset price over the exercise price. If call price <intrinsic value then he can buy call at c, exercise it immediately at S 1 and make a profit" of S1 EC

VALUE OF CALL OPTION:Value

Price of share

Put option at expiration:

When at the expiration date the price of the underlying asset is greater than exercised price, the put option will go unexercised. This is because there is no use of using option to sell at E when If the option were exercised, it would have resulted in a profit to seller of option of about (E-S1) + premium. When S1<E

Value of put option

Value

Price of share

2. BEFORE EXPIRATION:
Before expiration, the options call and put are usually sold for at least intrinsic valued (difference of E & S1).

(a) Call Option Pricing:

A call option will usually sell for at least its intrinsic value, Minimum value of call is always is equal to its intrinsic value. Intrinsic value = S>E To this would be added the time value, if any longer the time expiry, greater were time value. P=f (E, S, T) Y Price of Call option Intrinsic Value

450

Stock Price

In figure intrinsic value is shown, by, a 45 0 line starting at E, equal to the excess of stock price over the exercise price. At Stock price S 2, Call Option pence is out- of-the money i.e. zero intrinsic value then option price=S2B= only time value

(c) Put Option Pricing

It would sell for a price that is at least equal to intrinsic value, which is excess of exercise price over stock price, when option is in the money. For in the money Put Option i.e. S<E P=Intrinsic value +Time Value Time Value=f (Time of Maturity) Higher the time to maturity, higher is the time value.

For out-the-money/at the money Put Option i.e. S>E, E,S = 0 P=Time Value because intrinsic value = 0
B
Price of put option Time value

Value Intrinsic B1 Time Value Stock prices S1 E S2

DERIVATIVES TRADING 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 members committee under the Chairmanship of Dr. L.C. Gupta on 18th November, 96 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on 17th March, 98 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 SCRA was amended in Dec. 1999 to include derivatives within the ambit of 'securities' and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivative shall be legal and valid only it such contract are traded on a recognized stock exchange, thus precluding OTC derivative. The government also rescinded in March 2002, 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 2000. 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 (Sensex) index. This was followed by approval, for trading in options based on these two indexes and options on individual securities. The trading in index options commenced in June 2001. Futures contracts on individual stocks were launched in

November 2001. Trading and Settlement in derivatives contracts is done in accordance with the rules, bye-laws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Thus, the following five types of Derivatives are now being traded in the India Stock Market. * Stock Index Futures * Stock Index Options * Futures on Individual Stocks * Options on Individual Stocks * Interest Rate Derivatives

INDEX FUTURES:
Index futures are financial contracts for which the underlying is the cash market index like the Sensex, which is the brand index of India. Index futures contract is an agreement to buy or sell a specified quantity of underlying index for a future date at a price agreed Upon between the buyer and seller. The contracts have standardized specifications like market lot, expiry day, tick size and method of settlement.

INDEX OPTIONS:
Index Options are financial contracts whereby the right is given by the option seller in consideration of a premium to the option buyer to buy or sell the underlying index at a specific price (strike price) on or before a specific date (expiry date).

STOCK FUTURES:
Stock Futures are financial contracts where the underlying asset is an individual stock. Stock futures contract is an agreement to buy or sell a specified quantity of underlying equity share for a Future date at a price agreed upon between the buyer and seller. Just like Index derivatives, the specifications are pre-specified.

STOCK OPTIONS:
Stock Options are instruments whereby the right of purchase and sale is given by the option seller in consideration of a premium to the option buyer to buy or

sell the underlying stock at a specific price (strike price) on or before a specific date (expiry date).

INTEREST RATE DERIVATIVES:

The derivatives are taken on various rates of interests.

OPERATIONAL MECHANISM FOR DERIVATIVES TRADING:1. REGISTRATION WITH BROKER:

The first step towards trading in the derivatives market is selection of a proper broker with whom the investor would trade. Investors should complete all the registration formalities with the broker before commencement of trading in the derivatives market. The investor should also ensure to deal with a broker (member of the exchange) who is a SEBI registered broker and possesses a SEBI registration certificate.

2. CLIENT AGREEMENT:
The investor should sign the Client Agreement with the broker before the broker can place any order on his behalf. The client agreement includes provisions specified by SEBI and the derivatives segment.

3. UNIQUE CLIENT IDENTIFICATION NUMBER:

After signing the client agreement, the investor gets a unique identification number (ID). The broker would key this identification number in the system at the time of placing the order on behalf of the investor. This ID is broker specific i.e. if the investor chooses to deal with different brokers, he needs to sign the client agreement with each one of them and resultantly, he would have different Ids.

4. RISK DISCLOSURE DOCUMENT:

As stipulated in the Bye-Laws provide his particulars to the investor. The particulars would include his SEBI registration number, the name of the employees who would be primarily responsible for the client's affairs, the precise nature of his liability towards the client in respect of the business done on behalf of the investor. The broker must also apprise the investor about the risk associated with the business in derivative trading and the extent of his liability. This information forms part of the Risk Disclosure document, which the broker issues to the client. The investor should carefully read the risk disclosure document and understand the risks involved in the derivatives trading before committing any position in the market. The risk disclosure document has to be signed by the client and a copy of the same is retained by the broker for his records.

5. FREE COPY OF RELEVANT REGULATION:

The client is also entitled to a free copy of the extracts of relevant provisions governing the rights and obligations of clients, relevant manuals, notifications, circulars and any additions or amendments etc. of the derivatives segment or of any regulatory authority to the extent it governs the relationship between the broker and the client.

6. PLACING ORDER WITH THE BROKER:

The investor should place orders only after understanding the monetary implications in the event of execution of the trade. After the trade is executed, the investor can request for a copy of the trade confirmation slip generated on the systems on execution of the trade. The investor should also obtain from the broker, a contract note for the trade executed within 24 hours. The contract note should be time (order receipt and order execution) and price stamped. Execution prices, brokerage and other charges, if any,

should be separately mentioned in the contract note. If desired, the investor may change an order anytime before the same is executed on the exchange.

7. MARGINING SYSTEM IN DERIVATIVES:

The aim of margin money is to minimize the risk of default by either counter-party. The payment of margin ensures that the risk is limited to the previous day's price movement on each outstanding position. The different types of margins are:

A) INITIAL MARGIN:

The basic aim of initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit before the opening of the position in the futures transaction. This margin is calculated by STANDARD PORTFOLIO ANALYSIS OF RISK by considering the worst case scenario.

B) MARK TO MARKET MARGIN:

All daily losses must be met by depositing of further collateral-known as variation margin, which is required by the close of business, the following day. Any profits on the contract are credited to the client's variation margin account.

7. INVESTOR PROTECTION FUND:

The derivatives segment has established an "Investor Protection Fund" which is independent of the cash segment to protect the interest of the investors in the derivatives market.

8. ARBITRATION:
In case of any dispute between the members and the clients arising out of the trading or in relation to trading/settlement, the party thereto shall resolve such complaint, dispute by arbitrations procedure as defined in the rules and regulations and Bye-Laws of the respective exchanges.

REGULATORY FRAMEWORK
The trading of derivatives is governed by the provisions contained in the SC (R) A, the SEBI Act, the rules and regulations framed there under and the rules and bye-laws of stock exchanges.

Securities contracts (Regulation) Act, 1956

2

SC(R) A aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therewith. This is the principal Act, which governs the trading of securities in India. The term "securities" has been defined in the SC(R)A. As per Section 2(h), the 'Securities' include: 1. Shares, scrips, stock, bonds, debentures, stock or other marketable securities of a like nature in or of any incorporated company or other body corporate. 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes. 4. Government securities. 5. Such other instruments as may be declared by the Central Government to be securities 6. Rights or interests in securities "Derivative" is defined to include: A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of price, of underlying securities. Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are: Traded on a recognized stock exchange. Settled on the clearinghouse of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchanges.

REGULATIONS FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under the Chairmanship of Dr. L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock

index futures. SEBI also approved the "suggestive bye-laws" recommended by the committee for regulations and control of trading and settlement of derivatives contracts. The provisions in the SC(R)A and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of 'securities' in the SC(R)A made trading in derivatives possible with in the framework of that Act. 1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivative contract. 2. The Exchange shall have minimum 50 members. 3. The members of an existing segment of the exchange will not atomically become the members of derivative segment. The members of the derivatives segment need to fulfill the eligibility conditions as laid down by the LC Gupta committee. 4. The clearing and settlement of derivatives traders shall be through a SEBI approved clearing corporation/house. Clearing corporation/house complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs. 300 Lakh. The net worth of the member shall be computed as follows: a. b. c. d. e. f. Capital + Fee reserves Less non-allowable assets viz. Fixed assets Pledged securities Member's card Non-allowable securities (unlisted securities) Bad deliveries Doubtful debts and advances

g. h. i.

Prepaid expenses Intangible assets 30% marketable securities

6. The minimum contract value shall not be less than Rs. 2 Lakh. Exchange should also submit details of the futures contract they propose to introduce. 7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be prescribed by SEBI/Exchanges from time to time. 8. The L.C. Gupta committee report requires strict enforcement of "Know your customer" rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

DR. L.C.GUPTA COMMITTEEThe Securities and exchange board of India (SEBI) appointed a committee with Dr. L.C. Gupta as its chairman in November, 1996 to develop regulatory framework for derivatives trading in India. The committee recommended introduction of derivatives market in a phased manner with the introduction of index futures and SEBI appointed a group with Prof. J.R. Varma as its Chairman to recommend measures for risk containment in the derivative market in India. The recommendations of L.C. Gupta Committee at a glance: a) Stock index futures to be the starting point of equity derivatives. b) SEBI to approve rules, bye-laws and regulation of the derivatives exchange and the derivatives contracts. c) SEBI need not be involved in framing exchange level regulations. d) SEBI should create a special Derivatives Cell as it involves special knowledge, and a Derivatives advisory council may be created to tap outside experts for independent.

e) Legal restrictions on institutions, including mutual funds, on use of derivatives should be removed. f) Existing stock exchanges with cash trading to be allowed to trade derivatives if they meet prescribed eligibility conditionimportantly, a separate Governing Council and at least 50 members. g) Two categories of member-clearing members and non-clearing members, with the latter depending on the former for settlement of trades. This is no bring in more traders. h) Broker members, dealers and sales persons in the derivatives market must have passed a certificate programme to be registered with SEBI. i) Co-ordination between SEBI and the RBI of financial derivatives market must have passed a certificate programme to be registered with SEBI. j) Clearing corporation to be the center piece of the derivatives market, both for implementing the margin system and providing trade guarantee. In the near term, existing clearing corporation be allowed to participate in derivatives. For the long-term, a centralized clearing corporation has been recommended. k) Minimum net worth requirement of Rs. 3 crores for participants, maximum exposure limits for each broker/dealer on gross basis and capital adequacy requirements to be prescribed. l) Mark-to-market to be collected before next day's trading starts. m) As a conservative measure, margins for derivatives purposes not to take into account positions in cash and futures market and across all stock exchanges. n) Margins to be systematically collected and not left to discretion of brokers/dealers. o) Much stricter regulation for derivatives as compared to cash trading. p) Strengthen cash market with uniform settlement cycles among all SEs and regulatory oversight. Proper supervision of sales practices with registration of every client dealer/broker and risk disclosure as the corner-stone. with the

J.R. VARMA COMMITTEEAfter the submission of L.C. Gupta committee report and approval of the introduction of index futures trading by SEBI the board mandated the setting up of a group to recommend measures for risk containment in the derivative market in India. Prof. J.R. Varma was the chairman of the group.

ASSUMPTIONS-Volatility in Indian market is high.

-Volatility is not constant & varying. -There is no data on the volatility on Index futures. -Even at 99% "Value at Risk" model there could be possibility of default once in six months. -Not efficient organized arbitrage players.

RECOMMENDATIONS - Only traders with high net worth are allowed to trade in Derivatives.
- Imposition of Value at Risk margin system. - Submission of periodic reports by CC and SE to SEBI. - Continuously refining of Margin system. - Daily changes in the Margins be calculated and imposed. - Proper liquid net worth. -Online position monitoring at customer, Trading Member, Clearing Member and Market level.

RISK MANAGEMENT:NATIONAL SECURITIES CLEARING CORPORATION LTD has developed a

comprehensive risk containment mechanism for the Future & Option segment. The salient features of risk containment mechanism on the Future & Option segment are: 1. The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent.

2. NATIONAL SECURITIES CLEARING CORPORATION LTD. charges an upfront initial margin for all the open positions of a Clearing Member. It specifies the initial margin requirements for each futures/options contract on a daily basis. It also follows value-at-risk (VAR) based margining through Standard Portfolio Analysis of Risk. The Clearing Member in turn collects the initial margin from the TRADING MEMBERS and their respective clients. 3. The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T + 1 basis. 4. NATIONAL SECURITIES CLEARING CORPORATION LTD.'s on-line position monitoring system monitors a Clearing Member's open positions on a real-time basis. Limits are set for each CLEARING MEMBERS based on his capital deposits. The on-line position monitoring system generates alerts whenever a CLEARING MEMBERS reaches a position limit set up by NATIONAL SECURITIES CLEARING CORPORATION LTD.NATIONAL SECURITIES CLEARING CORPORATION LTD. monitors the CLEARING MEMBERSs for MTRADING MEMBERS value violation, while TRADING MEMBERSs are monitored for contract-wise position limit violation. 5. CLEARING MEMBERSs are provided a trading terminal for the purpose of monitoring the open position of all the TRADING MEMBERSs clearing and settling through him. A CLEARING MEMBERS may set exposure limits for a TRADING MEMBERS clearing and settling through him. NATIONAL SECURITIES CLEARING CORPORATION LTD. assists the CLEARING MEMBERS to monitor the intra-day exposure limits set up by

A CLEARING MEMBERS and whenever a TRADING MEMBERS exceed the limits, it stops that particular TRADING MEMBERS from further trading. 6. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in withdrawal of trading facility for all TRADING MEMBERSs a CLEARING MEMBERS is case of a violation by the CLEARING MEMBERS. 7. A separate settlement guarantee fund for this segment has been created out of the capital of members. The fund had a balance of Rs. 648 crore at the end of March 2002.

The most critical component of risk containment mechanism for F & O segment is the margining system and on-line position monitoring. The actual position monitoring and margining is carried out on-line through Parallel Risk Management System (PRISM). PRISM uses STANDARD PORTFOLIO ANALYSIS OF RISK (r) (Standard Portfolio Analysis of Risk) system for the purpose of computation of on-line margins, based on the parameters defined by SEBI.

MINIMUM BASE CAPITAL

A CLEARING MEMBERS is required to meet with the Base Minimum Capital requirements prescribed by NATIONAL SECURITIES CLEARING CORPORATION LTD. before activation. The clearing member has also to ensure that MINIMUM BASE CAPITAL is maintained in accordance with the requirements of NATIONAL SECURITIES CLEARING CORPORATION LTD. at all points of time, after activation. Every CLEARING MEMBERS is required to maintain MINIMUM BASE CAPITAL of Rs.50 lakhs with NATIONAL SECURITIES CLEARING CORPORATION LTD. in the following manner: (1) Rs.25 lakhs in the form of cash. (2) Rs.25 lakhs in any one form or combination of the below forms: Cash

FIXED DEPOSIT RECEIPTS (FDRs) issued by approved banks and deposited

with approved Custodians or NATIONAL SECURITIES CLEARING CORPORATION LTD.

BANK GUARANTEE

in favor of NATIONAL SECURITIES CLEARING

CORPORATION LTD. from approved banks in the specified format.

APPROVED SECURITIES in demat form deposited with approved

Custodians.

Any failure on the part of a CLEARING MEMBERS to meet with the MINIMUM BASE CAPITAL requirements at any point of time, will be treated as a violation of the Rules, Bye-Laws and Regulations of NATIONAL SECURITIES CLEARING CORPORATION LTD. and would attract disciplinary action inter-alia including, withdrawal of trading facility and/or clearing facility, closing out of outstanding positions etc.

ADDITIONAL BASE CAPITAL

Clearing members may provide additional margin/collateral deposit (additional base capital) to NATIONAL SECURITIES CLEARING CORPORATION LTD. and/or may wish to retain deposits and/or such amounts which are receivable from NATIONAL SECURITIES CLEARING CORPORATION LTD., over and above their minimum deposit requirements, towards initial margin and/ or other obligations.

EFFECTIVE DEPOSITS / LIQUID NETWORTH Effective deposits

All collateral deposits made by CLEARING MEMBERSs are segregated into component and non-cash component. cash

For Additional Base Capital, cash component means cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash component shall mean all other forms of collateral deposits like deposit of approved demat securities. At least 50% of the Effective Deposits should be in the form of cash.

Liquid Net worth

Liquid Net worth is computed by reducing the initial margin payable at any point in time from the effective deposits. The Liquid Net worth maintained by CLEARING MEMBERSs at any point in time should not be less than Rs.50 lakh (referred to as Minimum Liquid Net Worth).

MARGINS
NATIONAL SECURITIES CLEARING CORPORATION LTD. has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NATIONAL SECURITIES CLEARING CORPORATION LTD. is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. NATIONAL SECURITIES CLEARING CORPORATION LTD. uses the Standard Portfolio Analysis of Risk system for the purpose of margining, which is a portfolio base system.

Initial Margin:NATIONAL SECURITIES CLEARING CORPORATION LTD. collects initial margin up-front for all the open positions of a CLEARING MEMBERS based on the margins computed by NATIONAL SECURITIES CLEARING CORPORATION LTD.-STANDARD PORTFOLIO ANALYSIS OF RISK .A CLEARING MEMBERS is in turn required to collect the initial margin from the TRADING MEMBERSs and his respective clients. Similarly, a TRADING MEMBERS should collect upfront margins from his clients. Initial margin requirements are based on 99% value at risk over a one day time horizon. However, in the case of futures contracts (on index or individual securities), where it may not be possible to collect mark to market settlement value, before the commencement of trading on the next day, the initial margin may be computed over a two-day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage is as per the recommendations of SEBI from time to time.

INITIAL MARGIN REQUIREMENT FOR A MEMBER:For client positions - shall be netted at the level of individual client and grossed across all clients, at the Trading/ Clearing Member level, without any setoffs between clients. For proprietary positions - shall be netted at Trading/ Clearing Member level without any setoffs between client and proprietary positions.

For the purpose of STANDARD PORTFOLIO ANALYSIS OF RISK Margin, various parameters are specified from time to time. In case a trading member wishes to take additional trading positions his CLEARING MEMBERS is required to provide Additional Base Capital (ABC) to NATIONAL SECURITIES CLEARING CORPORATION LTD. ABC can be provided by the members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts and approved securities.

Premium

Margin

In addition to Initial Margin, Premium Margin would be charged to members. The premium margin is the client wise margin amount payable for the day and will be required to be paid by the buyer till the premium settlement is complete.

Assignment

Margin
Assignment Margin is levied on a CLEARING MEMBERS in addition to

STANDARD PORTFOLIO ANALYSIS OF RISK margin and Premium Margin. It is required to be paid on assigned positions of CLEARING MEMBERSs towards Interim and Final Exercise Settlement obligations for option contracts on individual securities, till such obligations are fulfilled. The margin is charged on the Net Exercise Settlement Value payable by a Clearing Member towards Interim and Final Exercise Settlement and is deductible from the effective deposits of the Clearing Member available towards margins. Assignment margin is released to the CLEARING MEMBERSs for exercise settlement pay-in.

PAYMENT OF MARGINS:The initial margin is payable upfront by Clearing Members. Initial margins can be paid by members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts and approved securities. Non-fulfillment of either the whole or part of the margin obligations will be treated as a violation of the Rules, Bye-Laws and Regulations of NATIONAL SECURITIES CLEARING

CORPORATION LTD. and will attract penal charges @ 0.09% per day of the amount not paid throughout the period of non-payment. In addition NATIONAL SECURITIES CLEARING CORPORATION LTD. may at its discretion and without any further notice to the clearing member, initiate other disciplinary action, inter-alia including, withdrawal of trading facilities and/ or clearing facility closing out of outstanding positions, imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, etc.

POSITION LIMITS, VIOLATIONS & PRICE SCAN RANGE

Position Limit

Clearing Members are subject to the following exposure / position limits in addition to initial margins requirements Exposure Limits Trading Member wise Position Limit Client Level Position Limits Market Wide Position Limits (for Derivative Contracts on Underlying Stocks) Collateral limit for Trading Members

VIOLATIONS:PRISM (Parallel Risk Management System) is the real-time position monitoring and risk management system for the Futures and Options market segment at NATIONAL SECURITIES CLEARING CORPORATION LTD.The risk of each trading and clearing member is monitored on a real-time basis and alerts/disablement messages are generated if the member crosses the set limits. Initial Margin Violation Exposure Limit Violation

Trading Member wise Position Limit Violation Client Level Position Limit Violation Market Wide Position Limit Violation Violation arising out of misutilization of trading member/ constituent collaterals and/or deposits Violation of Exercised Positions Clearing members, who have violated any requirement and / or

limits, may submit a written request to NATIONAL SECURITIES CLEARING CORPORATION LTD. to either reduce their open position or, bring in additional collateral deposits by way of cash or bank guarantee or FDR or securities. NATIONAL SECURITIES CLEARING CORPORATION LTD. renders a service to members, whereby the members can give standing instructions to debit their account towards additional base capital. A penalty of Rs. 5000/- is levied for each violation and is debited to the clearing account of clearing member on the next business day. In respect of violation on more than one occasion on the same day, each instance is treated as a separate violation for the purpose of calculation of penalty. The penalty is charged to the clearing member irrespective of whether the clearing member brings in margin deposits subsequently. Clearing Members and Trading Members are required to collect upfront initial margins from all their Trading Members/ Constituents. Clearing Members are required to compulsorily report, on a daily basis, details in respect of such margin amount due and collected, from the Trading Members/ Constituents clearing and settling through them, with respect to the trades executed/ open positions of the Trading Members/ Constituents, which the Clearing Members have paid to NATIONAL SECURITIES CLEARING CORPORATION LTD., for the purpose of meeting margin requirements. Similarly, Trading Members are required to report on a daily basis details in respect of such margin amount due and collected from the constituents clearing and settling through them, with respect to the trades executed/ open positions of the constituents, which the trading members have paid to the Clearing Members, and on which the Clearing Members have allowed initial margin limit to the Trading Members.

CHAPTER-2
2

REVIEW OF LITERATURE

Commodity derivative market in India had been existence since 1875 when Cotton Trade Association, Bombay undertook organized derivative trading in cotton. Although derivatives was initially conceived for the commodity market, in recent years there had been a tremendous development in financial derivatives market both in terms of trade volume and in variety of instruments used. The paper has been undertaken with the purpose to analyze the affect of international price movement of commodity derivative market in Indian commodity derivative market. The price movement in international commodity derivative exchanges is closely correlated to prices in Indian commodity derivative exchanges. Therefore the functioning as well as the profitability in Indian exchanges is effected by the current performance of the

international derivative market. It is imperative that any evaluation, projection or policy intervention on Indian commodity derivative market should be undertaken keeping the international commodity derivative market in perspective. Derivatives Defined: Derivative is a product whose value is derived from the value of one or more basic variables called bases (underlying assets) in a contractual manner. The underlying asset can be equity, forex, precious metals, commodity, or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of derivatives. A derivative instrument by itself does not constitute ownership. It is, instead, a promise to convey ownership. According to the Securities Contract (Regulation) Act, 1956, derivatives include: A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

Riddhi Kapadia in his paper Study on Derivatives Market in India: Current

Scenario and Future Trends. Studied that-The derivative market has become multitrillion dollar markets over the years. Derivatives are financial commitments indexed or linked in some capacity to changes in the value of underlying assets. The bulk of the derivatives trading internationally are linked to currencies and interest rates, other derivatives are linked to equity or equity indices. A very small volume of derivatives, compared to the total, is indexed to traditional commodities. Small by comparison to other derivatives markets, these

commodities-indexed derivatives markets are large compared to the underlying physical commodity markets. The Aims and Objectives of this research are to have an in-depth knowledge of the derivative markets in India and in this report entitled A Study on Derivatives Market in India Current Scenario and Future Trends, I have tried my level best to make it simple and understandable. Questionnaires, sampling and personal interviews were conducted for answering the research questions and achieving aims and objectives of research.

The findings were in favour of derivatives being vital for the stock market and they are not diminishing in todays world, but they are at the booming stage; and every institutional investor would want to use derivative as a tool to maximise its profits.

Dr.

Devajit

Mahanta

in

his paper

Commodity derivative,

International exchange, price trends studied thatCommodity derivative market in India had been existence since 1875 when Cotton Trade Association, Bombay undertook organized derivative trading in cotton. Although derivatives was initially conceived for the commodity market, in recent years there had been a tremendous development in financial deriveatives market both in terms of trade volume and in variety of instruments used. The paper has been undertaken with the purpose to analyse the affect of international price movement of commodity derivative market in Indian commodity derivative market. The price movement in international commodity derivative exchanges is closely correlated to prices in Indian commodity derivative exchanges. Therefore the functioning as well as the profitability in Indian exchanges is effected by the current performance of the international derivative market. It is imperative that any evaluation, projection or policy intervention on Indian commodity derivative market should be undertaken keeping the international commodity derivative market in perspective.

Conclusion:
Hence we can conclude on the basis of gold prices, that price movement in international commodity derivative exchanges is closely correlated to prices in Indian commodity derivative exchanges. Therefore the functioning as well as the profitability in Indian exchanges is effected by the current performance of the international derivative market. In this context it is imperative that any evaluation, projection or policy intervention on Indian commodity derivative market should be undertaken keeping the international commodity derivative market

in perspective. Such a step would ensure that the impact of the international commodity derivative market is internalized into the cost-benefit calculation of the Indian commodity derivative market which would go a long way in optimizing any strategies that are adopted by the stakeholders. DR. (MRS.) KAMLESH GAKHAR in her paper

DERIVATIVES MARKET IN INDIA: EVOLUTION, TRADING MECHANISM AND FUTURE PROSPECTS studied that
The Indian derivative market has become multi-trillion dollar markets over the years. Marked with the ability to partially and fully transfer the risk by locking in assets prices, derivatives are gaining popularity among the investors. Since the economic reforms of 1991, maximum efforts have been made to boost the investors confidence by making the trading process more users friendly. Still, there are some issues in this market. So, the present paper is an attempt to study the evolution of Indian derivative market, trading mechanism in its various products and the future prospects of the Indian Derivative market. The present paper is descriptive in nature and based on the secondary data. Inspite of the growth in the derivative market, there are many issue (e.g., the lack of economies of scale, tax and legal bottlenecks, increased off-balance sheet exposure of Indian banks need for an independent regulator etc), which need to be immediately resolved to enhance the investors confidence in the Indian derivative market.

CHAPTER-3
OBJECTIVE AND RESEARCH METHODOLOGY
OBJECTIVES OF THE PROJECT
The main objectives of my final project report are as follows:-

 To study the growth and trends of derivatives market To know the awareness & familiarity of investors, dealers and brokers regarding derivatives market. To know the experience of dealers, investors and brokers with derivatives. To get knowledge about shortcomings in Indian derivative market.

RESEARCH METHODOLOGY:Research is a procedure of logical and systematic application of the fundamentals of science to the general and overall questions of a study and scientific technique by which provide precise tolls, specific procedures and technical, rather than philosophical means for getting and ordering the data prior to their logical analysis and manipulation. Different type of research designs is available depending upon the nature of research project, availability of able manpower and circumstances. The study about Trends and future of derivatives in India is descriptive in nature. So survey method is used for the study.

Sampling Procedure
The small representative selected out of large population is selected at random is called sample. Well-selected sample may reflect fairly, accurately the characteristic of population. The chief aim of sampling is to make an inference about unknown parameters from a measurable sample statistics. The statistical hypothesis relating population. The sample size was 60 which include brokers, dealers and investors.

Sources of Data:
The sources of data include primary and secondary data sources.

Primary Sources:

Primary data is collected by structured questionnaire administered by sitting with guide and discussing problems.

Secondary Sources:
The secondary data is data, which is collected and compiled for the different purpose, which are used in research for this study. The secondary data include material collected from Newspaper Magazine Internet

Data collection instruments

The various method of data gathering involves the use of appropriate recording forms. These are called 'tools' or 'instruments of data collection. Collection Instruments: 1. Observation 2. Interview guide 3. Interview schedule Each tool is used for specific method of data gathering. The tool for data collection translates the research objectives in to specific term/questions to the response, which will provide research objective. The instrument data collection in our study interview schedule mainly. Every respondent was conducted personally with an interview schedule containing questions. Interview method was used because it can be explained more easily and clearly and takes less time to answer.

Methodology Assumptions:
The research was based on the following assumption:

1. The methodology used for this purpose is survey and questionable method. It is assumed that this method is more suitable for collection of data. 2. It is assumed that the respondent have sufficient knowledge to ensure questionable. 3. It is assumed that the respondent have filled right and correct option according to their view.

LIMITATIONS OF THE STUDY

No study is complete in itself, however good it may and every study has some limitations: Time is the main constraint of my study. Availability of information was not sufficient because of less awareness among investors/brokers Study is based only on NSE because information and trading in BSE is not available here. Sample size is not enough to have a clear opinion.

CHAPTER-4
DATA ANALYSIS

BROKER'S PERCEPTION ABOUT DERIVATIVES (ANALYSIS)

TRADING PERIOD IN DERIVATIVES

2 5 2 0 1 5 1 0 5 0 fromla s t 1yea rfromla st 2yea rfromla st 3yea r m ore tha n3 yea rs D ura tion

From my sample of 60, 13 (22%) brokers and investors investing in derivatives from last 1 year and less than this. 21(35%) are investing from last 2 years ,7 (11%) are investing from last 3 years and only 6 (10%) have experience of more than 3 years of investment in derivatives.

REASONS BEHIND ITS ADOPTION

2 5 2 0 1 5 1 0 5 0 R is k m a na g em ent H edg ing S pec ula tion L iquidity rea sonbehinda doption

Reasons behind adoption of derivatives are different by brokers, investors and dealers e.g. liquidity, risk management hedging, investor demand (speculation) etc. Out of 60 brokers, investors dealing in derivatives 14 (23%) adopt it due to characteristics of risk management, 15 (25%) due to hedging, 24 (40%) for investor (client's) demand (speculation) and remaining 7 (12%) due to liquidity.

EXPERIENCE WITH DERIVATIVE

2 5 2 0 1 5 1 0 5 0 P rofita ble Not profita ble E quitiesa re better Other Colum n1

Out of my sample size 60, only 23 (38%) find derivatives as quite profitable investment. 14 (23%) find that derivatives cant give big profits in future.17 (29%) feels that equities are better option for investment than derivatives. Remaining 6 (10%) have other opinion that only those investors, brokers can derive good return from derivatives those have surplus funds and patience for long period. Because derivative requires huge investment and risk also.

INVESTED AMOUNT IN DERIVATIVES:-

3 0 2 5 2 0 1 5 1 0 5 0 2 L akh 2 -5Lakh 5-1 0L akh O ther am ount A m ount

Out of my sample size 60, 27 (45%) investors and brokers have invested 2 lacs normally.9 (15%) invested between 2 lacs to 5lacs.and 15 (25%) invested between 5 lacs to 10 lacs,and remaining have invested in other amounts. Reason behind this is that those are investing from many years are taking the risk of investing huge amount.

TRADED PERIOD IN DERIVATIVES:-

25 20 15 10 5 0 weekly Monthly m ore than m ore than 2 one m onth m onth Traded period

13 (22%) investors and brokers are investing weekly in derivatives, 23 (38%) investing monthly,19 (32 %) investing after more than 1 month and only 5 ( 8%) investing too late after 2 months.

RELATIONSHIP WITH CASH MARKET:-

3 0 2 5 2 0 1 5 1 0 5 0 Pos itive Neg ative C an not s ay R elations hip witd cas h

Out of 60 brokers, dealers 27 (45%) have the positive response toward the relation between derivative and cash market and remaining 5 (8%) has negative response. 28 (47%) are not able to say anything because they dont have proper knowledge about stock market. They are investing with the guidance of brokers and with the support of their close relatives those are investing for last many years.

SETTLEMENT OF DERIVATIVES IN INDIAN INVESTORS PSYCHE:-

Is derivatives settled in Indian investor psyche?

4 0 3 5 3 0 2 5 2 0 1 5 1 0 5 0

S ettlem ent

Y es

No

Out of total 37 (62%) of investors and dealers are saying it hasn't settled in Indian investor psyche and 23 (38%) are saying it has.

SHORTCOMINGS IN INDAIN DERIVATIVE SYSTEM:27 (45%) brokers, investors respond towards shortage of domestic technical expertise. 31(52%) feel lack of awareness in investor about derivatives and remaining 2 (3%) market failure.

CHAPTER-5
FINDINGS & RECOMMENDATIONS

FINDINGS
1. Brokers not dealing in derivatives at present are also not going to adopt it in near futures. 2. Hedging & Risk Mgt is the most important feature of derivatives. 3. It is not for small investors. 4. It has increased brokers turnovers as well as helpful in aggregate 5. futures only. 6. There is a risk factor in derivative also. 7. Most of investors are not investing in derivatives. 8. People are not aware of derivatives, even people who have invested in it, hasnt adequate knowledge about it. These people are interested to take it in their future portfolio also. They consider it as a tool of risk management. 9. They normally invest in future contracts. 10. They are investing in future contract, because futures have up to home extent similar quality as Badla. investment Brokers haven't adequate knowledge about options, so most by them are dealing in

RECOMMENDATIONS
1. LOT SIZE:
Lot size should be reduced so that the major segment of an India society i.e. small saving class can come under F & O trading. There is strong need for revision of lot sizes as the lot sizes of some of the individual scrips that were worth of Rs. 200000 in starting, now same lot size amount to a much larger value.

2. SUB BROKER:
Sub-broker concept should be added and the actual brokers should give all rights of brokers in F & O segment also.

3. SCRIPS:
More scrip of reputed companies etc. should be introduced in "Future & Option segment".

4. TRADING PERIOD:
Trading period should be increased. 5. TRAINING CLASSES OR SEMINARS: There should be proper classes on derivatives for investors, traders, brokers, students and employees of stock exchanges. Because lack of knowledge is the main reason of its less development. The first step towards it should be seminars provide to brokers & LSE employees and secondly seminar to students.

CHAPTER-6
CONCLUSION

CONCLUSION
On the basis of overall study on derivatives it was found that derivative products initially emerged as hedging devices against fluctuation and commodity prices and commodity linked derivatives remained the soul form of such products. The financial derivatives came in spotlight in 1972 due to growing in stability in financial market. I was really surprised to see during my study that a layman or a simple investor does not even know how to hedge and how to reduce risk on his portfolios. All these activities are generally performed by big individual investors, institutional investors, mutual funds etc. No doubt that derivative growth towards the progress of economy is positive. But the problems confronting the derivative market segment are giving it a low customer base. The main problems that it confronts are unawareness and bit lot sizes etc. these problems could be overcome easily by revising lot sizes and also there should be seminar and general discussions on derivatives at varied places.

BIBLIOGRAPHY
1. BOOKS AND ARTICLES
NCFM on derivatives core module by NSEIL. The Indian Commodity-Derivatives Market in Operations. Bodie, Kane, Marcus & Mohanti Investment and Indian Perspective ( TMH, 6th Ed.). Pandey I M Financial Management ( Vikas, 2004, 9th Ed.). Kothari C R Research Methodology Methods & Techniques ( New Age International Publishers, 2004, 2nd Ed. ).

2. MAGAZINES
The Dalal Street LSE Bulletin

3. WEBSITES-https://en.wikipedia.org/wiki/Derivative_(finance) -http://www.ukessays.com/essays/finance/analysing-the-derivativesmarket-in-india-finance-essay.php -http://indianresearchjournals.com/pdf/IJMFSMR/2013/March/4.pdf -http://www.indianjournaloffinance.co.in/archives/2007/june-july2007.html -www.indianresearchjournals.com -http://www.articlesbase.com/human-resources-articles/future-ofderivatives-in-india-999592.html

4.JOURNALSDr. Mahanta Devajit, -Indian Commodity Derivative Market: A study of price trends in the International market, Volume: 2 | Issue: 1 | October 2012 | ISSN - 2249-555X Dr.Gakhar Kamlesh,-Derivatives Market in India: Evolution, Trading Mechanism and Future Prospects, International Journal of Marketing, Financial Services & Management Research,ISSN 2277- 3622,Vol.2, No. 3, March (2013)

ANNEXURE
SAMPLE OF QUESTIONNAIRE
Dear Respondent, I am a student of MBA IV semester. I am working on the project " TRENDS AND FUTURE OF DERIVATIVES IN INDIA: A DETAILED STUDY. You are requested to fill in the questionnaire to enable, to undertake the study on the said project. NAME: OCCUPATION: ADDRESS: PHONE NO.: 1) For how long you have been trading in derivatives? a) Less than 1 year c) 2 Year b) 1 Year d) 3 Year e) More than 3 years.

2) What is your purpose for trading in derivatives? a) Hedging c) Risk Management b) Speculation d) Liquidity

3) How will you describe your experience with derivative? a) I find these quite profitable

b) I don't find derivatives can give big profits c) I feel that equities are better than derivatives d) Any other __________________________________ 4) What is amount of money you are investing in normally? a) 2, 00,000 b) Rs. 2, 00,000 to Rs. 5, 00,000 c) Rs. 5, 00,000 to Rs. 10, 00,000 d) any other amount____________ 5) How often do you trade? a) Weekly b) Monthly c) More than 1 month d) More than 2 month 6) What according to you is relationship between derivative market and cash market? a) Positive b) Negative c) Can't say

7) According to you, have derivatives settled in Indian investors psychology? a) Yes b) No

8) What shortcomings do you feel in Indian derivative market? a) Lack of awareness among the investors about derivatives. b) Shortage of domestic technical expertise. c) If any other___________________________ 9) Which of following Media would you prefer the most for investor education? a) TV b) Newspaper c) Magazines

10) What suggestions do you want to make with regard to investors education in derivatives market in India?

THANKS FOR YOUR COOPERATION