TABLE OF CONTENTS

Chapter No.
1

Title

Page No.

1.1

Introduction
Meaning

3
4

1.2
1.3
1.4

Definition
History of derivatives
Importance of derivatives

1.5

Factors that led to growth of derivatives

1.6

Requirements of successful derivatives

10

1.7

Emergence of successful derivatives

11

Kinds of Derivatives

12

Forward Contracts
Futures
Options
Swaps

14

Objectives of the study

43

4
5

Data Processing and Analysis

Commodity Derivative Market in India:

45

2
2.1
2.2
2.3
2.4

5
8

19
26
37

46

The Past, Present and Future

6
7
8

FINDINGS
Conclusions
Bibliography
Appendices /Annexure

53
55

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DERIVATIVES

SECTION I

INTRODUCTION

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DERIVATIVES

INTRODUCTION
When one assesses this field, of think it is hyperbole to suggest that the development and
growth of financial derivatives constitute most dramatic success stories in modern economic
history. In short spaces of 55 years, financial derivatives have sprung from the conception to
global prominence spanning the worlds financial markets and institutions, permeating the global
financial system.

David W. Mullins
Former Vice Chairmen
Federal Reserve Board

With the opening of the economy to multinationals and the adoption of the liberalized economic
policies, the economy is driven more towards the free market economy. The complex nature of
the financial structuring itself involves the utilization of multi currency transactions. In the
present state of the economy there is imperative need for the corporate clients to protect their
operating profits by shifting some of the uncontrollable financial risk to those who are able to
bear and manage them, thus, risk management becomes a must for survival since there is a high
volatility in the present financial markets.

In this context, derivatives occupy an important place as a risk reducing machinery. Derivatives
are useful to reduce many of the risk. The financial institutions can ensure that the risk are
hedged by using derivatives like forwards, futures, options, swaps etc. derivatives thus, enable
the clients to transfer their financial risk to the financial market today, derivatives are absolutely
essential.

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DERIVATIVES

MEANING
Derivatives are financial instruments/contracts whose value depends upon the value of an
undertaking. Since their value is essential derived out of an underlying they are financial
abstraction whose value is derived mathematically from changes in the value of the underlying.
The underlying can be agricultural commodity like wheat, barely or tea; individual stock like
Microsoft, Daimler-Chrysler, Infosys and Zee Telefilms; stock indices like standards poor 500;
Nikkei- 225, BSE sensex and NSE Nifty; financial instruments like T. Bills, notes and bonds;
currencies like Dollar. Euro, Pound or even interest rates and literally anything.

DEFINATION
It is very difficult to define the term derivatives in a comprehensive manner, since many
developments have taken place in this field in recent years. Moreover, many innovative
instruments have been created by combining true or more of these financial derivatives so as to
cater the specific requirements of the users, depending upon the circumstances.
One such definition is derivatives are a special type of balance sheet instrument in which no
principal is ever paid
Another definition is derivatives are instruments which make payments calculated using price
of interest rates derived from balance sheet or cash instruments, but do not actually employ those
cash instruments to fund payments.
In the other definition is Derivatives involve payment / receipt of income generated by the
undertaking asset on a national principal.

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DERIVATIVES

HISTORY OF DERIVATIVES
Forward trading in some form or other is quite ancient. It is not clearly established as to where
and when the first forward market came into existence, Forward trading in a somewhat
systematic manner is believed to have been existence in the 12th Century English and French
fairs, the was forward trading in the rice in 17th Century in Japan. The trade, known as cho-aimai a kinai (rice- trade-an book), centered around Dojima, a district of Osaka.

The trade in rice grew evolved to the stage where receipts for future delivery were traded with
high degree of standardization. In 1730, the market received official recognition from Tokugwa
Shogun ate. The Dojima market can thus be regarded as the first future market in the sense of
organized exchange with standardized trading terms.

The first future markets in the United Sates, in Chicago. These markets gradually evolved into
futures trading. The evolution occurred in stages the first stage was staring of agreements to buy
grain in the future at a predetermined price with the intention of actual delivery gradually these
contracts became transferable traders find that these agreements were easier to buy and sell it
they were standardized in terms of quality of grain; market liit and place of delivery. This is how
modern futures market first came into being the Chicago Board of trade (CBOT) which opened
in 1848 is, to this day; the largest future market in the world.

In 1870, the New York Cotton Exchange was founded. The London Metal Exchange was
established in 1877 and is now leading the market in metal trading. The first financial futures
market was the International Monitory Market, founded in 1972 by Chicago Mercantile
Exchange. This was followed by London international Financial Futures Exchange in 1982.
The first organized forward markets in India came into existence in the late 19th and early 20th
Century in Calcutta (for jute and jute goods) and Mumbai (for cotton). Several new markets grew
over the first half of 20th Century.

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Options trading are relatively of recent origin in the 17th Century Holland, there were options in
tulip bulbs. Options trading in shares and agricultural commodities came into existence in US
from 1860s. However, these were not standardized traded options.

The first traded options market was started by (BOT) in April 26, 1973. Options on futures
contract commenced only in 1982. The introduction traded options opened the way first the
evolution of more complex derivatives.

The first swap transaction took place in 1981. Some amount of standardization in terms was
introduced by the international swap Dealers Association in 1985. Other derivatives like forward
rate Agreement (FRAs), range forwards, collars and the like evolved in the second half of the
1980s.

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SECTION II

ABOUT DERIVATIVES IN DETAIL

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IMPORTANCE OF DERIVATIVES
Derivatives are becoming increasingly important in world market as a tool for risk management.
Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks
and transfer them to parties willing to bear these risks. The kind if hedging that can be obtained
by using derivatives is cheaper and more convenient than what could be obtained by using cash
instruments. It is so because, when we use derivatives for hedging, actual delivery of the
underlying assets is not at all essential for settlement purposes.

Moreover, derivatives do not create any new risk. They simply manipulate risk and

transfer them to those who are willing to bear these risks.

Heading risk through derivatives is not similar to speculation, the gain or loss on a

derivatives deal is likely to be offset by an equivalent loss or gain in the values of underlying
assets. Offsetting of risk in an important property of hedging transactions. But, in speculation
one deliberately takes up a risk openly.

All derivatives instruments are very simple to operate. Treasury managers and portfolio

managers can hedge all risk without going through the tedious process of hedging each every day
amount / share separately.

Till recently, it may not have been possible for companies to hedge their long terms risk,

say 10-15 years risk. But with the rapid development of the derivative markets, now, it is
possible to cover such risk though derivative instrument like swap, thus, the availability of
advanced derivatives market enables companies to concentrate on those management decisions
other than funding decisions.

Further, all derivatives products are low cost products. Companies can hedge a

substantial portion of their balance sheet exposure, with a low margin requirement.

Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it also

possible for companies to get out of position in case that market reacts otherwise. This also does
not involve much cost.

Thus, derivatives are not only desirable but also necessary to hedge the complex exposure

and volatilities that the companies generally face in the financial market today.

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FACTORS CONTRIBUTING TO THE GROWTH

OF DERIVATIVE MARKET
The fact that the greatest expansion in futures and options took place in the 1970s and 80s was
no coincidence. The late 1960s and early 1070s witnessed major structural changes in world
financial markets.

The most important currencies at that time (the US Dollar & Pound sterling) came out of the
fixed exchange rate system and become floating currencies. Because of this, the exchange rate of
these currencies became uncertain whereas it had been fixed earlier. Similarly the early70s saw
a great degree of volatility in commodity price, due in part to the oil price hike by OPEC and the
turmoil in the currency market.

In the late 1970s another very important change occurred. Earlier, central banks had followed a
policy of relatively stable interest rates but guided by the advice of monetarist economists like
Milton Friedman, central banks began to exercise greater control over money supply and starting
using interest rate changes as a means for controlling it. As a result, frequent changes of interest
rate-both upwards and downwards-became the order of the day. (This remains the case now.)

In short, the 1970s and early 1980s were characterized by rapid changes in financial markets
which increased uncertainties. The greater the risk, the greater the need to manage it. Necessity
being the mother invention, the increased risk led to the growth of risk management toolsderivatives.

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REQUIREMENTS OF SUCCESSFUL DERIVATIVES.

Liquidity is the most important criterion of a successful futures market. The trading interest from
speculators is always / products serve a useful economic purpose of efficiently transferring risk
from a hedger to another market participant Vice versa. A successful, market is one in which the
right balance is truck between speculative interest and economic utility. Success cannot be
achieved without the existence of both. The factors that contribute to the success of a derivatives
market are:

The product: the derivatives product that is created must serve the users need;

otherwise it will not be accepted. It must be closely linked to the underlying cash market to
ensure that it is a good hedge in terms of the specifications such as size, maturity, settlement and
delivery.

Market support: for a successful market to evolve, the support of certain committed

trading parties is needed. Their support right from the beginning is crucial to the success of the
market because most institutional and other customers adopt a wait and see attitude when it
comes to participating in new markets.

The brokers: the good brokers and an efficient broking network are critical to the

success of a market. As members of an exchange brokers have a natural interest in the eventual
success of the market.

Education & marketing: one of the most important factors in ensuring the success

of a future market is education and marketing of the exchange, its product and services.
Education and marketing in the initial stages is important because at this stage, one is selling
hope hope for success, hope for the future.

Local community and government support: for developing a successful

market, support from the people and the institution in the local community and the government
are very important. Sound regulation in order to inspire confidence from both domestic and
international customers a strong regulatory have control over derivative transaction.

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EMERGENCE OF FINANCIAL DERIVATIVE PRODUCT

Derivatives product initially emerged as hedging devices against functions in commodity price
and commodity linked derivatives remained the sole from of such products for almost 300 yrs.
financial derivatives came into spotlight in the past 1970 period due to growing stability in FMs.
However, since their emergence, these products have become very popular and by 1990s they
accounted for about 2/3 rd of total transaction in derivative products.

In recent years, the markets for financial derivatives have grown tremendously in terms of
variety of instruments available, their complexity and also turnover. In class of equity derivatives
the world over, futures and options on stock indices have gained more popularity than an
individual stock, especially among institutional investors, who are the major users of index
linked derivatives even small investors find them useful due to high correlation of the popular
index with various portfolios and case of use. The lower cost associated product based on
individual securities is another reason for their growing use.

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SECTION III

KINDS OF DERIVATIVES

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DERIVATIVES

KINDS OF DERIVATIVES

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DERIVATIVES

TYPE 1
FORWARD CONTRACTS

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FORWARD CONTRACT
MEANING:Forward contract is a simple form of financial derivative instruments. It is an agreement to buy
or sell a specified quantity of an asset at a certain future date for a certain price agreed upon now.
In a forward contract, two parties agree to do a trade at some future date at a stated price and
quantity. No money changes at the time the deal is signed. However unlike futures contracts,
they are not traded on an exchange. They are private contracts between two parties which may be
between financial institutions, between a financial institution and one of its corporate client, etc.
Further, these contracts differ from cash or spot contracts where delivery is made immediate
within a short settlement period. Most of the forward contracts are traded on the over-the-counter
parties risk depends on the counter part only.

At the time the forward contract is written, a specified price is fixed at which the asset is
purchased or sold. This specified price is referred to as the delivery price. This delivery price is
set such that the value of the forward contract is zero at the time of its formation. This means that
it cost nothing to take either a long (buyer) or short (seller) position.

This is done by convention so that no cash is exchanged between the parties entering into the
contracts. In this way, the delivery price yields a fair price for the future delivery of the
underlying asset. One of the parties to a forward contract agrees to buy the underlying asset is
said to have a long position. On the other hand, the party that agrees to sell the same underlying
asset is said to have short position.

For example:- On June 1, Mr. X enters in to agreement to buy 50 bales of cotton on

December 1 at Rs. 1000per bale from Mr. Y , a cotton dealer .It is a case of forward contract
where Mr. X has to pay Rs. 50,000on December 1 , to Mr. Y and Mr. Y has to supply 50 bales of
cotton.

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FEATURES OF FORWARD CONTRACT

It is an agreement between two counter parties in which one is buyer and other is seller.

All the terms are mutually agreed upon by the counterparties at the time of the formation of the
forward contract.

It specified a quantity and type of the asset (commodity or security) to be sold and

purchased.

It specified the future date at which the delivery and payment are to be made.

It specified a price at which the payment is to be made by the buyer. The price is

determined presently to be paid in future.

It obligates the seller to deliver the asset and also obligates the buyer to buy asset.

No Money changes hands until the delivery date reaches, except for a small service fee, if

there is.

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CLASSIFICATION OF FORWARD CONTRACT

The forward contracts can be classified into different categories. Under the forward Contracts
(Regulation) Act, 1952, forward contracts can be classified in the following categories :

Hedge Contracts:

The basic features of such forward contracts are that they are freely transferable and do not
specify any particular lot, consignment of variety of delivery of the underlying goods or assets.
Delivery in such contracts is necessary except in a residual or optional sense. These contracts are
governed under the provision of the forward Contracts (Regulation) Act, 1952.)

Transferable Specific Delivery (TSD) Contracts:

These forward contracts are freely transferable from one party to other party. These are
concerned with a specific and predetermined consignment or variety of the commodity. There
must be delivery of the underlying asset at the expiration time. It is mandatory, such as contracts
are subject to the regulatory provision of the Forward Contracts (Regulation) Act, 1952, but the
central Government has the power to exempt ( in specified cases) such forward contracts.

Non Transferable Specific Delivery (NTSD) Contracts:

These contracts are of such nature which cannot be transferred at all. These may concern with
specific variety or consignment of goods or their terms may be highly specific. The delivery in
these contracts is mandatory at the time of expiration. Normally, these contracts have been
exempted from the regulatory provision of forward Act, but the Central Government, whenever
feels necessary, may bring them under the regulation of the Act.

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OTHER FORWARD CONTRACTS

Forward Rate Agreements:-

Forward Contracts are commonly arranged on domestic interest-rate bearing instruments as well
as on foreign currencies. A forward rate agreement is a contract between the two parties, (usually
one being the banker and other a bankers customer or independent party), in which one party
(banker) has given the other party (customer) a guaranteed future rate of interest to cover a
specified sum of money over a specified period of time in the future. For example, two parties
agree that a 6 percent per annum rate of interest will apply to one year deposit in six months
time. If the actual rate of interest proves to be different from 6 percent then one company will
pay and other receives the difference between the two sets of interest cash flows.

Example: Assume two companies might agree that 8 percent annum rate if interest will apply
to a one-year deposit in fix months time. If actual rate proves to be different from 8 percent per
annum, one companies pay and the other receives the present value of the difference between
two sets of interest (cash flows). This is known as a forward-rate agreement (FRA)

Range Forwards:-

These instruments are very much popular in foreign exchange markets. Under this instrument,
instead of quoting a single forward rate, a quotation is given in terms of a range, i.e., arrange
may be quoted for Indian rupee against US dollar at Ra. 47 to Rs. 49. It means there is no single
forward rate rather a series of rate ranging from Rs. 47 to 49 has been quoted. This is also known
as flexible forward contracts. At the maturity, if the spot exchange rate is between these two
levels, then the actual spot rate is used. On the other hand, if the spot rate rises above the
maximum of the range, i.e., Rs. 49 in the present case then the maximum level is used. Further, if
spot rate falls below the minimum level, i.e., Rs. 47, then the minimum rate will be used. As
such we see that these forward range contracts differ from normal forward contracts in two
respects, namely,

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TYPE 2
FUTURE CONTRACTS

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FUTURE CONTRACTS
MEANING
A future contract is an agreement between a buyer and seller where the seller agrees to deliver a
specified quantity and grade of a particular asset at a predetermined tome in futures at an agreed
upon price through a designated market (exchange) under stringent financial safeguards.
A futures contract, in other words, is an agreement to buy or sell a particular asset between the
two parties in a specified future period at an agreed price through a specified exchange. For
example, the S& P CNX NIFTY futures are traded on national stock Exchange (NSE). This
provides them transparency, liquidity, anonymity of trades, and also elements the counter party
risk due to the guarantee provider by National Securities Clearing Corporation Limited
(NSCCL).
Bombay stock Exchange (BSE) website defines futures contract: Futures are exchange traded
contracts to sell or buy finical instrument or physical commodities for future delivery at an
agreed price. There is an agreement to buy or sell a specified quantity of finical instrument /
commodity in a designation future month at a price agreed upon by the buyer and seller. The
contracts have certain standardized items specification.
The standardized items in any futures contract are:

Quantity of the underlying asset

Quantity of the underlying asset (not required in financial futures)

The date and month of delivery

The units of price quotation (not the price itself) and minimum change in price(tick size)

For example:Contract traded on Chicago Merchantville Exchange of wheat for the fine grade delivery months
in March, may, July, September and December are available for up to 18 months into the future.
Each contract size is 5000 bushels. Contracts traded on National Stock Exchange of equity share
for delivery period of one, two, six and twelve months named as NIFTY futures. Each contract
size is of 50 shares compressing different companies from different sector of economy.

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FEATURES OF FUTURE CONTRACT

Highly Standardized:

Futures are standardized and legally enforceable. Hence, they are traded only in organized Future
exchanges. It is also difficult to modify the agreement according to the needs of the contracting
parties. However, many variants of Futures are available. But, once the agreement is entered
into, the chances of modifying it are very remote.

Down Payment:

The contracting parties need not pay any down payment at the time of agreement. However, they
deposit a certain percentage of the contract price with the exchange and it is called initial margin.
This gives a guarantee that the contract will be honored.

Settlements:

Though future contracts can be held till maturity, they are not so in actual practice. Futures
instruments are "marked to the market' and the exchange records profit and loss on them on daily
basis. That is, once a futures contract is entered into, profits or losses to both the parties are
calculated on a daily basis.
The difference between the futures price and the spot price on that day constitutes either profit or
loss depending upon the prevailing^ spot prices. The spot price is nothing but the market price
prevailing then For example, on Monday morning X enters into a futures agreement with Y to
buy 50 bales of cotton at Rs. 100/- per bale on Friday afternoon. At the close of trading on
Monday, the futures price goes up by Rs. 10/-per bale. Now, X will get a cash profit of Rs. 500/for 50 bales at the rate of Rs. 10/- per bale. X can also cancel the existing futures contract with
the price Rs. 100/- per bale or he can enter into a new futures contract at Rs. 110/-per bale.

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Hedging of Price Risks:

The main feature of a futures contract is to hedge against price fluctuations. The buyers of a
futures contract hope to protect themselves from future spot price increases and the sellers from
future spot price decreases. Parties enter into futures agreements on the basis of their
expectations of the future price in the spot market for the assets in question.

Linearity:

As stated earlier, futures contract is nothing but a standardized forward contract. Therefore, it
also possesses the property of linearity. Parties to the contract get symmetrical gains or losses
due to price fluctuation of the underlying asset on either direction.

Secondary Market:

Futures are dealt in organized exchanges, and as such, they have secondary market too.

Non delivery of the Asset :

The delivery of the asset in question is not essential on the date of maturity of the contract in the
case of a futures contract Generally parties simply exchange the difference between the future
and spot prices on the date of maturity.

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TYPES OF FUTURES
Like forwards, futures may also be broadly divided into two types namely:
(i) Commodity Futures
(ii) Financial Futures

Commodity Futures :A commodity future is a futures contract in commodities like agricultural products metals and
minerals etc. In organized commodity future markets, contracts are standardized with standard
quantities. Of course, this standard varies from commodity to commodity. They also have fixed
delivery dates in each month or a few months in a year. In India commodity futures in
agricultural products are popular.
Some of the well established commodity exchanges are as follows:
(i) London Metal Exchange (LME) to deal in gold
(ii) Chicago Board of Trade (CBT) to deal in soya bean oil.
(iii)New York Cotton Exchange (CIN) to deal in cotton.
(iv) Commodity Exchange, New York (Comex) to deal in agricultural products.
(v) International Petroleum Exchange of London (IPE) to deal in crude oil.

Financial Futures :Financial futures refer to a futures contract in foreign exchange or financial instruments like
Treasury bill, commercial paper, stock market index or interest rate. It is an area where financial
service companies can play a very dynamic role. Financial futures are very popular in Western
countries as hedging instruments to protect against exchange rate / interest rate fluctuations and
for ensuring future interest rates on loans.
Some of the well established financial futures exchanges are the following:
(i) International Monetary Market (IMM) to deal in U.S. treasury bills, Euro dollar deposits,
Sterling etc.
(ii) London International Financial Futures Exchange (LIFFE) to deal in Euro dollar deposits.
(iii) New York Futures Exchange (NYFE) to deal in Sterling, Euro dollar deposits etc.

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TYPES OF FINANCIAL FUTURES

Stock Index Futures :It is a futures contract on major stock market indices. This type of contract is very much useful
for speculators, investors and especially portfolio managers. They can hedge against future
decline or increase in prices of portfolios depending upon the situation. Generally, the asset will
not be delivered on the maturity of the contract. The parties simply exchange the difference
between the future and spot prices on the date of maturity. But, these kinds of financial futures
are relatively new in India.

Interest rate futures :It is one of the important financial futures instruments in "the world. Futures trading on interest
bearing,, securities started only in 1975, but the growth in this market has been "tremendous.
Important interest-bearing securities are like treasury bills, notes, bonds, debentures, euro-dollar
deposits and municipal bonds. In this market, almost entire range of maturities bearing securities
is traded. For example, three-month maturity instruments like treasury bills and euro-dollar time
deposits, including foreign debt instruments at Chicago Mercantile Exchange (CME), British
Government Bonds at London International Financial Futures Exchange.(LIFFE), Japanese
Government Bonds at CBOT, etc. are traded. This market is also further categorized into shortterm and long-term interest bearing instruments. A few important interest rate futures traded on
various exchanges are: notional gilt-contracts, short-term deposit futures, Treasury bill futures,
euro-dollar futures, Treasury bond futures and treasury notes futures.

Foreign currencies futures:These financial futures, as the name indicates, trade in the foreign currencies, thus, also known
as exchange rate futures. Active futures trading in certain foreign currencies started in the early
1970s. Important currencies in which these futures contracts are made such as US-dollar, Pound
Sterling, Yen, French Francs, Marks, Canadian dollar, etc. These contracts have a directly
corresponding to spot market, known as interbank foreign exchange market, and also have a
parallel interbank forward market. Normally futures currency contracts are used for hedging
purposes by the exporters, importers, bankers, financial institutions and large companies.
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FORWARD Vs FUTURES
Particulars

Forward Contracts

Futures Contracts

Nature

OTC Contracts Tailored to Exchange-traded

Size

specific needs.

Process

Are private and negotiated Uses a clearing house which

Standardized and published.

bilaterally between the parties provides protection for both

with no exchange.

the parties.

Margin requirements

Involves no margin payments.

Requires a margin to be paid.

Uses

Used for hedging and physical used

delivery

prices

for

hedging

and

speculating

Are not transparent as there is Are

no reporting requirement

transparent

.Futures

contracts are reported by the

exchanges

Settlement

By actual delivery or offset Usually by closing out and

with cash settlement

Credit risk

Forward

contracts

substantial
lines of credit

usually

cash settlement
can

be Credit risk largely eliminated

requires by use of margin deposit and

daily cash settlement of profits
and losses through the clearing
house

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TYPE 3
OPTIONS CONTRACTS

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OPTIONS
MEANING
An Option is a particular type of a contract between two parties where one person give the other
person the right to buy or sell a specific asset at a specified price within a specific time period .In
other word, the option is a specific derivative instrument under which one party gets the right,
but no obligation, to buy or sell a specific quantity of an agreed price, on or before a particular
date.

For example:- One person buys an option contract to purchase 100 share of State Bank of
India at Rs. 300 per share for a period of 3 months. It means that the said person has the right to
purchase the share of State Bank of India at Rs 300 per share within 3 months from the date of
the contract. If the price of State Bank of India increases, he will exercise the option, and if price
falls below Rs 300 then he will not exercise his option.
It is evident from the above that an option is the right, but not obligation to buy or sell something
at a specified date at a state price. It means the option buyer will exercise the optionally when he
is in profit. In case of loss, he will not exercise

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FEATURES OF OPTION CONTRACT

Highly Flexible:

On one hand, potion contracts are highly standardized and so they can be traded only in
organized exchanges. Such option instruments cannot be made flexible according to the
requirements of the writer as well user. On the other hand, there are also privately arranged
options which can be traded over the counter. These instruments can be made according to the
requirements of the writer and user. Thus, it combines the features of futures as well as
forward contracts.

Down Payment:

The option holder must pay a certain amount called premium for holding the right of exercising
the option. This is considered to be the consideration for the contract. If the option holder does
not exercise his option, he has to forego this premium. Otherwise, this premium will be deducted
from the total payoff in calculating the net payoff due to the option holder.

Settlement:

No money or commodity or share exchanged when the contract is written. Generally this option
contract terminates either at the time of exercising the option by the option holder or maturity
whichever is earlier. So, settlement is made only when the option holder exercises his option.
Suppose the option is not exercised till maturity, then the agreement automatically lapses and no
settlement is required.

Non- Linearity:

Unlike futures and forward, an option contract does not possess the property of linearity. It
means that the option holders profit, when the value of the underlying asset moves in one
direction is not equal to his loss when its value moves in the opposite direction by the same
amount. In short, profit and Losses are not symmetrical under an option contract. For example:Mr. X purchases a two month call option on rupees at Rs. 100= 3.35$. Suppose, the rupees
appreciates within two months by 0.05$ per one hundred rupees, then the market price would be
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Rs. 100 = 3040$. If the option holder Mr. X exercises his option, he can purchase at the rate
mentioned in the option i.e., Rs. 100 = 3.35 $. He gets a payoff at the rate of 0.05$ per every one
hundred rupees. On the other hand, if the exchange rate moves in the opposite direction by the
same amount and reaches a level of Rs. 100 = 3.30 $. Option holder will not exercise his option.
Then, his loss will be zero. Thus, in an option contract, the gain is equal to the loss.

No Obligation to Buy or Sell:

In all option contracts, the option holder has a right to buy or sell an underlying asset. He can
exercise this right at any time during the currency of the contract. But, in no case, he is under an
obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.

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CLASSIFICATION OF OPTION
Option may fall under any one of the following main categories:

Call Option

Put Option

Double Option

American Option & European Option

Call Option :A call option is one which gives he the option holder the right to buy a underlying asset
(Commodities, foreign exchange, Stocks, Share etc.) at a predetermined price called exercise
price or strike price on or before a specified date in future . In such a case the writer of a call is
under an obligation to sell the asset at the specified price, in case the buyer exercises his option
to buy. Thus, the obligation to sell arises only when the option is exercised.

Put Option
A put option is one which gives the option holder the right to sell an underlying asset at a
predetermined price on or before a specified date in future. It means that the writer of a put
option is under an obligation to buy the asset at the exercise price provided the option holder
exercise his option to sell.

Double Option
A double option is one which give the option holder both the rights- either to buy or to sell an
underlying asset at a predetermined price on or before a specified date in future Authorized
declares for option trading in rupee dollar exchange markets. The Bombay Stock Exchange and
National stock Exchange have also started option trading in stock from 2001.

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DERIVATIVES
American Option & European Option:
In an Option contract, if the option can be exercised at any time between the writing of the
contract and its expiration, it is called as an American option. On the other hand, if it can be
exercised only at the time of maturity, it is termed as European option.

Exchange Traded Options & Over the Counter- Traded Options:

The options can be traded like other financial assets either on an organized

exchange or on the

over-the-counter market.
Exchange traded options, like future contracts, are standardized and are traded on organized
exchanges. Being standardized in nature, these option contracts has underlying asset, limited
number of strike prices, limited expiration dates and so on. They are performed and cleared
through clearing house, and also default list is eliminated. Transaction cost is also limited in this
case as it depends on creditworthiness of the borrower.
The OTC-traded options, on the other hand are customer tailor agreements sold directly by the
dealer. In case of OTC options; all terms and conditions to the contract are negotiated and
mutually determined by buyer & seller. It involves higher default rick since there are only two
parties and if option writer commits default, there is no guarantee to the buyer.

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OPTION TERMINOLOGY
Following are the important terms which are frequently used in option trading:

Parties of the option contract :-

There are two to an option contract: the buyer (the holder) and the writer (the seller). The writer
grants the buyer a right to buy or sell a particular asset in exchange for a certain sum of money
for the obligation taken by him in the option contract .

Exercise price :-

The price at which the underlying asset may be sold purchased by the option buyer from the
option writer is called as exercise or strike price. At this price the buyer can exercise his option.

Expiration date and exercise date :-

The date on which an option contract expires is called as expiration date or maturity date. The
option holder has the right to exercise his option on any date before the expiration date. In other
words, the date which an option is void is called the expiration date. Exercise date is the date
upon which the option is actually exercised whereas the expiration date is the last day upon
which the option may be exercised.

Option premium :-

The price at which option holder buys the right from the option writer is called option premium
or option price. This is the consideration paid by the buyer to the seller and remained with the
seller whether the option is exercised or not .In other word, the price or premium is paid by the
holder to the writer of the option against the obligation undertaken. This is fixed and paid at the
time of the formation or writing an option deal.

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Option In, Out and At- the money :-

An option contract at a particular time, can be in the money , out of the money and at the
money. When the underlying futures price/stock price is greater than the strike or exercise
price, the call option will be in the money, and if the futures price is lesser than the strike
price, it will be called out of the money call option . Further if the futures price is equal to
the strike price, it is said that call option is at the money . The reverse is the position in case
of put options.

______________________________________________
Call option

Put option

_______________________________________________
In the money

Futures > Strike

Futures <Strike

At-the-money

Futures = strike

Futures =Strike

Out-of money

Futures < strike

Futures >Strike

________________________________________________
The break Even-Price :
It is that price of the stock where the gain on the option is just equal to the option premium. The
break even price level is determined by adding the strike price and the premium paid together.
In other words the option is sufficiently deep in the money to cover the option premium and
yields a potentially unlimited net profit. Since there is zero sum game the profit from selling a
call is the mirror image of the profit from buying the call.

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DERIVATIVES

THE UNDERLYING ASSESTS UNDER WHICH OPTIONS ARE

AVAIABLE: Stock options :Individual shares of common stock have been traded for many years. Trading on standardized
options on equity shares started in 1973 on CBOE whereas on put options began in 1977 Stock
options on number of over the counter stock are also available. While strike prices are not
because of cash dividends paid to common stock holders the strike price is adjusted for stock
splits stock dividends reorganization recapitalizations etc which affect the value of underlying
stock. In India National Stock exchange & Bombay Stock Exchange have started options trading
in stocks from the year. 2001.

Index options :-

When an option contract is entered into with an option to buy or sell shares or stocks, it is known
as Share Option. Share option transactions are generally index-based. All calculations are based
on the charge in index value. For example, the present value of an index is 300. A person Mr.
buys a month call option for an index value of 350 by paying 10% of the present index value in
points at the rate of Rs. 10 per point. Now, the option price is taken as Rs. 300 and the strike
price or exercise price is Rs. 350. So long as the index remains below 350, the option holder will
not exercise his option since he will be incurring losses. Now, the loss will be limited to the
premium paid at the rate of Rs. 10/- per point. As the spot price increases beyond the strike price
level, exercise of the option becomes profitable. Suppose the spot rate reaches 360, option may
be exercised. The option holder gets a profit of Rs. 100 (10 points X 10). However, his new
position will be Rs. 100-300 (premium 10% on 300 X 10). He incurs a net loss of Rs. 200. When
the spot rate reaches 380, the breakeven point is reached. Beyond this index value, the option
holder starts making a profit. A person with more money can trade the index at a higher price of
Rs. 100 or 200 per index point. However, this kind of game can be played by speculators only.
Genuine portfolio managers can use this instrument to hedge their risks due to heavy fluctuation
in the price of share and stocks.

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DERIVATIVES

Foreign Currency option:-

Foreign currency option or simple currency option is a financial instrument that give the option
holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a
fixed price per unit for a specified time period (until the expiration date ). In other words, a
foreign currency option is a contract for future delivery of a specific currency in exchange for
another in which the holder (buyer) of the option has the right to buy (Call) or sell put a
particular currency at an agreed price (the strike or exercise price). For or within specified
period. The seller of the option (writer) gets the premium from the buyer of the option for the
obligation undertaken in the contract.
The buyer of an option is termed as holder whereas the seller of an option is called the writer or
grantor .In other words , there are two parties in an option contract buyer and seller. If one party
is buyer in a particular currency , the other party will be automatically a seller in that particular
currency. It should be further noted that a rupee call option which gives the holder the right to
buy rupees against dollar is also a dollar put option, giving the right to sell dollar against rupee.
Every currency option contract has three different price elements: (a) the exercise or strike price
(rate) at which the foreign currency can be purchase or sold, (b) the premium, which is the cost
or price or value of the option itself and (c) the underlying or actual spot exchange rate in the
currency market exists on the exercise day. In the last decade the foreign currency options have
frequently used as a hedging tool and for speculative trading purposes, specifically in the
developed countries like USA, UK Japan, Germany etc. A number of the commercial banks in
the United States (USA) and other capital markets offer flexible foreign currency options on
transactions of one million US dollar or more.

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OPTIONS VS FUTURES CONTRACTS

The basic difference of the options and futures contracts is obligation. In the option contracts,
one party (the buyer) is obligated to transact the contract at a later date, only the other party
(seller) is under obligation to in the option contract, and only if the buyer desires so. On the other
hand, in case of futures root, both the parties, buyers and sellers, are under obligation to perform
the contract.
In case of options contracts, one party (the buyer) has to pay in cash the option price (premium)
to other party (seller) and this is not returned to the buyer whether he insists for actual
performance of the contract or not. In case of futures contract, no cash is transferred to either
party at the time of the termination of the contract.
The risk and reward characteristics of these two contracts also differ. In the case of futures
contract, the buyer of the contract realizes the gains in cash when the price of the futures
contract increases and incurs losses in case of fall in the prices. The position is opposite in case
of the seller of the futures contract. However, in the case of options contracts, such symmetric
risk/reward relationship does not rise. The most that the buyer of an option can lose is the option
price against which he possesses all the, potential benefits. The maximum profit that the seller of
the option contract may realize is the options this is to offset against substantial down side risk.
In case of option contracts, they are brought into existence by being traded; if none is traded,
none rusts; conversely, there is no limit to the number of option contracts that can be in existence
at any time, However, in the case of futures contracts, there is process of closing out position
which cause contracts .case to exit, hence, diminishing the total number in comparison to
options.

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DERIVATIVES

TYPE 4
SWAPS CONTRACTS

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SWAPS
MEANING

The word 'swap' literally means an exchange. A derivative or financial swap may be defined as a
contract whereby two parties (known as counterparties), exchange two streams of cash flows
over a defined period of time, usually through an intermediary like a financial institution. The
nature of the cash flows to be exchanged is defined in the contract.

CONCEPT
Swaps are the most versatile of derivative products. The development of the swap market was an
important milestone in the evolution of international capital markets in the 1980 s. It has
fundamentally transformed the way in which today's financier or bankers look at funding
choices.) While FRA s and futures are single period price-fixing contracts/swaps are multiperiod price-fixing contracts. Swaps were developed essentially as OTC products; but today, a
number of exchange-traded versions of swaps are available as well. At the outset, it is necessary
to distinguish financial swaps from foreign exchange swaps. In the case of foreign exchange
swaps, a currency is simultaneously bought and sold for two value datesone of these may be
spot and the other may be forward or both the legs may relate to two different forward dates. In
the case of swaps in the derivatives context, we refer most often to contracts where two streams
of cash flows are exchanged by two parties over a defined time period. Foreign exchange swaps
essentially involve short-term exchanges while financial swaps, are essentially long-term in
nature. Swaps, fundamentally exist because different institutions have varied access to financial
markets and due to different needs. Currency and interest rate swaps are techniques that
transform the currency and interest rate characteristics of a liability or an asset, from one form to
another. Thus, swap is a utility for transforming the characteristics of financial claims.

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TERMINOLOGY OF SWAPS
Terms which are essential for to understand the swaps are listed below:

Counterparties refer to the two parties to a swap. The counterparty that pays fixed

rate cash flows is known as buyer of the swap and the one who receives fixed rate cash flows is
known as the seller. Thus, in any swap, the fixed-rate payer is the buyer and the fixed-rate
receiver is the seller. This is analogous to a normal commercial transaction, wherein a buyer pays
a fixed sum of money as the price for acquiring a good. In the case of a swap, the fixed interest
rate payer is said to be the buyer.

Swap Dealer/market maker is the intermediary between two counterparties, who

stands ready to match any client's currency or interest rate requirements by offering himself as
the counterparty to the swap. Typically it signifies at least one of the counterparties, who is
willing to take the swap on his books.

Effective/Value date refers to the date on which the swap commences, i.e., the date

from which interest starts accruing. The start date is normally a spot date i.e., 2 days after the
transaction date. Sometimes the swap may have a corporate start date in which the swap becomes
effective from a date a week later.

Termination/Maturity date is the date on which the swap terminates.

Swap tenor /Maturity is the period between the effective and termination dates.

Swap coupon is the fixed rate or the fixed price which does not change over the tenor

of a swap. This is also known as swap price, swap rate or swap strike.

Reference rate indicates the rate on which the floating leg is based. Internationally,

the most common reference rate is the LIBOR.

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DERIVATIVES

Reset dates are the dates on which the floating leg is reprised on the basis of the

reference rate. Usually, it is semiannual.

Notional principal amount (NPA) is the amount involved in the swap which is

never exchanged. It is used purely on a notional basis for calculating the periodic payments
between the counterparties.

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DERIVATIVES

TYPES OF SWAPS
Interest rate swaps:An interest rate swap is a financial agreement between the two parties who wish to change the
interest "payments or receipts in the same currency on assets or liabilities to a different basis.
There is no exchange of principal amount, in this swap. In other words, it is an exchange of
interest payment for a specific maturity on a agreed upon notional amount. The term 'notional'
refers to the theoretical principal underlying the swap. The principal amount applies only for the
purpose of calculating the interest to be exchanged under an interest rate swap. Maturities range
from a year to over 15 years, however, most transactions fall within two years to ten years
period. The simplest example of interest rate swap is to exchange of fixed for floating rate
interest payments between two parties in the same currency. This is also known in the market as
plain vanilla swap, exchange of borrowings, or coupon swap. It involves credit differentials
between two borrowers in the fixed and floating debt markets which generate substantial cost
savings for both the counter parties.

Currency swaps:-

A swap deal can also be arranged across currencies. It is an oldest technique in swap market. In
this swap, the two payment streams being exchanged are denominated in two different
currencies. For example, a firm which has borrowed Japanese yen at a fixed interest rate can
'swap away' the exchange rate risk by setting up a-contract whereby it receives yen at a fixed rate
in return for dollars at either a fixed or a floating interest rate.
The currency swap is, like interest rate swap, also two party transactions, involving two counter
parties with different but complimentary needs being bought by a bank. In this swap, normally
three basic steps are involved which are as under:

Initial exchange of principal amount

Ongoing exchange of interest

Re-exchange of principal amounts on maturity

The first step in this swap is the initial exchange of the principal amounts at an agreed rate of
exchange. This rate is usually based on the spot exchange rate. This initial exchange can be on a

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DERIVATIVES
notional basis, i.e., no physical exchange of principal amounts. The counter parties simply
convert principal amounts into the required currency-via-the spot market.
The second step is related with ongoing exchange of interest. After establishing the principal
amounts, the counter parties exchange interest payment on agreed date based on the outstanding
principal amounts at the fixed interest rates agreed at the outset of the transaction.
The third step is the re-exchange of principal to principal amounts. Agreement on this enables
the counter parties to re-exchange the principal sums at the maturity date.

Debt equity swap:-

There can be different structure of swap contracts but the basics are fairly simple in debt-equity
swap, a firm buy's a country's debt on the secondary loan market at a discount and swaps into
local equity. In other words, the debts are exchanged for equity by one firm with the other.
Recently, a market for less-developed countries (LDC) debt-equity swap has developed that
enable the investors to purchase the external debts of such underdeveloped countries to acquire
equity or domestic currency in those same countries. Earlier, six major debt notions Chile,
Brazil, Mexico, Venezuela, Argentina. And the Philippines have initiated such debt-equity swap
programmers. This market was developed in 1983 and by the 1988, the same was reached to $15
billion in size, and further it is on rising trend.

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SECTION IV

OBEJECTIVES OF THE STUDY

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DERIVATIVES

Objectives of the study

To understand the overview of derivatives market in India

To know the mechanism of derivatives trading in India

To study the importance of Derivatives and Risk Market

To study the factors contributing to the growth of derivatives markets

To study the emergence of financial derivative products

To evaluate the commodity derivative market with special reference to the future scope

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SECTION V

DATA PROCESSING AND

ANALYSIS

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DATA PROCESSING AND ANALYSIS

Commodity Derivative Market in India: The Past, Present and
Future
The history of commodity derivative market in India dates back to the ancient times, but the first
organized market was established in 1875. However, by mid 1960s government took a drastic
step by banning derivatives trade altogether. The commodity derivative market remained
virtually absent in next four decades and it made the restart only in early 2000s. Since its
reintroduction it is thriving and the current trend shows strong growth potential of the market,
although, the actual growth trajectory will depend upon the attitude of the policy
makers and the efficiency of the regulatory mechanism.

Introduction
Commodity derivatives made their appearance before financial derivatives in the world and also
in India. Informal trading in commodity derivatives was there even in ancient India, but the
formal market took shape in the late nineteenth century. However, the growth path of the Indian
derivative market was not smooth. Trading remained banned for a long period of time since 1966
and it was reintroduced in the early 2000s. The present study makes an overview of the Indian
commodity derivatives market and examines its sustainability. The study discusses the evolution
of the market, its present status and the future prospect.

Evolution of the Commodity Derivative Market in India

The beginning of the modern worldwide commodity derivative market can be traced to Chicago,
which had emerged as an important agricultural commodity trading center in the early 1800s. In
1848, the Chicago Board of Trade (CBOT) was founded as a commodity exchange. Commodity
derivatives are not new in India too. In fact, forward trading in commodities existed in India
from ancient times (it was mentioned in Kautilyas Arthashastra), but the first modern futures
market was established in 1875 for cotton contracts by the Bombay Cotton Trade Association.

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Oilseed and food grain futures followed and before the World War II, futures were being traded
on commodities such as wheat, rice, sugar, groundnut, groundnut oil, raw jute, jute products and
castor seed as well as precious metals. During World War II futures trading was prohibited to
contain runaway speculation and illegal hoarding.

After independence, the Forward Contracts (Regulation) Act was enacted in 1952 to regulate the
trading in forward and futures. The Forward Markets Commission (FMC) which oversees
forward trading was instituted as a regulatory body the following year. The Act applied to all
contracts whereby the delivery of goods occurs after a period longer than 11 days. The task of
the commission was to monitor and regulate the trading of forward contracts since manipulation
in these markets are likely to create severe imbalances with adverse welfare effects.
Nevertheless, Indian markets did not really blossom over the following four decades. Regulators
viewed markets in general with suspicion and derivative markets particularly as the terrain of
unscrupulous speculation. Price control was a central feature of economic policy during much of
this period. This overly regulated nature of the economy did not bode well for the development
of these markets. In 1966, futures trade was altogether banned to give effective powers to
government price control.
A few select commodities saw a reintroduction of futures in 1980 following the Khusro
Committee report. But the real breakthrough came with the liberalization of the Indian economy
in the early 1990s. In 1993, the Kabra Committee was appointed to look into forward markets.
The committee recommended in 1994 that all futures banned in 1966 be reintroduced as well as
many others added. Six years later, the National Agricultural Policy 2000 envisioned the removal
of price controls in agricultural markets and widespread use of futures contracts. However, the
commodity futures market made the true restart in early 2000s with establishment of a number of
nationwide multi commodity exchanges.

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Commodity Futures Market in the Last Decade

Throughout the last decade the commodity futures market has developed significantly in terms of
both network and volume. At present, there is a two-tier structure for Commodity Exchanges in
India: Regional and Country-Wide. Regional exchanges are permitted to have only a limited
number of contracts whose membership is local. Countywide national exchanges are multicommodity electronic exchanges with a demutualized ownership pattern. Currently, there are
three such exchanges, viz., MCX (Multi Commodity Exchange), NMCE (National Multi
Commodity Exchange) and NCDEX (National Commodities and Derivatives Exchange).
MCX has evolved as the largest exchange in the country. MCX started its operations on
November 10, 2003 and today it holds a market share of over 80 per cent of the Indian
commodity futures market and has more than 2000 registered members operating through over
100,000 trader work stations across India. The exchange has also emerged as the sixth largest
and amongst the fastest growing commodity futures exchange in the world, in terms of the
number of contracts traded in 2009. MCX offers more than 40 commodities across various
segments such as bullion, ferrous and non-ferrous metals, and a number of agri-commodities on
its platform. The Exchange is the worlds largest exchange in silver, the second largest in gold,
copper and natural gas and the third largest in crude oil futures, with respect to the number of
futures contracts traded. MCX maintains an Insured Settlement Guarantee Fund of about Rs. 100
crores. Even as reform initiatives are slowly taking shape, turnover in the Indian commodity
futures market has increased many times over. The total value of trade in the Commodity Futures
Market has risen substantially in the last few years (Table 1). MCX recorded the highest turnover
in terms of value of trade from 2006 to 2010 followed by NCDEX and NMCE. Total value of
trading in the commodity futures market rose from Rs. 34,84,485 crore in 2006 to Rs. 36,54,487
crore during 2007 and similarly it has continuously increased to Rs. 94,94,725 crore in 2010. The
average daily value of trades in the commodity exchanges improved from Rs. 15,000 crore
during 2007 to Rs. 18,500 crore in 2008 and to Rs 23,200 crore in 2009. The growth could be
attributed to larger participation in the market, increase in global commodity prices, the advent of
new commodity exchanges and the restoration of trade in some of the suspended agricultural
commodities. At present, futures contracts are available for over 100 commodities across the
country. The total number of commodities traded on Futures Exchanges are categorized into two
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major groups, viz., Agricultural Commodities and Non-Agricultural Commodities. Nonagricultural commodities are further categorized into bullion/ precious metals, base metals,
energy and polymer products. Agricultural commodities are further categorized into cereals, oil
and oilseeds, pulses, fibres, plantations, spices and others that include guar seed, mentha oil,
potato, sugar, etc. Nevertheless, of all the contracts available, only a few have been traded
actively and gained major volumes including gold, silver, copper, crude oil, guar seed, chana,
urad, mentha oil, soy oil and jeera. There has been a change in the composition of trade. Initially,
agricultural commodities dominated the market, bullions occupying the second place. In 200405, for instance, 69% of the total volume of trade was in agricultural commodities and the rest
was in bullions and metals. However, the importance of agricultural commodities has decreased
sharply in recent years while that of bullions has increased. In 2010-11, bullions occupied the
first position with 45% share followed by metals with 24% and energy with 19%

Table 1: Turnover in Commodity Futures Markets (Rs. Crore)

Exchange
YEAR
2009
2010
Multi
Commodity 20,25,663 27,30,415
Exchange of India (MCX)

2011
42,84,653

2012
59,56,656

2013
78,95,404

National Commodity and 12,43,327 7,74,965

Derivatives
Exchange
Limited (NCDEX)

6,28,074

8,05,720

9,73,217

National Multi Commodity 1,11,462 25,056

Exchange of India Ltd.
(NMCE)
Others
1,04,033 1,24,051
Total
34,84,485 36,54,487

37,272

1,95,907

1,80,738

83,885
50,33,884

1,32,173
70,90,456

4,45,366
94,94,725

The share of agricultural commodities in futures trading has come down to the level of 12%
(Figure 1).

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Future of the Futures Market and Regulatory Issues

Derivative market serves two basic purposes in an economy. It provides hedging opportunities to
those who suffer from uncertainties in market prices. It applies particularly to agricultural and
primary articles for which supply depends highly on natural conditions such as weather.
The producer, in this market, can fix his product price beforehand by agreeing on a forward
contract. Buyers can also do the same to confirm the purchase price. In fact, commodity futures
evolved as a means of hedging, although latter on it was used more for speculation purposes. In
India, for instance, over 95 per cent of the trading volume in futures today comprises speculative
trades. Derivative market performs another economic function, viz., Price Discovery. Price
discovery has been defined as revealing information about future cash market prices through the
futures market. Producers and consumers take their decisions partly on the basis of current
market prices (spot prices) of the products and partly on the prices to prevail in future. While
current prices are known, future prices are unknown and should be estimated. Futures market
therefore can provide them with necessary guidelines as to the future prices of the commodities.
Despite its genuine usefulness in the society, however, commodity market has often been
criticized on the ground that it involves unscrupulous speculation and hoarding and fuels
inflation in the country. Critics raise the point that speculators dominate the futures market and
determine the futures price, that is, the price at which the commodity can be traded in future. The
futures price, in turn, influences the current market price, that is, the spot price of the
commodity. Commodity prices may therefore be guided by futures prices. The problem is acute
for most of the commodities traded in futures market are agricultural goods and other primary
articles such as minerals. Based on this theoretical underpinning commodity market was banned
in the early 60s. In recent times also, trading in certain commodities was suspended on this
ground. The criticism of the commodity market and the point for its suspension are countered by
academicians and business experts. They argue that speculation is not specific to futures market.
Speculation is common even in the spot market. The demand-supply forces in the spot market
are guided by the expectations of the market participants about the future. Thus, even if we
prohibit futures market and let spot market to operate efficiently, the current price will always
reflect, among other things, the participants view about future demand and supply.

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This is something fundamental about all markets. Futures market links the conditions and
prospects of present and future supply and demand in a transparent and efficient manner. The
belief that markets would be more stable in the absence of price signals emanating from the
futures market is open to question. While there are arguments and counter arguments for
promotion of commodity futures, the market regulator would perhaps be better guided by
empirics. Investigation into the relationship between spot market and derivative market seems
urgent for that purpose. Spot market has obvious influence over futures market. But reverse
causality, i.e. the causality running from futures market to spot market, if any, is really a cause
for concern. The market regulator should therefore make a thorough and commodity specific
empirical analysis before putting stringent restrictions on trade of a certain commodity or
banning it altogether

Figure 1: Share of Commodity Groups in Trade Volume

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Global Scenario
The following table shows the position of Indian commodity market in the International
Commodity Market with respect to certain significant commodities.

COMMODITY

INDIA WORLD SHARE RANK

RICE (PADDY)

240

2049

11.71

Third

WHEAT

74

599

12.35

Second

PULSES

13

55

23.64

First

GROUNDNUT

35

17.14

Second

RAPSEED

40

15.00

Third

SUGARCANE

315

1278

24.65

Second

TEA

0.75

2.99

25.08

First

COFFEE (GREEN)

0.28

7.28

3.85

Eight

JUTE AND JUTE FIBRES 1.74

4.02

43.30

Second

COTTON (LINT)

18.84

10.09

Third

2.06

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SECTION VI

FINDINGS

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FINDINGS

After a long period of suspension commodity derivative market was reintroduced in India

in early 2000s. Since its resumption, however, the market has been growing at a very high pace.
The growth is evident in the spread of market network as well as in volume of trade.

Earlier there were only regional exchanges in the country. Now there are national level

bourses, namely, MCX, NCDEX and NMCE which dominate the market.

Almost 100 commodities (agricultural and nonagricultural) are traded in different

exchanges. The volume of trade has increased from Rs. 34, 84,485 crore in 2006 to Rs. 94,
94,725 crore in 2010. It all shows that the market has strong growth potential.

In liberalized regime we should welcome it and treat the commodity derivative market as

an integral part of the economy.

Derivatives provide hedging opportunities and also help in price discovery.

The ill effect of the market, if any, arises from improper regulation and the market as

such cannot be blamed for that.

The prospect of the market therefore hinges on the efficacy of the regulator

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SECTION VII

CONCLUSION

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Conclusion
Commodity derivatives have a crucial role to play in the price risk management process for the
commodities in which it deals. And it can be extremely beneficial in agriculture-dominated
economy, like India, as the commodity market also involves agricultural produce. Derivatives
like forwards, futures, options, swaps etc are extensively used in the country. However, the
commodity derivatives have been utilized in a very limited scale. Only forwards and futures
trading are permitted in certain commodity items.
Derivatives are beneficial in much ways. In addition to the main are of hedging and risk
transference, they help in price stabilization. They also help in adding liquidity to the market and
also add to employment. But if not controlled, derivatives can play havoc with institutions, due
to non-linear nature of derivative risk. Speculations in derivatives although useful unless backed
by strong internal controls can create systematic risks. Derivatives risks are measured in terms of
value at risk as they are nonlinear in nature. Regulatory controls in derivatives valuation, risk
measurement, disclosure, and capital adequacy have received the attention of regulators and
standard derivatives evaluations have now been accepted.

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DERIVATIVES

SECTION VIII

BIBLIOGRAPHY

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DERIVATIVES

REFERANCES:
BIBLIOGRAPHY:
Futures markets Sunil. K. Parameswaran

Understanding futures market Robert. W. Klob

Derivatives Market in India Susan Thomas

Financial Derivatives V. K. Bhalla

Financial Services and Markets Dr. S. Guruswamy

Futures and Options D. C. Gardner

WEBLIOGRAPHY:
www.cxotoday.com

www.indiamart.com

www.moneycontrol.com

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