PROJECT REPORT ON

SUBMITTED TO PUNJAB TECHNICAL UNIVERSITY, JALANDHAR IN THE PARTIAL FULFILLMENT O

F THE REQUIREMENT FOR THE DEGREE OF
SUBMITTED TO:-
SUBMITTED BY :VINAY KUMAR M.B.A 4th year ROLL NO - 80608317058
STUDENT DECLARATION
I Vinay kumar hereby declare that In Final Project Report on “ Trends And Future O
f Derivatives In India: A Detailed Study” which is submitted in partial fulfillmen
t of the requirements of degree of Masters Of Business Administration to Punjab
Technical University, Jalandhar is my original work and not submitted for the aw
ard of any other degree, diploma, fellowship or other similar titles.
Vinay Kumar
ACKNOWLEDGEMENT
This formal piece of acknowledgement may be sufficient to express the feelings o
f gratitude people who have helped me in successfully completing my Final Projec
t Report. I am grateful to Lect. Ruchi for giving me a chance to do my Final Pro
ject Report on “Trends And Future Of Derivatives In India: A Detailed Study” which r
equired extensive study of various Brokers and Investors that are engaged in Der
ivatives investment. I feel,I shall always remain indebted to Mrs. Sarabjeet kau
r(Head Of Department, Management) without whom it is being impossible to comple
te my project report.He gave his kind supervision,guidance,timely support and al
l other kind of help required in each and every moment of need. I am deeply inde
bted to my dear parents,friends whose blessings and inspirations have brought me
up to this stage of my carreer. (VINAY KUMAR)
CONTENTS OF THE TABLE
1. PROJECT ASSIGNED.
Introduction of the project. Objectives of the project.
2. CONCEPT OF STOCK MARKET.
Introduction to stock market – a global approach. History of stock market.
Features and characterstics of stock market. Future Plans for developing stock m
arket. Various Functions performed in stock market. Performance of stock market
in Indian market.
3.FINANCIAL DERIVATIVES MARKET.
Introduction. Historical aspect.
Products, participants and functions.
Derivative terminology. Reasons behind its evolution. Requirements for Future an
d Options. Strength of Indian capital market. Importance of derivative investmen
t. Instruments involved in derivative. Performance in India.
 Regulatory framework.
4.ANALYSIS OF THE PROJECT.
Research Methodology. Graphical analysis.
5.RESULTS AND FINDINGS.
Reasons behind less development of F &O at AMRITSAR stock
exchange.
6.SUGGESTIONS. 7.LIMITATIONS OF STUDY. 8.CONCLUSIONS. 9.BIBLOGRAPHY. 10.SAMPLE O
F QUESTIONNAIRE.
INTRODUCTION OF THE PROJECT
Derivatives have vital role to play in enhancing shareholder value by ensuring a
ccess to the cheapest source of funds. Active use of derivatives instruments all
ows the overall business risk profile to be modified, thereby providing the pote
ntial to improve earning quality by offsetting undesired risk. Under my project
report, I have studied various trends that comes in the way of Derivatives marke
t. Because impression is usually given that losses arose from derivatives are ex
tremely complex and difficult to understand financial strategies. So after inter
viewing with different brokers ,investors and dealers, I have tried to give a so
lution to these complexities. i also find out that what would be the future of d
erivative market in india on the basis of interviews and observations of brokers
, dealers and investors. regarding future, I have find out that derivatives can
indeed be used safely and successfully provided a sensible control and managemen
t strategy is established and executed. inspite of that more awareness should be
done and technical expertise knowledge should be more expanded.
OBJECTIVES OF THE PROJECT
The main objectives of my final project report are as follows:
To study the various trends that comes in the way of Derivatives market To find
out that what would be the future and market potential of derivative To know the
awareness & familiarity investors, dealers and brokers hold To know the experie
nce of dealers, investors and brokers with derivatives till To get knowledge abo
ut shortcomings in indian derivative market.
market in india.

regarding derivatives market.

date.
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 bo
dies 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 su
bject 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 devel
opment etc. A stock exchange provides necessary mobility to capital and directs
the flow of capital into profitable and successful enterprises. The Securities C
ontract (Regulation) Act 1956 defines stock exchange as: “A body of individuals wh
ether 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 primar
y market. It is the essential pillar of the private
sector and corporate economy. It is the open auction market where buyers and sel
lers meet and involve a competitive price for the securities.
It reflects hopes aspiration and fears of people regarding the performance of th
e economy. It exerts a powerful and significant influence as a depressant or sti
mulant of business activity. So, stock exchange mobilizes savings, canalizes the
m as securities into those enterprises which are favored by the investors on the
basis of such criteria as – - Future growth prospects. - Good returns. - Apprecia
tion of capital. The stock exchange serves the role of barometer, not only of th
e state of health of individual companies, but also of the nation’s economy as a w
hole (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 exc
hange operating in the 19th century were those of Bombay set up in 1875 and in A
hemdabad set up in 1894. These were organized as voluntary nonprofit making asso
ciations of brokers to regulate and protect their interests. Before the control
on securities trading became a central subject under the constitution in 1950. I
t 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 rec
ognized 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 s
ubject, central legislation was proposed and a committee headed by sh. A.D.GORWA
LA 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 reg
ional 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 trad
ing 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 re
gulations of stock exchange. Membership is must for transacting business. Invest
ors and speculators, who want to buy and sell securities, can do so through memb
ers of stock exchange i.e. brokers. There are mainly three participants in stock
exchange i.e. • Issuer of security (company). • Investor of security (Individual, H
UF). • Intermediaries and products (broker, merchant bankers and shares, bonds, wa
rrants, derivatives products etc.). It is the market as well as source for the c
apital. 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, howev
er, in the future; the business model of ISE would be the most preferred method
of accessing multiple markets with low cost and high credibility of an Exchange.
ISE 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 deri
vative segment through NSE and DP services initially for the participants and la
ter 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 t
hink such consolidation enables optimal utilization of existing resources, enhan
ced due to economies of scale and permit product innovation, a sign o any dynami
c market. On account of this philosophy we are proposing to implement most of th
e new products centrally on ISE, like, Internet trading, IPO segment, Distributi
on of mutual funds units, Information dissemination, etc. We are also planning t
o provide trading support to the commodities Exchanges and also consider providi
ng hem entry into the securities industries. The creation of a national market h
as provided the brokers of the RSEs and individual investors in the regions and
opportunity approach the liquid national level market. This market is expected t
o provide liquidity in small capital
companies as the other National Level markets have a higher entry norm and may n
ot 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 cap
ital 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 com
panies 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 (incl
uding fine, suspension or even expulsion of membership) may be there if broker m
ake 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 1. The Stock Exchange Mumbai 2. Ahmed
abad Stock Exchange nt 1875 1897 Voluntary Non profit org. Voluntary Non profit
org. Public ltd. Company Voluntary Non profit org. Company guarantee Company ltd
. ltd. By By Type of Organization
3. Calcutta Stock Exchange 1908 4. Madhya Pradesh Stock 1930 Exchange 5. Madras
Stock Exchange Ltd. 1937
6. Hyderabad Stock Exchange Ltd. 1943 7. Delhi Stock Exchange 1947 1957 1978 198
2 1982 1983
guarantee Public ltd. Company Pvt. Converted into
Association Ltd. 8. Bangalore Stock Exchange 9. Cochin Stock Exchange 10.U.P. St
ock Exchange Ltd. 11.Pune Stock Exchange Ltd. 12.Ludhiana Stock Exchange
public ltd. company Public ltd. Company Public ltd. Company Company ltd. By guar
antee Public ltd. Company
13.Guwahati Stock Exchange 1984 14.Magadh Stock Exchange Ass. 1986 (Patna) 15.Ja
ipur Stock Exchange Ltd. 16.Bhubaneshwar Stock Exchange 17.SaurashtraKutch 1983
1989
Public ltd. Company Company ltd. By guarantee Public ltd. Company Company ltd. B
y guarantee Company guarantee N.D N.D N.D N.D N.D N.D ltd. By
Stock 1989
Exchange Ltd. 18.Vadodara Stock Exchange Ltd. 1990 19.National Stock Exchange of
1994 India Ltd. 20.Coimbatore Stock Exchange 1996
Ltd. 21.OTC Stock Exchange of India 22.Mangalore Stock Exchange Ltd. 23.Intercon
nected Stock Exchange (ICSE)
WHO BENEFITS FROM STOCK EXCHANGE
1.
Investors: - It provides them liquidity, marketability, safety etc. Company: - I
t provides them access to market funds, higher Brokers: - They receive commissio
n in lieu of services to Economy and Country: - There is large flow of saving, b
etter
of investments.
2.
rating and public interest.
3.
investors.
4.
growth more industries and higher income.
INTRODUCTION TO DERIVATIVES
Primary market is used for raising money and secondary market is used for tradin
g in the securities, which have been used in primary market. But derivative mark
et is quite different from other markets as the market is used for minimizing ri
sk arising from underlying assets. The work "derivative" originates from mathema
tics. 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 var
iable) = 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 c
an 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. b. c. d. e. Any type of agriculture p
roduct of grain (not prevailing in India) Price of precious and metals gold Fore
ign exchange rates Short term as well as long-term bond of securities of differe
nt 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 elimin
ate the risk of change in price by that date. The price of these derivatives is
driven from spot price of wheat. DEFINITION OF DERIVATIVE In 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 u
nsecured, Risk instrument or contract for difference or any other form of securi
ty. 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 marke
t. Agricultural F&O 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. Th
is situation led to development of derivatives as effective "Risk Management too
ls". Derivative trading in financial market started in 1972 when "Chicago Mercan
tile Exchange opened its International Monetary Market Division (IIM). The IMM p
rovided an outlet for currency speculators and for those looking to reduce their
currency risks. Trading took place on currency. Futures, which were contracts f
or 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 corpo
rate and institutional investors to effectively manage their portfolios of asset
s and liabilities through instruments like stock index futures and options. An e
quity 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 futur
es or index options. Therefore the stock index futures first emerged in U.S.A. i
n 1982.
PRODUCTS, PARTICIPANTS AND FUNCTIONS
Derivative contracts have several variants. The most common are FORWADS, FUTURES
, OPTIONS AND SWAPS. The following three categories of Participants-Hedgers, Spe
culators, 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 want 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 t
his 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 price in two different markets. If for example, they see the future pric
e of an asset getting out of line with the cash price, they will take off settin
g 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 fut
ures at today s pre-agreed 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 pric
e. Futures contracts are the special types of forward contracts in the sense tha
t 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 t
he buyer the right but not the obligation to sell a given quantity of the underl
ying 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-t
erm option contracts are popularly known as Leaps or Long term Equity Anticipati
on Securities.
(5)
BASKETS:
Baskets options are option on portfolio of underlying asset. Equity Index Option
s are most popular form of baskets.
(6) SWAPS:
these are private agreements between two parties to exchange cash flows in the f
uture according to a prearrange formula. They can be regarded as portfolios of f
orward 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 mark
et tangible asset are traded whereas in derivatives market contract based on tan
gible assets or intangible like index or rates are traded. b) The value of deriv
ative contract is always based on and linked to the underlying asset. Though, th
is linkage may not be on point-to point basis. c) Cash market contracts are sett
led by delivery and payment or through an offsetting contract. the derivative co
ntracts on tangible may be settled through payment and delivery, offsetting cont
ract or cash settlement, whereas derivative contracts on intangibles are necessa
rily settled in cash or through offsetting contracts. d) The cash markets always
has a net long position, whereas the net position in derivative market is alway
s zero. e) Cash asset may be meant for consumption or investment. Derivatives ar
e used for hedging, arbitration or speculation. f) Derivative markets are highly
leveraged and therefore could be much more riskier.
THE DERIVATIVE MARKETS PERFORM A NUMBER OF ECONOMIC FUNCTIONS:
(1) Prices in organized derivative markets reflect the perception of market part
icipants 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 t
he expiration of the derivative contract. Thus derivatives help in discovery of
future as well current prices. (2) The derivative market helps to transfer the r
isks from those who have them but may like them those who have an appetite for t
hem. (3) Derivatives due to their inherent nature are linked to the underlying c
ash markets. With the introduction of derivative, the underlying market, witness
higher trading volumes because of participation by more players who would not o
therwise participate for lack of an arrangement to transfer risk. (4) Derivative
s have a history of attracting many bright, creative, welleducated people with a
n entrepreneurial attitude. They often energize others to create new business, n
ew products and new employment opportunities, the benefits of which are immense.
(5) Derivatives market helps increase savings and investments in the long run T
ransfer 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. Howeve
r at the same time you feel that overall market may not perform as good and ther
efore price of your stock may also fall in line with overall marked trend. You e
xpect that some adverse economic or political event might affect the market sent
iments, though fundamentals of the company will remain good, therefore, it is go
od to retain the stock. In both these situations you would like to insure your p
ortfolio against any such market fall. Such insurance is known as hedging. Hedgi
ng is a tool to reduce the inherent risk in an investment. Various strategies de
signed 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 ca
rry adjusted for any return on investment. However, due to uncertainty about int
erest rates, distortions in spot prices, or uncertainty about future income stre
am, prices in futures market may not truly reflect the expected spot price in fu
ture. This imbalance in future and spot price gives rise to arbitrage opportunit
ies. Transaction made to take advantage of temporary distortions in the market a
re known as arbitrage transactions.
(3) SPECULATION:
you may have very strong opinion about the future market price of a particular a
sset based on past trends, current information and future expectation. Likewise
you may also have an opinion about the overall market trend. To take advantage o
f such opinion, individual asset or the entire market (index) could be sold or p
urchased. 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 positi
on in the same opinion contract, at the same strike price, for fulfillment of th
e obligation, in accordance with the procedure specified in by the relevant auth
ority from time to time.
BADLA:
It is an indigenous mechanism of postponing the settlement of trade. This produc
t is peculiar to India markets. This involves Badla financiers, stock lenders an
d stock traders. The long buyers and short sellers may postpone settlement of th
eir trade by making payments and giving delivery by using the services of Badla
financiers and stock lenders who assume their positions for Badla charges. Count
erparty risk, unpredictable charges and high risk due to inadequate margining ar
e inherent limitations of Badla.
BASIS:
It is difference between spot price and future price of the same asset. In norma
l markets this basis is always negative, i.e. spot price is always less than fut
ure 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 i
ndex. It shows how the price of scrip would move with every percentage point cha
nge in the market index.
CONTRACT VALUE
It is the value arrived at by multiplying the strike price of the option contrac
t 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 ri
sk. Some amount of margins is collected upfront and some are collected shortly a
fter the trade. Failure to pay margins may result in mandatory closure of positi
on.
OFFSETTING CONTRACT:
new matching contract, which offsets an existing contract, is known as offsettin
g contract.
OPTION PREMIUM:
It is consideration paid by the option buyer to option writer. The premium has t
wo components intrinsic value and time value. Intrinsic value is the difference
between the spot price of the underlying and exercise price of the contract. Tim
e value represents the cost of carrying the underlying for the option period, ad
justed for any dividend and option premium.
RISK TRANSFER:
It refers to hedging against the price risk through futures. The holder of an as
set, 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 mak
ing gain
REASON FOR STARTING DERIVATIVES
1.Counter party risk on the part of broker, in case it ask money from us but bef
ore giving delivery of shares goes bankrupt. 2.Liquidity risk in the form that t
he 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 a
s the scrip in which they want to invert might not be available at the right pri
ce. 6.Systematic risk in the form that the price of scrip may go up or to reason
affecting the sentiment of whole market. down due
THE REQUIREMENTS FOR SETTING UP FUTURE AND OPTION TRADING ARE 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 h
ouse 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 sele
ction 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 re
gulation in all the stock exchanges. 6. Standardization of the terms governing t
he options contracts. This would decrease the transaction costs, For a given und
erlying security, all contracts on the options exchange should have an expiry da
te, 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 capit
al 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 Securi
ties Clearing Corporation (NSCCL) 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 secur
ities 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 t
he payment structure of assets to correspond to investor market view. 4. No phys
ical delivery of share certificate so reduction in cost by stamp duty. 5. Increa
se in hedger, speculator and arbitrageurs. 6. It does not totally eliminate spec
ulation, 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 p
rice". The two parties are: • Who takes a long position – agreeing to buy • Who takes
a short position—agreeing 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 v
alue 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 in
formation or analysis, which forecast an upturn in price, and then be can go lon
g 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 t
o book profits. Speculator may well be required to deposit a margin upfront. How
ever, this is generally a relatively small proportion of the value of assets und
erlying the forward contract.
EFFECT OF CHANGE IN PRICE:
As mentioned above the value of such a contract in zero for both the parties. Bu
t later as the price & the underlying asset changes, it gives positive or negati
ve value for contract.
PRICE UNDERLYING ASSETS INCREASE DECREASE
& HOLDER POSITION POSITIVE
&
LONG HOLDER & SHORT POSITION VALUE NEGATIVE VALUE
NEGATIVE VALUE
POSITIVE VALUE
E.g.
A agrees to deliver 100 equity shares of Reliance to B on Sept. 30, 2002 at a Ra
te of Rs. 120 per share. Now if the price of share on that date is Rs. 140 per s
hare, 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 t
han delivery price. Profit/Loss = ST-E ST = spot price on maturity date E = deli
very price
LIMITATIONS OF FORWARD CONTRACT
1. No standardization. 2. One party can breach its obligation. 3. Lack of centra
lization of trading. 4. Lack of liquidity. To overcome this other type of deriva
tion instrument known as "Future Contracts" were introduced.
VALUATION OF FORWARD CONTRACT
The forward contract can be put under three categories for the purpose & valuati
on:
VALUATION OF THOSE SECURITIES PROVIDING NO INCOME
Shares, which neither expects to do not pay any, dividend in future nor having a
rbitrage 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 compoun
ding T = time of maturity. If F>S0ert In this case the investor will buy asset a
nd 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 asse
ts 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 matures
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 cont
ract, 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 INCOME
If there is certain cash income to be generated on securities in future to the i
nvestor, we will determine present value of income e.g. in case of preference sh
are. Present Value of Dividend = Rate & Interest (continuously compounded) ~If t
here 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 pres
ent 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 th
e proceeding Profit (at maturity) (So-I) ert –F
E.g.
Let us consider a 6-month forward contract on 100 shares at Rs. 38 each risk fre
e of interest (compounding continuously) earn is 10% p.a. dividend is expected t
o a yield of Rs. 1.50 in 4 months.
Solution: divided receivable after 4 months
resent Value & dividend
=
100x1.50=Rs.1.50
= 150xe (4/12)(0.10)50
= Rs 50x0.9672=RS 145.88 = (3800-145.8) e(0.5)(0.10) = 3654.92x1.05127 F = 3842.
31
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 the
ir 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 part
icular assets at a specific future date; specific size, date of delivery, place
and alternative asset. It takes obligation on both parties to fulfill the contra
ct.
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 corporat
ion or clearing house. Clearinghouse is associated with matching, processing, re
gistering, confirming setting, reconciling and guaranteeing the trades on the fu
ture 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 NS
E have one month, and three-month expiry
cycles, which expire on the last Thursday of the month. Thus a January expiratio
n 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 tra
ding.
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 instanc
e, 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 fo
r 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 contr
act 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 adj
usted 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 balan
ce in the margin account never becomes negative. If the balance amount falls bel
ow the maintenance margin, the investor receives a margin call and is expected t
o top up the margin account to the initial margin level before trading commences
on the next day.
INSTRUMENTS OF FUTURE CONTRACTS
COMMODITY FUTURES
1. Trader in American Exchanges like CBOT, New York: Commodity Exchange, Chicago
Mercantile Exchange (CME), New York Mercantile Exchange Includes: Wheat, Natura
l Gas, Platinum, Gold, and Cattle etc. 2. Contract Life: Mostly for 90 days or l
ess. 3. Maturity date is mostly non-standardized. 4. Quality specified
FINANCIAL FUTURES
1. Introduced by IMM (a division of CME) It Includes: 10 or 5 year treasury note
s (in 1976 by I:M:M), S & P 5000, Nikkie 225, Euro Dollars, British Pound, Canad
ian Dollars, Mini Value line Stock Index, Russell 2000, Russell 3000, etc. 2. Mo
stly Longer time e.g. US Treasury Bond Futures are of even more than 2 years 3.
Maturity date is standardized. 4. There connot be any quality variations into th
ese assets.
TYPE OF FUTURE CONTRACTS:
INDEX FUTURES & STOCK FUTURES INDEX FUTURES:
Of the financial futures, Index future contracts are key contracts, introduced i
n U.S. A, in 1982 by the "Commodity Futures Trading Commission" (CFTC) by approv
ing 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 ma
rket is further expected to reduce impact cost. 80-90% of retail participation i
s expected in India because. 1. Brokerage cost is lower. 2. Savings in cost is p
ossible 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. Institu
tional and large equity holders need portfolios hedging facility. Index derivati
ves are more suited to them and more cost effective than in individual stocks. P
ension funds in the US are known-to use stock index futures for risk hedging pur
pose.
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 impli
es 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 pa
rticipate in "Individual Stock Futures" trading e.g. in Reliance SEB! Frame guid
elines for its trading stock futures can be effectively used for hedging: specul
ation and arbitrage At present there are 31 scrips in which stock derivatives ar
e trading. E.g. the Reliance stock traders at Rs. 1000 and the two month futures
trades 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.
Carry type commodities Non-Carry type commodities
II.
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 d
ivisible. 4. Bid-asks spreads do not exit so that it is assumed that only one pr
ice prevails.There is no restriction on short selling. Also short selling gets t
o use the full proceeds of the sales valuations. This includes stock index futur
es. 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 INVESTMENT PURPOSE
These types of commodities are held
COMMODITIES VALUATION
by significant number. Of investor for futures safety as investment alone. ~If s
torage 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 storag
e 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 b
e 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 consid
er a 6 months gold futures contract of 100 gm.
Assume that the spot price is Rs. 480 per gram and that it cost Rs. 3 per gram f
or the 6 monthly period to store gold and that the cost is incurred at the end o
f the period. If the risk free rate of Interest is 12% p.a. compounded continuou
sly then R=0.12, s=480 x 100= 48000, e = 6/12 = 0.5 S=3 x 100 e-(0.12 x 0.5) = R
s. 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 CostCarin
g Returns, in these arbitrage arguments doesn t work investor stores these on be
cause of its consumption value only not for investment. Valuation of non-carry c
ommodity futures requires another concept. i.e. "Convenience return" or "Conveni
ence 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 OF 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 (underlyi
ng) Assets Loss
INTERPRETATION
The figure shows P/L for a long futures position. The investor bought futures wh
en THE INDEX WAS AT 1220. If Index If Index His futures position shows profits H
is futures position shows losses
(b) Payoff for seller of futures contract-short futures
It can be explained by taking an example: A speculator who sells a 2 months Nift
y Index futures contracts when the nifty stands at 1220 (Nifty an underlying ass
ets) Profit …Nifty (underlying assets)
Loss INTERPRETATION: When Index moves When index movers. Seller start making Pro
fits. Seller starts making Loss.
FORWARD VS. FUTURES Features
-Operational Mechanism -Contract Specifications -Counter party Risks -Liquidity
-Price Discovery -Example -Settlement
Forward
Traded between two parties Differ from traded to trade Exists such risk Low Not
Efficient Currency Market At end of period
Future
Trade on Exchange Standardised contracts No such risk High Highly Efficient Futu
re 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 Price Quotation Tick Size Daily Price Lim
it Cents substitution and at different bushel established by the exchange. quart
er-cents ($12.50 per contract.) One-quarter cent per bushel ($12.50 per contract
) 20 cent per bushel ($1000 per contract) previous above day s or below the pric
e settlement
(expandable to 30 cent per bushel) No limit in the spot month (limit are lifted
two business day before the spot month begins.) Contract Months Contract Year La
st Trading day March, May, July, September and December. Starts in July and ends
in May Seventh business day preceding the last business day of the delivery mon
th.
Last Delivery Day Trading Hours
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.
Ticker Symbol
W
OPTIONS
Options are fundamentally different from forward and futures. An option gives th
e holder/buyers of the option the right to do something. The holder does not hav
e committed himself to doing something. In contrast, in a forward or futures con
tract, the two parties have committed them self to doing something. Whereas it n
othing (expect margin requirement) to enter in to a futures he purchases of an o
ption require an up front payment.
HISTORICAL BACKGROUND OF OPTION:
Although options have exercised for a long time, they were traded OTD, without m
uch 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. I
t was only in early, 1900s that a group of firms set up what is known as the "pu
t and call brokers and dealers association" with the aim of providing a mechanis
m 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 hon
or it In 1973, Black, Marton, Scholes invented the Black-Scholes formula. In Apr
il 1973, CBOE was set up specially for the purpose of trading options. The marke
t for options develop so rapidly that by early 80 s number of share underlying t
he 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 amoun
t (and quality) of a commodity, currency, index or financial instruments a to bu
y or sell a specified number of underlying futures contracts, at a specified pri
ce on a before a give date in the future. Thus, option like futures, also provid
e a mechanism by which one can acquire a certain commodity on other assets, or t
ake 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 take "long position" the seller take "short position" S
o 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 p
remium buys the right but not the obligation exercise his option on the seller/w
riter. Writer of an option: the writer of a call/put option is the one who recei
ves the option premium and is thereby obliged to sell/buy the asset if the buyer
exercise on him. Option price: option price is the price, which the option buye
r pays to the option seller. It is also referred as option premium. Expiration d
ate: 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 specifi
ed in the options contract is knows as strike price or the exercise price. Ameri
can options: these are the options that can be exercised at any time upto the ex
piration date. Most exchange-traded options are Americans. European options: the
se are the options that can be exercised only on the expiration date itself. The
se are easier or analyze than American option, and properties of American option
s are frequently deducted from those of its European counterpart. In the money o
ption: an in the money option is an option that would lead to a positive cash fl
ow 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 th
e strike price,
 the call is set to deep ITM. In the case of a put, the put is ITM if the index i
s below the strike price. At-money option: (ATM) 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:(OTM) option is an option that would lead to a negative cash flow it was
exercised immediately. A call option on the index is OTM 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
OTM. In the case of a put, the put is OTM if the index is above the strike price
. Intrinsic value of an option: the option premium can be broken into two compon
ents-intrinsic values and time value. The intrinsic value of a call is the amoun
t the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is ze
ro. Time value of an option: it is a difference between its premium and its intr
insic value. Both calls and puts have time value. An option that is OTM or ATM h
as only time value. Usually the maximum time value exists when the options is AT
M. 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 t
he date of maturity.
EXAMPLE
Suppose it is January now and the investor buys a March option contract on Relia
nce Industries (RIL) Share with an exercise price/strike price Rs. 210. With thi
s he get a right to buy share on a particular date in March, of course he is und
er no obligation. Obviously, if at the expiry date the price in market (spot pri
ce on expiry date) is above the exercise price he ll exercise his option and rev
erse is also true.
PUT OPTION:
It gives the holder the right to sell a specific quantity of underlying assets a
t 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 R
s. 210 per share the investor get the right to sell 100 share @ 210 per share. T
he investor would naturally exercise his right if on maturity date price were be
low 210 and stand to gain and viceversa. Buying out options is buying insurance.
To buy a put option on Nifty is to buy insurance: which reimburses the full ext
ent to which-Nifty drops below the strike price of the put option. This is attra
ctive to many people.
AMERICAN Vs EUROPEAN OPTION
Its owner can exercise an American option at any time on or before the expiratio
n 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 co
ntracts are skewed. One way naturally wonder as to why the seller (writer) of an
option would always be obliged to sell/buy an asset whereas the other party get
s the right? The answer is that writer of an option receives, a consideration fo
r Undertaking the obligation. This is known as the price or premium to the selle
r for the option. The buyer pays the premium for the option to the seller whethe
r 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 matching writer. Exercise the opt
ion. Close out the position by write a, call option or it in case of
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 th
e 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 No
t 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 underlyi
ng
Option-to-option holder in case of—he opt for expiry date.
i.e How Option Work
CALL OPTIONS Spot Nifty: 1100 Strike Price: 1150 Duration :3 months No. of optio
n bought=200 Premium per option:10 Total premium paid=2000
Da y1
Da y 90
Spot Nifty:1200 Buyer exercise the option Profit: No. of option x price Differen
tial-Premium paid=Rs. (200x(1200-1150)2000=Rs.8000)
Spot Nifty: 1000 Buyer foregoes the option Loss premium paid Rs. 2000
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)
Da y1
Spot Nifty: 1100 Strike Price: 1150 Duration :3 months No. of option bought=200
Premium per option:10 Total premium paid=2000
Da y 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
Call option Before
expiration
1 AT EXPIRATION (a) Call option pricing at expiration:
If the price of the underlying asset were lower than the exercise price on the e
xpiration 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 o
ut 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 ex
ercise option, the allowing seller to retain premium. In even of (irrational) ex
ercise of such a call, writer can purchase asset as S1 and give it at making a p
rofit of (E+S1)+ premium. On the other hand, if the call happens to be in the mo
ney, it ll, be worth its intrinsic value, equal to excess of asset price over th
e exercise price. If call price <intrinsic value then he can buy call at c, exer
cise it immediately at S1 and make a profit" of S1—E—C
VALUE OF CALL OPTION
Value
E
Price of share
Put option at expiration:
When at the expiration date the price of the underlying asset is greater than ex
ercised price, the put option will go unexercised. This is because there is no u
se 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 intrin
sic 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
E
Stock Price
X
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 S2, Call Option pence is out- of-the money i.e. zero intrinsic va
lue 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 ex
cess 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 Ma
turity) 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 b coz i
ntrinsic 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 prom
ulgation of the securities laws (amendment) ordinance, 1995 which withdrew the p
rohibition on options in securities. The market for derivatives, however, did no
t take off, as there was no regulatory framework to govern trading of derivative
s. SEBI set up a 24 members committee under the Chairmanship of Dr. L.C. Gupta o
n 18th November, 96 to develop appropriate regulatory framework for derivatives
trading in India. The committee submitted its report on 17th March, 98 prescribi
ng necessary preconditions for introduction of derivatives trading in India. the
committee recommended that derivatives should be declared as securities so th
at regulatory framework applicable to trading of securities could also govern
trading of securities. SEBI also set up a group in June 1998 under the Chairmans
hip of Prof. J.R. Varma, to recommend measures for risk containment in derivativ
es market in India. The report, which was submitted in October, 1998, worked out
the operational details of margining system, methodology for charging initial m
argins, broker net worth, deposit requirement and real time monitoring requireme
nts. The SCRA was amended in Dec. 1999 to include derivatives within the ambit o
f securities and the regulatory framework was developed for governing derivati
ves 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 preluding
OTC derivative. The government also rescinded in March 2002, the three decade o
ld 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 commen
ce 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 opt
ions commenced in June 2001. Futures contracts on individual stocks were launche
d in November 2001. Trading and Settlement in derivatives contracts is done in a
ccordance with the rules, bye-laws, and regulations of the respective exchanges
and their clearing house/corporation duly approved by SEBI and notified in the o
fficial gazette. Thus, the following five types of Derivatives are now being tra
ded in the India Stock Market. * Stock Index Futures * Stock Index Options * Fut
ures on Individual Stocks * Options on Individual Stocks * Interest Rate Derivat
ives
INDEX FUTURES:
Index futures are financial contracts for which the underlying is the cash marke
t index like the Sensex, which is the brand index of India. index futures contra
ct 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 specification
s 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 s
eller in consideration of a premium to the option buyer to buy or sell the under
lying index at a specific price (strike price) on or before a specific date (exp
iry date).
STOCK FUTURES:
Stock Futures are financial contracts where the underlying asset is an individua
l stock. Stock futures contract is an agreement to buy or sell a specified quant
ity 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 s
ell the underlying stock at a specific price (strike price) on or before a speci
fic date (expiry date).
INTEREST RATE DERIVATIVES:
The derivatives are taken on various rates of interests. OPERATIONAL MECHANISM F
OR DERIVATIVES TRADIN
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. Inves
tors should complete all the registration formalities with the broker before com
mencement 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 a
nd 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 sign
ing 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 pl
acing the order on behalf of the investor. This ID is broker specific i.e. if th
e investor chooses to deal with different brokers, he needs to sign the client a
greement 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 affai
rs, 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 d
erivative trading and the extent of his liability. This information forms part o
f the Risk Disclosure document, which the broker issues to the client. The inves
tor 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 provision
s governing the rights and obligations of clients, relevant manuals, notificatio
ns, circulars and any additions or amendments etc. of the derivatives segment or
of any regulatory authority to the extent it governs the relationship between t
he broker and the client.
6. PLACING ORDER WITH THE BROKER:
The investor should place orders only after understanding the monetary implicati
ons in the event of execution of the trade. After the trade is executed, the inv
estor can request for a copy of the trade confirmation slip generated on the sys
tems 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 shoul
d be time (order receipt and order execution) and price stamped. Execution price
s, brokerage and other charges, if any, should be separately mentioned in the co
ntract note. If desired, the investor may change an order anytime before the sam
e 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-par
ty. 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 poten
tial loss in one day. Both buyer and seller have to deposited before the opening
of the position in the futures transaction. This margin is calculated by SPAN b
y considering the worst case scenario. B) MARK TO MARKET MARGIN: All daily losse
s must be met by depositing of further collateral-known as variation margin, whi
ch is required by the close of business, the following day. Any profits on the c
ontract are credited to the client s variation margin account.
7. INVESTOR PROTECTION FUND:
The derivatives segment has established an "Investor Protection Fund" which is i
ndependent of the cash segment to protect the interest of the investors in the d
erivatives market.
8. ARBITRATION:
In case of any dispute between the members and the clients arising out of the tr
ading or in relation to trading/settlement, the party thereto shall resolve such
complaint, dispute by arbitrations procedure as defined in the rules and regula
tions and ByeLaws 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 SC(R)
A aims at preventing undesirable transactions in securities by regulating the bu
siness of dealing therein and by providing for certain other matters connected t
herewith. 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 securitie
s 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 t
he investors in such schemes. 4. Government securities. 5. Such other instrument
s as may be declared by the Central Government to be securities 6. Rights or int
erests in securities "Derivative" is defined to includes: • A security derived fro
m a debt instrument, share, loan whether secured or unsecured, risk instrument o
r contract for differences or any other form of security. • A contract which deriv
es its value from the prices, or index of price, of underlying securities. Secti
on 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 c
ontracts are: Traded on a recognized stock exchange. Settled on the clearinghous
e 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 de
velop 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 deriva
tives trading in India beginning with stock index futures. SEBI also approved th
e "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 securitie
s. The amendment of the SC(R)A to include derivatives within the ambit of secur
ities 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 i
n 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 exc
hange/segment should have a separate governing council and representation of tra
ding/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 m
embers and will obtain prior approval of SEBI before start of trading in any der
ivative 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 appr
oved clearing corporation/house. Clearing corporation/house complying with the e
ligibility conditions as laid down by the committee have to apply to SEBI for gr
ant of approval. 5. Derivative brokers/dealers and clearing members are required
to seek registration from SEBI. This is in addition to their registration as br
okers of existing stock exchanges. The minimum networth for clearing members of
the derivatives clearing corporation/house shall be Rs. 300 Lakh. The networth o
f the member shall be computed as follows: • Capital + Fee reserves • Less non-allow
able assets viz. a. b. c. d. e. f. g. h. i. Fixed assets Pledged securities Memb
er s card Non-allowable securities (unlisted securities) Bad deliveries Doubtful
debts and advances 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 i
nitial 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 b
e registered with the derivatives broker. The members of the derivatives segment
are also required to make their clients aware of the risks involved in derivati
ves trading by issuing to the client the Risk Disclosure Document and obtain a c
opy of the same duly signed by the client. 9. The trading members are required t
o have qualified approved user and sales person who have passed a certification
programme approved by SEBI.
DR. L.C.GUPTA COMMITTEE
The 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 fo
r derivatives trading in India. The committee recommended introduction of deriva
tives 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 fo
r 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 o
f equity derivatives. b) SEBI to approve rules, bye-laws and regulation of the d
erivatives exchange and the derivatives contracts. c) SEBI need not be involved
in framing exchange level regulations. d) SEBI should create a special Derivativ
es Cell as it involves special knowledge, and a Derivatives advisory council may
be created to tap outside experts for independent. e) Legal restrictions on ins
titutions, including mutual funds, on use of derivatives should be removed. f) E
xisting stock exchanges with cash trading to be allowed to trade derivatives if
they meet prescribed eligibility condition—importantly, a separate Governing Counc
il 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 tra
des. 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 bet
ween SEBI and the RBI of financial derivatives market must have passed a certifi
cate programme to be registered with SEBI. j) Clearing corporation to be the cen
ter piece of the derivatives market, both for implementing the margin system and
providing trade guarantee. In the near term, existing clearing corporation be a
llowed to participate in derivatives. For the long-term, a centralized clearing
corporation has been recommended. k) Minimum networth requirement of Rs. 3 crore
s for participants, maximum exposure limits for each broker/dealer on gross basi
s and capital adequacy requirements to be prescribed. l) Mark-to-market to be co
llected 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 with the dealer/broker and ris
k disclosure as the corner-stone.
J.R. VARMA COMMITTEE
After the submission of L.C. Gupta committee report and approval of the introduc
tion of index futures trading by SEBI the board mandated the setting up of a gro
up 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 India markets are high. -Volatility is not constant & varying. -T
here 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 arbitragers players. RECOMMENDATIONS - Only traders with high net wort
h be allowed to traded in Derivatives. - Imposition of VAR margin system. - Subm
ission of periodic reports by CC and SE to SEBI. - Continuously refining of Marg
in system. - Daily changes in the Margins be calculated and imposed. - Proper li
quid net worth. -Online position monitoring at customer, TM, CM and Market level
.
RISK MANAGEMENT
NSCCL has developed a comprehensive risk containment mechanism for the F & O seg
ment. The salient features of risk containment mechanism on the F & O segment ar
e: 1. The financial soundness of the members is the key to risk management. Ther
efore, the requirements for membership in terms of capital adequacy (net worth,
security deposits) are quite stringent. 2. NSCCL charges an upfront initial marg
in for all the open positions of a CM. It specifies the initial margin requireme
nts for each futures/options contract on a daily basis. It also follows value-at
-risk (VaR) based margining through SPAN. The CM in turn collects the initial ma
rgin from the TMs and their respective clients. 3. The open positions of the mem
bers are marked to market based on contract settlement price for each contract.
The difference is settled in cash on a T + 1 basis. 4. NSCCL s on-line position
monitoring system monitors a CM s open positions on a real-time basis. Limits ar
e set for each CM based on his capital deposits. The on-line position monitoring
system generates alerts whenever a CM reaches a position limit set up by NSCCL.
NSCCL monitors the CMs for MTM value violation, while TMs are monitored for con
tract-wise position limit violation. 5. CMs are provided a trading terminal for
the purpose of monitoring the open position of all the TMs clearing and settling
through him. A CM may set exposure limits for a TM clearing and settling throug
h him. NSCCL assists the CM to monitor the intra-day exposure limits set up by
a CM and whenever a TM exceed the limits, it stops that particular TM from furth
er trading. 6. A member is alerted of his position to enable him to adjust his e
xposure or bring in additional capital. Position violations result in withdrawal
of trading facility for all TMs a CM is case of a violation by the CM. 7. A sep
arate settlement guarantee fund for this segment has been created out of the cap
ital of members. The fund had a balance of Rs. 648 crore at the end of March 200
2. The most critical component of risk containment mechanism for F & O segment i
s the margining system and on-line position monitoring. The actual position moni
toring and margining is carried out online through Parallel Risk Management Syst
em (PRISM). PRISM uses SPAN (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 Member (CM) is required to meet with the Base Minimum Capital (BMC) r
equirements prescribed by NSCCL before activation. The CM has also to ensure tha
t BMC is maintained in accordance with the requirements of NSCCL at all points o
f time, after activation. Every CM is required to maintain BMC of Rs.50 lakhs wi
th NSCCL in the following manner:
(1) Cash
Rs.25
lakhs
in
the
form
of
cash.
(2) Rs.25 lakhs in any one form or combination of the below forms:
FIXED DEPOSIT RECEIPTS (FDRs) issued by approved banks
and deposited with approved Custodians or NSCCL
BANK GUARANTEE in favour of NSCCL from approved banks in
the specified format.
APPROVED SECURITIES
approved Custodians.
in demat form deposited with
Any failure on the part of a CM to meet with the BMC requirements at any point o
f time, will be treated as a violation of the Rules, Bye-Laws and Regulations of
NSCCL and would attract disciplinary action inter-alia including, withdrawal of
trading facility and/ore clearing facility, closing out of outstanding position
s etc.
ADDITIONAL BASE CAPITAL
Clearing members may provide additional margin/collateral deposit (additional ba
se capital) to NSCCL and/or may wish to retain deposits and/or such amounts whic
h are receivable from NSCCL, 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 CMs are segregated into cash
component and non-cash component. For Additional Base Capital, cash component me
ans cash, bank guarantee, fixed deposit receipts, T-bills and dated government s
ecurities. Non-cash component shall mean all other forms of collateral deposits
like deposit of approved demat securities. At least 50% of the Effective Deposit
s should be in the form of cash. Liquid Networth Liquid Networth is computed by
reducing the initial margin payable at any point deposits. The Liquid Networth m
aintained by CMs at any point in time should not be less than Rs.50 lakhs (refer
red to as Minimum Liquid Net Worth). in time from the effective
MARGINS
NSCCL has developed a comprehensive risk containment mechanism for the Futures &
Options segment. The most critical component of a risk containment mechanism fo
r NSCCL is the online position monitoring and
margining system. The actual margining and position monitoring is done online, o
n an intra-day basis. NSCCL uses the SPAN (Standard Portfolio Analysis of Risk)
system for the purpose of margining, which is a portfolio based Initial system M
argin
NSCCL collects initial margin up-front for all the open positions of a CM based
on the margins computed by NSCCL-SPAN .A CM is in turn required to collect the i
nitial margin from the TMs and his respective clients. Similarly, a TM should co
llect 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 c
ollect mark to market settlement value, before the commencement of trading on th
e next day, the initial margin may be computed over a two-day time horizon, appl
ying the appropriate statistical formula. The methodology for computation of Val
ue 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 proprietory positions - shall be netted at Trading/ Clearing Member level wi
thout any setoffs between client and proprietory positions. For the purpose of S
PAN Margin, various parameters are specified from time to time. In case a tradin
g member wishes to take additional trading positions his CM is required to provi
de Additional Base Capital (ABC) to NSCCL. ABC can be provided by the members in
the form of Cash , Bank Guarantee , Fixed Deposit Receipts and approved securit
ies .
Premium
Margin
In addition to Initial Margin, Premium Margin would be charged to members. The p
remium margin is the client wise margin amount payable for the day and will be r
equired to be paid by the buyer till the premium settlement is complete.
Assignment
Margin
Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margi
n. It is required to be paid on assigned positions of CMs towards Interim and Fi
nal Exercise Settlement obligations for option contracts on individual securitie
s, 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 CMs for exercise settlement pay-in.
PAYMENT OF MARGINS
The initial margin is payable upfront by Clearing Members. Initial margins can b
e paid by members in the form of Cash , Bank Guarantee, Fixed Deposit Receipts a
nd approved securities .
Non-fulfillment of either the whole or part of the margin obligations will be tr
eated as a violation of the Rules, Bye-Laws and Regulations of NSCCL and will at
tract penal charges @ 0.09% per day of the amount not paid throughout the period
of non-payment. In addition NSCCL may at its discretion and without any further
notice to the clearing member, initiate other disciplinary action, inter-alia i
ncluding, 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 addition to initial margins requirements • Exposure Limits • Trading Member
wise Position Limit • Client Level Position Limits
Limits
Clearing Members are subject to the following exposure / position limits in
• Market Wide Position Limits (for Derivative Contracts on Underlying Stocks) Coll
ateral 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 NSCCL. 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 Memberwise Position Li
mit Violation
• Client Level Position Limit Violation • Market Wide Position Limit Violation • Viola
tion arising out of misutilisation of trading member/ constituent collaterals an
d/or deposits • Violation of Exercised Positions Clearing members who have violate
d any requirement and/ or limits, may submit a written request to NSCCL to eithe
r reduce their open position or, bring in additional collateral deposits by way
of cash or bank guarantee or FDR or securities. NSCCL renders a service to membe
rs, whereby the members can give standing instructions to debit their account to
wards additional base capital.
A penalty of Rs. 5000/- is levied for each violation and is debited to the clear
ing 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 separa
te violation for the purpose of calculation of penalty. The penalty is charged t
o the clearing member irrespective of whether the clearing member brings in marg
in deposits subsequently. Clearing Members (CMs) and Trading Members (TMs) are r
equired to collect upfront initial margins from all their Trading Members/ Const
ituents. CMs are required to compulsorily report, on a daily basis, details in r
espect of such margin amount due and collected, from the TMs/ Constituents clear
ing and settling through them, with respect to the trades executed/ open positio
ns of the TMs/ Constituents, which the CMs
have paid to NSCCL, for the requirements.
purpose
of
meeting
margin
Similarly, TMs are required to report on a daily basis details in respect of suc
h margin amount due and collected from the constituents clearing and settling th
rough them, with respect to the trades executed/ open positions of the constitue
nts, which the trading members have paid to the CMs, and on which the CMs have a
llowed initial margin limit to the TMs.
RESEARCH METHODOLOGY & ANALYSIS
RESEARCH METHODOLOGY Research is a procedure of logical and systematic applicati
on of the fundamentals of science to the general and overall questions of a stud
y and scientific technique by which provide precise tolls, specific procedures a
nd technical, rather than philosophical means for getting and ordering the data
prior to their logical analysis and manipulation. Different type of research des
igns is available depending upon the nature of research project, availability of
able manpower and circumstances. The study about " Trends and future of derivat
ives in india " is descriptive in nature. So survey method is used for the study
. Sampling Procedure The small representative selected out of large population i
s selected at random is called sample. Well-selected sample may reflect fairly,
accurately the characteristic of population. The chief aim of sampling is to mak
e an inference about unknown parameters from a measurable sample statistics. The
statistical hypothesis relating t population. The sample size was 60 which incl
udes brokers,dealers and investors.
Sources of Data: The sources of data includes primary and secondary data sources
. Primary Sources: Primary data is collected by structured questionnaire adminis
tered by sitting with guide and discussing problems. Secondary Sources: The seco
ndary data is data, which is collected and compiled for the different purpose, w
hich are used in research for this study. The secondary data include material co
llected from: Newspaper Magazine Internet Data collection instruments The variou
s method of data gathering involves the use of appropriate recording forms. Thes
e 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 colle
ction translates the research objectives in to specific term/questions to the re
sponse, 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 expla
ined more easily and clearly and takes less time to answer. Methodology Assumpti
ons: The research was based on the following assumption: 1. The methodology used
for this purpose are survey and questionable method. It is assumed that this me
thod is more suitable for collection of data. 2. It is assumed that the responde
nt have sufficient knowledge to ensure questionable. 3. It is assumed that the r
espondent have filled right and correct option according to their view.
BROKER S PERCEPTION ABOUT DERIVATIVES (ANALYSIS)
TRADING PERIOD IN DERIVATIVES
Trading period in derivatives.
25 20 15 10 5 0 Less than 1 year 1 year 2 year 3 year More than 3 year 13 13 7 6
Series1 Series2 21
From my sample of 60, 13 (22%) brokers and investors investing in derivatives fr
om last 1 year and less than this. 21(35%) are investing from last 2 years ,7 (1
1%) are investing from last 3 years and only 6 (10%) have experience of more tha
n 3 years of investment in derivatives.
REASONS BEHIND ITS ADOPTION
Purpose for derivative Trading
3 0 2 5 2 0 1 5 1 0 5
u la tio n en t
2 4 1 5 1 4 7 S rie e s1 S rie e s2
0
H e dg in g
S p ec
Reasons behind adoption of derivatives are different by brokers,investors and de
alers e.g. liquidity, risk management hedging, investor
R
is k
M a na g em
Li qu id ity
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%) d
ue to liquidity.
EXPERIENCE WITH DERIVATIVE
Out of my sample size 60, only 23 (38%) find derivatives as quite profitable inv
estment. 14 (23%) find that derivatives can’t give big profits in future.17 (29%)
feels that equities are better option for onvestment than derivativies.remaining
6 (10%) have other opinion thatonly those investors,brokers can derive good ret
urn from derivatives those have surplus funds and patience for long period..beca
use derivative requires huge investment and risk also.
INVESTED AMOUNT IN DERIVATIVES
Invested am ount in derivative trading.
3 0 2 5 2 0 1 5 1 0 5 0 2 la cs 2 lacs-5 la cs 5 lacs-1 0 la cs A yo e n th r S
rie e s1 S rie e s2 S rie e s3
Out of my sample size 60 ,27 (45%) investors and brokers have invested 2 lacs no
rmally.9 (15%) invested between 2 lacs to 5 lacs.and 15 (25%) invested between 5
lacs to 10 lacs,and remaining have invested in other amounts. Reason behind thi
s is that those are investing from many years are taking the risk of investing h
uge amount.
TRADED PERIOD IN DERIVATIVES
T d dp rio fo d riv tiv ra e e d r e a e in e tm n v s e t.
2 5 2 0 1 5 1 0 5 0 We e kly M n ly o th M re th n o a 1m n o th M re th n o a 2
m n s o th 1 3 5 2 3 1 9 S rie e s1 S rie e s2
13 (22%) investors and brokers are investing weekly in derivatives,23 ( 38%) inv
esting monthly,19 (32 %) investing after more than 1 month and only 5 ( 8%) inve
sting too late after 2 months.
IMPACT ON CUSTOMER BASE
Impact on customer base.
50 40 30 20 10 0 Increase 3 Decrease Remain same 15 Series1 Series2 42
Out of 60 brokers and investors, 3 ( 5%) of brokers said that it doesn t increas
e their customer base because introducing small savings as investment, but deriv
atives increases customer base of 42 (70%) wich is more than half.it is basicall
y beneficial for those who are investing from last 2 or more years. In investmen
t sector need minimum of Rs. 2,00,000 as investment so it is basically for corpo
rate and investment sector only not for small investors.15 ( 25%) said their cus
tomer base remain same because they have started just now for investing in deriv
atives.in future it will increase their customer base.
RELATIONSHIP WITH CASH MARKET
relation Between derivative and cash market.
30 20 10 0 Positiv e Negativ e Can t say 5 27 28 Series1 Series2
Out of 60 brokers,dealers 27 (45%) have the positive response toward the relatio
n between derivative and cash market and remaining 5 (8%) has negative response.
28 (47%) are not able to say anything because they don’t have proper knowledge ab
out stock market.they are investing with the guidance of brokers and with the su
pport of their close relatives those are investing for last many years.
BROKER S PERCEPTION TOWARDS INDIAN INVESTOR i.e. is settled in Indian investor p
syche?
Relation am ong derivative and cash m arket.
40 30 20 10 0 Yes N o 23 Series1 37
out of total 37 (62%) of investors and dealers are saying it hasn t settled in I
ndian investor psyche and 23 (38%) are saying it has.
DERIVATIVES AND RISK
Every broker says that there is a risk factor (up to some extent) in derivatives
also.
SHORTCOMINGS IN INDAIN DERIVATIVE SYSTEM
27 (45%) brokers,investors respond towards shortage of domestic technical expert
ise. 31(52%) feel lack of awareness in investor about derivatives and remaining
2 (3%) market failure.
RESULTS / FINDINGS
1. 2.
3.
Brokers not dealing in derivatives at present are also not going to adopt it in
near futures. Hedging & Risk Mgt. Is the most important feature of derivatives.
It is not for small investors. It has increased brokers turnovers as well as hel
pful in aggregate investment. Brokers haven t adequate knowledge about options,
so most by them are dealing in futures only. There is a risk factor in derivativ
e also. Most of investors are not investing in derivatives.
4. 5.
6.
7.
8.People are not aware of derivatives, even people who have invested in it, hasn’t
adequate knowledge about it. These people are interested to take it in their fu
ture portfolio also. They consider it as a tool of risk management. 9.They norma
lly invest in future contracts. 10.They are investing in future contract, becaus
e futures have up to home extent similar quality as Badla.
REASON BEHIND LESS DEVELOPMENT OF F&O SEGMENT AT L.S.E. At L.S.E. the is become
possible by L.S.E.S.L, which is working as a broker at N.S.E. and the broker of
L.S.E. (301 members) are working as a client of LSES Ltd. Itself (in reality). S
o they can t trade as a broker of their client and sub-broker concept does not e
xist in F&O segment. At National Level 1. Securities and contract s regulations
act has recognized "index" as a security very later i.e. in Nov. 2001. It will t
ake time to take position in derivative or capital market. 2. 3. 4. The Limited
mutual faith in the parties involved. It hasn t a legalized market. Commodity F
& O market has not yet been come to India. this will make easy to understand and
take simple investor under investor base of derivative trading. 5. 6. 7. Market
failures Scandals Inadequate infrastructures
8. 9. 10. 11. 12.
Shortage to domestic technical expertise, in India even most of people are not a
ware of concept derivatives. Large lot size, so small investors are not able to
come under derivative segment. There are less scripts under derivatives segment.
High margin as compare to Badla. In India there can t be a long term trading in
F & O, it is only for 1 to 2 or maximum for 3 months.
SUGGESTIONS
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 scrips of reputed companies etc. should be
introduced in "F & O 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, s
tudents 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 pro
vide to brokers & LSE employees and secondly seminar to students.
LIMITATIONS OF THE STUDY
No study is complete in itself, however good it may and every study has some lim
itations: Time is the main constraint of my study. Availability of information w
as not sufficient because of less awareness among investors/brokers Study is bas
ed only on NSE because information and trading in BSE is not available here. Sam
ple size is not enough to have a clear opinion.
CONCLUSION
On the basis of overall study on derivatives it was found that derivative produc
ts initially emerged as hedging devices against fluctuation and commodity prices
and commodity linked derivatives remained the soul form of such products. The f
inancial derivatives came in spotlight in 1972 due to growing in stability in fi
nancial 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 p
ortfolios. All these activities are generally performed by big individual invest
ors, institutional investors, mutual funds etc. No doubt that derivative growth
towards the progress of economy is positive. But the problems confronting the de
rivative market segment are giving it a low customer base. The main problems tha
t it confronts are unawareness and bit lot sizes etc. these problems could be ov
ercome easily
by revising lot sizes and also there should be seminar and general discussions o
n derivatives at varied places.
BIBLIOGRAPHY
1. BOOKS AND ARTICLES NCFM on derivatives core module by NSEIL. The Indian Commo
dity-Derivatives Market in Operations. 2. MAGAZINES The Dalal Street LSE Bulleti
n 3. INTERNET SITES
www.nseindia.com www.derivativeindia.com www.bseindia.com www.sebi.gov.in
SAMPLE OF QUESTIONNAIRE
Dear Respondent, I am a student of MBA 2nd year. I am working on the project " T
RENDS 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 Y
ear b) 1 Year d) 3 Year e) More than 3 years.
2) What is your purpose for trading in derivatives? a) Hedging c) Risk Managemen
t b) Speculation d) Liquidity
3) How will you describe your experience with derivative till date? a) I find th
ese 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 amo
unt____________ 5)How often do you trade? a) Weekly d) More than 2 month 6)What
is your customer base with introduction of derivatives? a) Increase b) Decrease
c) Remain same b) Monthly c) More than 1 month
7)What according to you is relationship between derivative market and cash marke
t?
a) Positive
b) Negative
c) Can t say
8) According to you have derivatives settled in Indian investors psyche? a) Yes
b) No
9)What shortcomings do you feel in Indian derivative market? a) Lack of awarenes
s among the investors about derivatives. b) Shortage of domestic technical exper
tise. c) If any other___________________________ 10) Which of following Media wo
uld you prefer the most for investor education? a) TV b) Newspaper c) Magazines
11) What suggestions do you want to make with regard to investors education in d
erivatives market in India?
THANKS FOR YOUR COOPERATION