GHAZIABAD

INSTITUTE OF TECHNOLOGY AND SCIENCE,

MOHAN NAGAR, GHAZIABAD

SUMMER INTERNSHIP PROJECT REPORT

ON TITLE

“DERIVATIVE MARKET- INDIA’’

BY

MUKTA DHEER
Enrollment No : PG2K8 181
E mail id muktadheer88@gmail.com

IL&FS INVESTSMART SECURITIES LIMITED

(A group company of HSBC)

I INDIA’S FINANCIAL MULTIPLEX I

1
 A REPORT

ON

“DERIVATIVE MARKET”
_____________________________________________________________
A report submitted in complete fulfillment of the requirements of PGDM program
of INSTITUTE OF TECHNOLOGY AND SCIENCE GHAZIABAD

SUBMITTED TO:

PROF. PRIYA
FACULTY
I.T.S GHAZIABAD

RAHUL KUMAR AGARWAL

ASM
IL&FS INVESTSMART SECURITIES LIMITED
E MAIL RAHULAGARWAL@hsbci.in

ACKNOWLEDGEMENT

2
 The beatitude, bliss and euphoria that accompany the successful completion of any task
would not be complete without the expression of appreciation of simple virtues to the
people who made it possible.

The final project report is submitted to institute of technology and science, Ghaziabad
for partial fulfilment of diploma, post graduate diploma in management (PGDM).

This project is an attempt to study “DERIVATIVE MARKET-INDIA”

At IL&FS INVESTSMART SECURITIES LTD.(HSBC Group).
I would like to thanks to the Management of IL&FS INVESTSMART
SECURITIES LTD. (HSBC Group) for giving me the opportunity to do my two-month
project training in their esteemed organization. I am highly obliged to Mr. RAHUL
KUMAR AGARWAL (AREA SALES MANAGER) for granting me to undertake my
training at RDC RAJ NAGAR branch.
I express my thanks to all Sales Managers and other relationship managers under
whose guidance and direction, I gave a good shape to my training. Their constant review
and excellent suggestions throughout the project are highly commendable. My heartfelt
thanks go to all the executives who helped me to gain knowledge about the actual
working and the processes involved in various departments. I would also like to
sincerely thank my faculty guide PROF. PRIYA whose guidance has helped me to
Understand and complete my project in a timely and proper manner

MUKTA DHEER

3
 DECLARATION

I do hereby declare that the project report is submitted as partial fulfilment of the
requirement of PGDM Program of INSTITUTE OF TECHNOLOGY AND SCIENCE,
GHAZIABAD.

The Project has been done under the guidance of Mr. RAHUL KUMAR AGARAWAL,
in Raj nagar branch ,Ghaziabad and PROF. PRIYA Faculty guide, INSTITUTE OF
TECHNOLOGY AND SCIENCE, Ghaziabad
No part of this report has not been published or submitted elsewhere for the fulfilment of
any degree or diploma for any institute or university.

MUKTA DHEER

EXECUTIVE SUMMARY

4
 New ideas and innovations have always been the hallmark of progress made by mankind.
At every stage of development, there have been two core factors that drives man to ideas
and innovation. These are increasing returns and reducing risk, in all facets of life.
The financial markets are no different. The endeavour has always been to maximize
returns and minimize risk. A lot of innovation goes into developing financial products
centred on these two factors. It has spawned a whole new area called financial
engineering.
Derivatives are among the forefront of the innovations in the financial markets and aim to
increase returns and reduce risk. They provide an outlet for investors to protect
themselves from the vagaries of the financial markets. These instruments have been very
popular with investors all over the world.
Indian financial markets have been on the ascension and catching up with global
standards in financial markets. The advent of screen based trading, dematerialization,
rolling settlement have put our markets on par with international markets.
As a logical step to the above progress, derivative trading was introduced in the country
in June 2000. Starting with index futures, we have made rapid strides and have four types
of derivative products- Index future, index option, stock future and stock options. Today,
there are 30 stocks on which one can have futures and options, apart from the index
futures and options.
This market presents a tremendous opportunity for individual investors .The markets
have performed smoothly over the last two years and has stabilized. The time is ripe for
investors to make full use of the advantage offered by this market.
We have tried to present in a lucid and simple manner, the derivatives market, so that the
individual investor is educated and equipped to become a dominant player in the market

CONTENTS

5
 PAGE NO.

INTRODUCTION TO PROJECT 7

COMPANY PROFILE 8

DERIVATIVES
a) Derivative defined 13
b) Types of market 15
c) History of derivatives 25
d) Indian derivative market 27
e) Need for derivatives in India today 28
f) Myths and realities about derivatives 28
g) Comparison of new system with existing system 31
h) Factor contributing to the growth of derivatives 36
i) Benefits of derivatives 39

DEVELOPMENT OF DERIVATIVE MARKET IN INDIA 41

NATIONAL EXCHANGES 45

RESEARCH OBJECTIVE 48

RESEARCH METHODOLOGY 48

ANALYSIS & INTERPRETATION 51

RECOMMENDATION & LIMITATION 62

BIBLIOGRAPHY 63

ANNEXURE
a) Questionnaire 64
b) Abbreviations 68

INTRODUCTION

6
A Derivative is a financial instrument whose value depends on other, more basic,
underlying variables. The variables underlying could be prices of traded securities
and stock, prices of gold or copper. Derivatives have become increasingly important
in the field of finance, Options and Futures are traded actively on many exchanges,
Forward contracts, Swap and different types of options are regularly traded outside
exchanges by financial intuitions, banks and their corporate clients in what are termed
as over-the-counter markets – in other words, there is no single market place
organized exchanges. Interpretation

NEED OF THE STUDY

The study has been done to know the different types of derivatives and also to know
the derivative market in India. This study also covers the recent developments in the
derivative market taking into account the trading in past years.
Through this study I came to know the trading done in derivatives and their use in the
stock markets.

SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better
understanding various strategies with different situations and actions have been given.
It includes the data collected in the recent years and also the market in the derivatives
in the recent years. This study extends to the trading of derivatives done in the
National Stock Markets.

7
 2. COMPANY PROFILE

IL&FS Investsmart securities Limited (IISL) is one of India’s leading financial

services organizations providing individuals and corporate with customized financial
management solutions. IL&FS investsmart limited( IIL) through its subsidiaries in India
and Singapore provide a wide range of investment products to its retail and institutional
client including equity broking investment banking, insurance broking and distribution,
mutual fund distribution and related financial services.
IIL’s 2000 employees provide a complete range of investment solution to over
138000 customers in India through its 88 branches and 190 franchised outlets from 133
cities. Company is having a market capitalization of approximately US $260 million.
Investsmart is listed on the national stock exchange (NSE) and the Bombay stock
exchange (BSE) and its global depository share are listed on the LUXEMBURG STOCK
EXCHANGE
At IISL, we believe in "Realizing your goals together". You will find in us - a trusted
investment partner to help you work towards achieving your financial goals. Our
institutional expertise, combined with a thorough understanding of the financial markets
results in appropriate investment solutions for you.
Our strong team of all your investment needs through a office near you. All you need
to do is drop in at the nearest branch or call us and we’ll be happy to do the rest!
Investsmart recognized as “National Relationship Managers, Customer Service
Executives, Advisory Managers and Research Analysts, offers efficient execution backed
by in-depth research, knowledge and expertise to customers across the country. With a
pan-India presence of over 300 offices, IISL is geared to meet “Best Performing
Financial Advisor-Retail” for two tear in a row (2006-07 and 2007-08) by CNBC
TV18.

8
Vision

To become a long term preferred long term financial to a wide base of customer whilst
optimizing Stake holder value.

Mission

To establish a base of 1 million satisfied customer by 2010 We will create this by

being a responsible trustworthy partner.

Corporate action

An approach to business that reflects responsibility, transparency and ethical

behaviour Respect for employee client and stake holder group.

PROMOTER OF THE COMPANY

IL&FS Investsmart securities Limited (IISL) is one of India’s leading companies in the
Financial Services industry. It was promoted in 1997 by Infrastructure Leasing & Financial
Services (IL&FS), one of India's leading infrastructure development and finance companies.

9
 The company is now held by HSBC, one of the world’s largest banking and financial
services organizations.
In India, The HSBC Group offers a range of financial services including corporate,
commercial, retail and private banking, insurance, asset management, investment banking,
equities and capital markets, institutional brokerage, custodial services. It also provides software
development expertise and global services facilities for the HSBC Group’s operations
worldwide.

HSBC ACQUIRED 93.86 % OF IL&FS INVESTSMART IN INDIA

HSBC has completed the acquisition of 93.86 % of IL&FS investsmart limited

(investsmart). A leading retail brokerage in India for a total consideration of INR 1311 crore
(approx. US $296.4 million)
Sandy flockhart Group managing director and CEO of HSBC Asia pacific said “investsmart
gives HSBC access to the world’s third-largest investor base with over 20 million retail
investors. In fact ,the business already has 1,43,000 customers and operates in 128 cities with
Indian GDP expected to grow by 7.8% in 2009. The opportunity here is obvious and underlines
why HSBC has a stated strategic aim of focusing on high-growth economics”
Under the transaction agreement, HSBC acquired 43.85% of Investsmart from
E*TRADE Mauritius Limited, an indirectly wholly-owned subsidiary of E*TRADE
Financial Corporation, and 29.36 per cent from Infrastructure Leasing and Financial
Services Limited (IL&FS). The decision to acquire a controlling stake in Investsmart
triggered an open offer to public shareholders, through which HSBC has accepted shares
equivalent to 20.65 per cent of Investsmart's capital.
E*TRADE Mauritius Limited, IL&FS and those that tendered shares through the open
offer received INR200 per share for their Investsmart shares. In addition, IL&FS was
paid, as part of a three-year non-compete agreement, INR82.0 crore (approximately
US$17.9 million). In accordance with local regulations, HSBC paid interest of INR2.3

10
per share to the public shareholders who tendered their shares. This amounted to INR3.31
crore approximately US$0.72 million).

Naina Lal Kidwai, Group General Manager and Chief Executive Officer, HSBC in India,
added: "Investsmart is a great addition to our current operations, which already constitute
the second largest foreign banking network in India. We look forward to working with
Investsmart's management team and growing this business."
HSBC was advised on the acquisition by the investment banking division of HSBC
Global Banking and Markets. The HSBC Group in India is represented by several entities
including The Hongkong and Shanghai Banking Corporation Limited which offers a
full range of banking and financial services to its over 2.8 million customers in India
through its 47 branches and 170 ATMs across 26 cities. HSBC is one of India's leading
financial services groups, with over 34,000 employees in its banking, investment banking
and capital markets, asset management, insurance broking, two global IT development
centres and six global resourcing operations in the country. The Bank is the founding and
a principal member of the HSBC Group which, with over 9,500 offices in 85 countries
and territories and assets of US$2,547 billion at 30 June 2008, is one of the world's
largest banking and financial services organizations.

In September 2008, HSBC Securities & Capital Markets (HSCI) and HSBC Violet
Investments (Mauritius) had acquired 29.35% and 43.85% stakes held by IL&FS and E
Trade in IL&FS Investsmart. Post the stake acquisition, HSCI’s total holding in IL&FS
Investsmart increased to 50.01%, taking the total stake held by HSBC and HSCI together
in the company to 93.86%

HSBC Securities & capital markets (India) private limited 34,922,751 50.01 %
HSBC Violet investment (Mauritius) limited 30,625,692 43.85 %
Others 4,287,830 6.14 %
Total 69836273 100 %

11
 Currently HSBC group is having 93.86% of share in IL&FS investsmart securities limited.
HSBC securities and capital markets (INDIA) private limited has 50.01% HSBC violet
investment (maturities) limited has 43.85% in investsmart. Now the company is running under
the management of HSBC group.

12
3. INTRODUCTION TO DERIVATIVES

The origin of derivatives can be traced back to the need of farmers to protect themselves
against fluctuations in the price of their crop. From the time it was sown to the time it
was ready for harvest, farmers would face price uncertainty. Through the use of simple
derivative products, it was possible for the farmer to partially or fully transfer price risks
by locking-in asset prices. These were simple contracts developed to meet the needs of
farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would
receive for his harvest in September. In years of scarcity, he would probably obtain
attractive prices. However, during times of oversupply, he would have to dispose off his
harvest at a very low price. Clearly this meant that the farmer and his family were
exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would
face a price risk that of having to pay exorbitant prices during dearth, although favorable
prices could be obtained during periods of oversupply. Under such circumstances, it
clearly made sense for the farmer and the merchant to come together and enter into
contract whereby the price of the grain to be delivered in September could be decided
earlier. What they would then negotiate happened to be futures-type contract, which
would enable both parties to eliminate the price risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers
and merchants together. A group of traders got together and created the ‘to-arrive’
contract that permitted farmers to lock into price upfront and deliver the grain later.
These to-arrive contracts proved useful as a device for hedging and speculation on price
charges. These were eventually standardized, and in 1925 the first futures clearing house
came into existence.

13
 Today derivatives contracts exist on variety of commodities such as corn, pepper,
cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of
financial underlying like stocks, interest rate, exchange rate, etc.

3.1DERIVATIVES DEFINED
A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can be
equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of change in
price by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the “underlying” in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures

contracts in commodities all over India. As per this the Forward Markets Commission
(FMC) continues to have jurisdiction over commodity futures contracts. However when
derivatives trading in securities was introduced in 2001, the term “security” in the
Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative
contracts in securities. Consequently, regulation of derivatives came under the purview of
Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities
for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivatives is
governed by the regulatory framework under the SCRA. The Securities Contracts
(Regulation) Act, 1956 defines “derivative” to include-

A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract differences or any other form of security.

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

14
 Figure.1 Types of Derivatives Market

3.2 TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange

Index Future Index option Stock option Stock future

Interest

rate Futures

3.3 TYPES OF DERIVATIVES

Derivatives

Future Option Forward Swaps

15
 Figure.2 Types of Derivatives

FORWARD CONTRACTS

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

specified price. One of the parties to the contract assumes a long position and agrees
to buy the underlying asset on a certain specified future date for a certain specified
price. The other party assumes a short position and agrees to sell the asset on the
same date for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are n o r m a l l y traded outside the exchanges.

The salient features of forward contracts are:

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

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

size, expiration date and the asset type and quality.

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

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

• If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized,

as in the case of foreign exchange, thereby reducing transaction costs and
increasing transactions volume. This process of standardization reaches its limit in
the organized futures market. Forward contracts are often confused with futures
contracts. The confusion is primarily because both serve essentially th e same

16
economic functions of allocating risk in the presence of future price uncertainty.
However futures are a significant improvement over the forward contracts as
they eliminate counterparty risk and offer more liquidity.

FUTURE CONTRACT

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

buy or sell a certain underlying instrument at a certain date in the future, at a pre-set
price. The future date is called the delivery date or final settlement date. The pre-set
price is called the futures price. The price of the underlying asset on the delivery date is
called the settlement price. The settlement price, normally, converges towards the
futures price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which
differs from an options contract, which gives the buyer the right, but not the obligation,
and the option writer (seller) the obligation, but not the right. To exit the commitment, the
holder of a futures position has to sell his long position or buy back his short position,
effectively closing out the futures position and its contract obligations. Futures contracts
are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets
margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:

• The underlying. This can be anything from a barrel of sweet crude oil to a short
term interest rate.
• The type of settlement, either cash settlement or physical settlement.

17
 • The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term interest
rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In case of bonds, this specifies which bonds can be
delivered. In case of physical commodities, this specifies not only the quality of
the underlying goods but also the manner and location of delivery. The delivery
month.
• The last trading date.
• Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:
Although the value of a contract at time of trading should be zero, its price constantly
fluctuates. This renders the owner liable to adverse changes in value, and creates a credit
risk to the exchange, who always acts as counterparty. To minimize this risk, the
exchange demands that contract owners post a form of collateral, commonly known as
Margin requirements are waived or reduced in some cases for hedgers who have physical
ownership of the covered commodity or spread traders who have offsetting contracts
balancing the position.
Initial margin: is paid by both buyer and seller. It represents the loss on that contract, as
determined by historical price changes, which is not likely to be exceeded on a usual
day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may exhaust the
initial margin, a further margin, usually called variation or maintenance margin, is
required by the exchange. This is calculated by the futures contract, i.e. agreeing on a
price at the end of each day, called the "settlement" or mark-to-market price of the
contract.
To understand the original practice, consider that a futures trader, when taking a position,
deposits money with the exchange, called a "margin". This is intended to protect the
exchange against loss. At the end of every trading day, the contract is marked to its

18
present market value. If the trader is on the winning side of a deal, his contract has
increased in value that day, and the exchange pays this profit into his account. On the
other hand, if he is on the losing side, the exchange will debit his account. If he cannot
pay, then the margin is used as the collateral from which the loss is paid.

3. Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways,
as specified per type of futures contract:
• Physical delivery - the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the
buyers of the contract. In practice, it occurs only on a minority of contracts. Most
are cancelled out by purchasing a covering position - that is, buying a contract to
cancel out an earlier sale (covering a short), or selling a contract to liquidate an
earlier purchase (covering a long).
• Cash settlement - a cash payment is made based on the underlying reference rate,
such as a short term interest rate index such as Euribor, or the closing value of a
stock market index. A futures contract might also opt to settle against an index
based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For many equity
index and interest rate futures contracts, this happens on the Last Thursday of certain
trading month. On this day the t+2 futures contract becomes the t forward contract.

Pricing of future contract

In a futures contract, for no arbitrage to be possible, the price paid on delivery (the
forward price) must be the same as the cost (including interest) of buying and storing the
asset. In other words, the rational forward price represents the expected future value of
the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying

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

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

19
This relationship may be modified for storage costs, dividends, dividend yields, and
convenience yields. Any deviation from this equality allows for arbitrage as follows.
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today (on the
spot market) with borrowed money.
2. On the delivery date, the arbitrageur hands over the underlying, and receives the
agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.
In the case where the forward price is lower:
1. The arbitrageur buys the futures contract and sells the underlying today (on the
spot market); he invests the proceeds.
2. On the delivery date, he cashes in the matured investment, which has appreciated
at the risk free rate.
3. He then receives the underlying and pays the agreed forward price using the
matured investment. [If he was short the underlying, he returns it now.]
4. The difference between the two amounts is the arbitrage profit.

20
 TABLE 1-
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURES FORWARD CONTRACT FUTURE CONTRACT

Operational Traded directly between two Traded on the exchanges.

Mechanism parties (not traded on the
exchanges).

Contract Differ from trade to trade. Contracts are standardized contracts.

Specifications

Counter-party Exists. Exists. However, assumed by the clearing

risk corp., which becomes the counter party to
all the trades or unconditionally guarantees
their settlement.

Liquidation Low, as contracts are tailor High, as contracts are standardized

Profile made contracts catering to the exchange traded contracts.
needs of the needs of the
parties.

Price discovery Not efficient, as markets are Efficient, as markets are centralized and all
scattered. buyers and sellers come to a common
platform to discover the price.

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

Individual stock Futures in India.

21
OPTIONS -
A derivative transaction that gives the option holder the right but not the obligation to
buy or sell the underlying asset at a price, called the strike price, during a period or on a
specific date in exchange for payment of a premium is known as ‘option’. Underlying
asset refers to any asset that is traded. The price at which the underlying is traded is
called the ‘strike price’.

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

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying asset-
stock or any financial asset, at a specified price on or before a specified date is known as
a ‘Call option’. The owner makes a profit provided he sells at a higher current price and
buys at a lower future price.

b. PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying asset-
stock or any financial asset, at a specified price on or before a specified date is known as
a ‘Put option’. The owner makes a profit provided he buys at a lower current price and
sells at a higher future price. Hence, no option will be exercised if the future price does
not increase.

Put and calls are almost always written on equities, although occasionally preference
shares, bonds and warrants become the subject of options.

22
4. SWAPS -
Swaps are transactions which obligates the two parties to the contract to exchange a
series of cash flows at specified intervals known as payment or settlement dates. They
can be regarded as portfolios of forward's contracts. A contract whereby two parties agree
to exchange (swap) payments, based on some notional principle amount is called as a
‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle
amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

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

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

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

23
The other kind of derivatives, which are not, much popular are as follows:

5. BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options are
most popular form of baskets.

6. LEAPS -

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

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

7. WARRANTS -

Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.

8. SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the expiry of
the options. Thus a swaption is an option on a forward swap. Rather than have calls and
puts, the swaptions market has receiver swaptions and payer swaptions. A receiver
swaption is an option to receive fixed and pay floating. A payer swaption is an option to
pay fixed and receive floating.

24
 3.1 HISTORY OF DERIVATIVES:

The history of derivatives is quite colourful and surprisingly a lot longer than most people
think. Forward delivery contracts, stating what is to be delivered for a fixed price at a
specified place on a specified date, existed in ancient Greece and Rome. Roman emperors
entered forward contracts to provide the masses with their supply of Egyptian grain.
These contracts were also undertaken between farmers and merchants to eliminate risk
arising out of uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.
The first organized commodity exchange came into existence in the
early 1700’s in Japan. The first formal commodities exchange, the Chicago Board of
Trade (CBOT), was formed in 1848 in the US to deal with the problem of ‘credit risk’
and to provide centralised location to negotiate forward contracts. From ‘forward’ trading
in commodities emerged the commodity ‘futures’. The first type of futures contract was
called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT
listed the first ‘exchange traded’ derivatives contract, known as the futures contracts.
Futures trading grew out of the need for hedging the price risk involved in many
commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of
CBOT, was formed in 1919, though it did exist before in 1874 under the names of
‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB).
The first financial futures to emerge were the currency in 1972 in the US. The first
foreign currency futures were traded on May 16, 1972, on International Monetary
Market (IMM), a division of CME. The currency futures traded on the IMM are the
British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German
Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by
interest rate futures. Interest rate futures contracts were traded for the first time on the
CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first
stock index futures contracts were traded on Kansas City Board of Trade on February 24,
1982.The first of the several networks, which offered a trading link between two
exchanges, was formed between the Singapore International Monetary Exchange
(SIMEX) and the CME on September 7, 1984.

25
Options are as old as futures. Their history also dates back to ancient Greece and Rome.
Options are very popular with speculators in the tulip craze of seventeenth century
Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a
high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb
options. There was so much speculation that people even mortgaged their homes and
businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as
there was no mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an American financier,
Russell Sage, in 1872. These options were traded over the counter. Agricultural
commodities options were traded in the nineteenth century in England and the US.
Options on shares were available in the US on the over the counter (OTC) market only
until 1973 without much knowledge of valuation. A group of firms known as Put and
Call brokers and Dealer’s Association was set up in early 1900’s to provide a mechanism
for bringing buyers and sellers together.
On April 26, 1973, the Chicago Board options Exchange (CBOE) was
set up at CBOT for the purpose of trading stock options. It was in 1973 again that black,
Merton, and Scholes invented the famous Black-Scholes Option Formula. This model
helped in assessing the fair price of an option which led to an increased interest in trading
of options. With the options markets becoming increasingly popular, the American Stock
Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in
options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties. The
collapse of the Bretton Woods regime of fixed parties and the introduction of floating
rates for currencies in the international financial markets paved the way for development
of a number of financial derivatives which served as effective risk management tools to
cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on which
futures contracts are traded. The CBOT now offers 48 futures and option contracts (with

26
the annual volume at more than 211 million in 2001).The CBOE is the largest exchange
for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500
stock indices. The Philadelphia Stock Exchange is the premier exchange for trading
foreign options.
The most traded stock indices include S&P 500, the Dow Jones Industrial
Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade
almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.
3.5 INDIAN DERIVATIVES MARKET
Starting from a controlled economy, India has moved towards a world where prices
fluctuate every day. The introduction of risk management instruments in India gained
momentum in the last few years due to liberalisation process and Reserve Bank of India’s
(RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation process to manage risk. NSE gauging the market requirements initiated the
process of setting up derivative markets in India. In July 1999, derivatives trading
commenced in India

Table Chronology of instruments

1991 Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for
index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and
interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives

3.6 Need for derivatives in India today

27
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Today, derivatives have become part and parcel
of the day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading
methods and was using traditional out-dated methods of trading. There was a huge gap
between the investors’ aspirations of the markets and the available means of trading. The
opening of Indian economy has precipitated the process of integration of India’s financial
markets with the international financial markets. Introduction of risk management
instruments in India has gained momentum in last few years thanks to Reserve Bank of
India’s efforts in allowing forward contracts, cross currency options etc. which have
developed into a very large market.

3.7 Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Financial derivatives came into the spotlight
along with the rise in uncertainty of post-1970, when US announced an end to the Bretton
Woods System of fixed exchange rates leading to introduction of currency derivatives
followed by other innovations including stock index futures. Today, derivatives have
become part and parcel of the day-to-day life for ordinary people in major parts of the
world. While this is true for many countries, there are still apprehensions about the
introduction of derivatives. There are many myths about derivatives but the realities that
are different especially for Exchange traded derivatives, which are well regulated with all
the safety mechanisms in place.
What are these myths behind derivatives?
• Derivatives increase speculation and do not serve any economic purpose
• Indian Market is not ready for derivative trading
• Disasters prove that derivatives are very risky and highly leveraged instruments
• Derivatives are complex and exotic instruments that Indian investors will find
difficulty in understanding
• Is the existing capital market safer than Derivatives?
Derivatives increase speculation and do not serve any economic purpose

28
Numerous studies of derivatives activity have led to a broad consensus, both in the
private and public sectors that derivatives provide numerous and substantial benefits to
the users. Derivatives are a low-cost, effective method for users to hedge and manage
their exposures to interest rates, commodity
Prices or exchange rates. The need for derivatives as hedging tool was felt first in
the commodities market. Agricultural futures and options helped farmers and processors
hedge against commodity price risk. After the fallout of Bretton wood agreement, the
financial markets in the world started undergoing radical changes. This period is marked
by remarkable innovations in the financial markets such as introduction of floating rates
for the currencies, increased trading in variety of derivatives instruments, on-line trading
in the capital markets, etc. As the complexity of instruments increased many folds, the
accompanying risk factors grew in gigantic proportions. This situation led to
development derivatives as effective risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional
investors to effectively manage their portfolios of assets and liabilities through
instruments like stock index futures and options. An equity fund, for example, can reduce
its exposure to the stock market quickly and at a relatively low cost without selling off
part of its equity assets by using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks
and raising capital, derivatives improve the allocation of credit and the sharing of risk in
the global economy, lowering the cost of capital formation and stimulating economic
growth. Now that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global markets
increasing market liquidity and efficiency and facilitating the flow of trade and finance.

29
Indian Market is not ready for derivative trading
Often the argument put forth against derivatives trading is that the Indian capital market
is not ready for derivatives trading. Here, we look into the pre-requisites, which are
needed for the introduction of derivatives, and how Indian market fares:

PRE-REQUISITES INDIAN SCENARIO

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

High Liquidity in the The daily average traded volume in Indian capital market
underlying today is around 7500 crores. Which means on an average
every month 14% of the country’s Market capitalisation
gets traded. These are clear indicators of high liquidity in
the underlying.
Trade guarantee The first clearing corporation guaranteeing trades has
become fully functional from July 1996 in the form of
National Securities Clearing Corporation (NSCCL).
NSCCL is responsible for guaranteeing all open positions
on the National Stock Exchange (NSE) for which it does
the clearing.
A Strong Depository National Securities Depositories Limited (NSDL) which
started functioning in the year 1997 has revolutionalised
the security settlement in our country.
A Good legal guardian In the Institution of SEBI (Securities and Exchange Board
of India) today the Indian capital market enjoys a strong,
independent, and innovative legal guardian who is helping
the market to evolve to a healthier place for trade practices.

30
What kind of people will use derivatives?

Derivatives will find use for the following set of people:

• Speculators: People who buy or sell in the market to make profits. For example, if you
will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1
month future of Reliance at Rs 350 and make profits
• Hedgers: People who buy or sell to minimize their losses. For example, an importer has
to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the
importer can minimize his losses by buying a currency future at Rs 49/$
• Arbitrageurs: People who buy or sell to make money on price differentials in different
markets. For example, a futures price is simply the current price plus the interest cost. If
there is any change in the interest, it presents an arbitrage opportunity. We will examine
this in detail when we look at futures in a separate chapter. Basically, every investor
assumes one or more of the above roles and derivatives are a very good option for him.

3.8 Comparison of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new system
is very useful especially to retail investors. It increases the no of options investors for
investment. In fact it should have been introduced much before and NSE had approved it
but was not active because of politicization in SEBI.
The figure 3.3a –3.3d shows how advantages of new system (implemented from June
20001) v/s the old system i.e. before June 2001
New System Vs Existing System for Market Players

31
Figure 3.3a

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril

&Prize
1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum
Trading, margin loss to extent of on delivery basis loss possible
trading& carry price change. 2) Buy Call &Put to premium
forward transactions. by paying paid
2) Buy Index Futures premium
hold till expiry.

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

Figure 3.3b

Arbitrageurs

32
 Existing SYSTEM New

Approach Peril &Prize Approach Peril

&Prize
1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free
one and selling in whichever way the promising as still game.
another exchange. Market moves. in weekly settlement
forward transactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
more or less than Fair price

• Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril

&Prize
1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional
offload holding available risk latter by paying premium. cost is only
during adverse reward dependant 2)For Long, buy ATM Put premium.

33
market conditions on market prices Option. If market goes up,
as circuit filters long position benefit else
limit to curtail losses. exercise the option.
3)Sell deep OTM call option
with underlying shares, earn
premium + profit with increase prcie

Advantages
• Availability of Leverage

Figure 3.3d

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril

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

Advantages
• Losses Protected.

34
 Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology
have contributed to a great extent to these developments. While both exchange-traded
and OTC derivative contracts offer many benefits, the former have rigid structures
compared to the latter. It has been widely discussed that the highly leveraged institutions
and their OTC derivative positions were the main cause of turbulence in financial
markets in 1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.

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

35
The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic nature of
gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative
activities on available aggregate credit; (iv) the high concentration of OTC derivative
activities in major institutions; and (v) the central role of OTC derivatives markets in the
global financial system. Instability arises when shocks, such as counter-party credit
events and sharp movements in asset prices that underlie derivative contracts, occur
which significantly alter the perceptions of current and potential future credit exposures.
When asset prices change rapidly, the size and configuration of counter-party exposures
can become unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However, the
progress has been limited in implementing reforms in risk management, including
counter-party, liquidity and operational risks, and OTC derivatives markets continue to
pose a threat to international financial stability. The problem is more acute as heavy
reliance on OTC derivatives creates the possibility of systemic financial events, which
fall outside the more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through the use of exchange traded derivatives. In
view of the inherent risks associated with OTC derivatives, and their dependence on
exchange traded derivatives, Indian law considers them illegal.

3.9 FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

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

globalisation of the markets, technological developments and advances in the financial
theories.

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of value. The objects having value
maybe commodities, local currency or foreign currencies. The concept of price is clear to

36
almost everybody when we discuss commodities. There is a price to be paid for the
purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of
another persons money is called interest rate. And the price one pays in one’s own
currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have ‘demand’
and producers or suppliers have ‘supply’, and the collective interaction of demand and
supply in the market determines the price. These factors are constantly interacting in the
market causing changes in the price over a short period of time. Such changes in the price
are known as ‘price volatility’. This has three factors: the speed of price changes, the
frequency of price changes and the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The break down of the BRETTON WOODS agreement
brought and end to the stabilising role of fixed exchange rates and the gold convertibility
of the dollars. The globalisation of the markets and rapid industrialisation of many
underdeveloped countries brought a new scale and dimension to the markets. Nations that
were poor suddenly became a major source of supply of goods. The Mexican crisis in the
south east-Asian currency crisis of 1990’s has also brought the price volatility factor on
the surface. The advent of telecommunication and data processing bought information
very quickly to the markets. Information which would have taken months to impact the
market earlier can now be obtained in matter of moments. Even equity holders are
exposed to price risk of corporate share fluctuates rapidly.

These price volatility risks pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against adverse price
changes in commodity, foreign exchange, equity shares and bonds.

B.} GLOBALISATION OF MARKETS –

37
Earlier, managers had to deal with domestic economic concerns; what happened in other
part of the world was mostly irrelevant. Now globalisation has increased the size of
markets and as greatly enhanced competition .it has benefited consumers who cannot
obtain better quality goods at a lower cost. It has also exposed the modern business to
significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods
from India declined because of this crisis. Steel industry in 1998 suffered its worst set
back due to cheap import of steel from south East Asian countries. Suddenly blue chip
companies had turned in to red. The fear of china devaluing its currency created
instability in Indian exports. Thus, it is evident that globalisation of industrial and
financial activities necessitates use of derivatives to guard against future losses. This
factor alone has contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological break
through. Advances in this area include the development of high speed processors,
network systems and enhanced method of data entry. Closely related to advances in
computer technology are advances in telecommunications. Improvement in
communications allow for instantaneous world wide conferencing, Data transmission by
satellite. At the same time there were significant advances in software programmes
without which computer and telecommunication advances would be meaningless. These
facilitated the more rapid movement of information and consequently its instantaneous
impact on market price.
Although price sensitivity to market forces is beneficial to the economy as a whole
resources are rapidly relocated to more productive use and better rationed overtime the
greater price volatility exposes producers and consumers to greater price risk. The effect
of this risk can easily destroy a business which is otherwise well managed. Derivatives
can help a firm manage the price risk inherent in a market economy. To the extent the

38
technological developments increase volatility, derivatives and risk management products
become that much more important.

39
D.} ADVANCES IN FINANCIAL THEORIES –
Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed
by Black and Scholes in 1973 were used to determine prices of call and put options. In
late 1970’s, work of Lewis Edeington extended the early work of Johnson and started the
hedging of financial price risks with financial futures. The work of economic theorists
gave rise to new products for risk management which led to the growth of derivatives in
financial markets.
The above factors in combination of lot many factors led to growth of derivatives
instruments
3.10 BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:
1.] RISK MANAGEMENT –
Futures and options contract can be used for altering the risk of investing in spot market.
For instance, consider an investor who owns an asset. He will always be worried that the
price may fall before he can sell the asset. He can protect himself by selling a futures
contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in
the futures market, as you will see later. This will help offset their losses in the spot
market. Similarly, if the spot price falls below the exercise price, the put option can
always be exercised.
2.] PRICE DISCOVERY –
Price discovery refers to the markets ability to determine true equilibrium prices. Futures
prices are believed to contain information about future spot prices and help in
disseminating such information. As we have seen, futures markets provide a low cost
trading mechanism. Thus information pertaining to supply and demand easily percolates
into such markets. Accurate prices are essential for ensuring the correct allocation of
resources in a free market economy. Options markets provide information about the
volatility or risk of the underlying asset.
3.] OPERATIONAL ADVANTAGES –
As opposed to spot markets, derivatives markets involve lower transaction costs.
Secondly, they offer greater liquidity. Large spot transactions can often lead to significant

40
price changes. However, futures markets tend to be more liquid than spot markets,
because herein you can take large positions by depositing relatively small margins.
Consequently, a large position in derivatives markets is relatively easier to take and has
less of a price impact as opposed to a transaction of the same magnitude in the spot
market. Finally, it is easier to take a short position in derivatives markets than it is to sell
short in spot markets.
4.] MARKET EFFICIENCY –
The availability of derivatives makes markets more efficient; spot, futures and options
markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is
possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence
these markets help to ensure that prices reflect true values.
5.] EASE OF SPECULATION –
Derivative markets provide speculators with a cheaper alternative to engaging in spot
transactions. Also, the amount of capital required to take a comparable position is less in
this case. This is important because facilitation of speculation is critical for ensuring free
and fair markets. Speculators always take calculated risks. A speculator will accept a
level of risk only if he is convinced that the associated expected return is commensurate
with the risk that he is taking.

The derivative market performs a number of economic functions.

• The prices of derivatives converge with the prices of the underlying at the
expiration of derivative contract. Thus derivatives help in discovery of future as
well as current prices.
• An important incidental benefit that flows from derivatives trading is that it acts
as a catalyst for new entrepreneurial activity.
• Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.

41
 4.1 DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of
the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on
options in securities. The market for derivatives, however, did not take off, as there was
no regulatory framework to govern trading of derivatives. SEBI set up a 24–member
committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India. The committee
submitted its report on March 17, 1998 prescribing necessary pre–conditions for
introduction of derivatives trading in India. The committee recommended that derivatives
should be declared as ‘securities’ so that regulatory framework applicable to trading of
‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998
under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment
in derivatives market in India. The report, which was submitted in October 1998, worked
out the operational details of margining system, methodology for charging initial
margins, broker net worth, deposit requirement and real–time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to
include derivatives within the ambit of ‘securities’ and the regulatory framework were
developed for governing derivatives trading. The act also made it clear that derivatives
shall be legal and valid only if such contracts are traded on a recognized stock exchange,
thus precluding OTC derivatives. The government also rescinded in March 2000, the
three decade old notification, which prohibited forward trading in securities. Derivatives
trading commenced in India in June 2000 after SEBI granted the final approval to this
effect in May 2001. SEBI permitted the derivative segments of two stock exchanges,
NSE and BSE, and their clearing house/corporation to commence trading and settlement
in approved derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE–30 (Sense) index. This was followed by
approval for trading in options based on these two indexes and options on individual
securities.

42
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts on individual
stocks were launched in November 2001. The derivatives trading on NSE commenced
with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options
commenced on June 4, 2001 and trading in options on individual securities commenced
on July 2, 2001. Single stock futures were launched on November 9, 2001. The index
futures and options contract on NSE are based on S&P CNX Trading and settlement in
derivative contracts is done in accordance with the rules, byelaws, and regulations of the
respective exchanges and their clearing house/corporation duly approved by SEBI and
notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade
in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE
report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O

segment. It constituted 70 per cent of the total turnover during June 2002. A primary
reason attributed to this phenomenon is that traders are comfortable with single-stock
futures than equity options, as the former closely resembles the erstwhile badla system.

• On relative terms, volumes in the index options segment continue to remain poor.
This may be due to the low volatility of the spot index. Typically, options are considered
more valuable when the volatility of the underlying (in this case, the index) is high. A
related issue is that brokers do not earn high commissions by recommending index
options to their clients, because low volatility leads to higher waiting time for round-trips.

• Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in January
2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are
increasingly becoming pessimistic on the market.

43
• Farther month futures contracts are still not actively traded. Trading in equity
options on most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O segment as a less
risky alternative (read substitute) to generate profits from the stock price movements. The
fact that the option premiums tail intra-day stock prices is evidence to this. If calls and
puts are not looked as just substitutes for spot trading, the intra-day stock price variations
should not have a one-to-one impact on the option premiums.

• The spot foreign exchange market remains the most important segment but
the derivative segment has also grown. In the derivative market foreign
exchange swaps account for the largest share of the total turnover of
derivatives in India followed by forwards and options. Significant
milestones in the development of derivatives market have been (i)
permission to banks to undertake cross currency derivative transactions subject
to certain conditions (1996) (ii) allowing corporates to undertake long term
foreign currency swaps that contributed to the development of the term
currency swap market (1997) (iii) allowing dollar rupee options (2003) and
(iv) introduction of currency futures (2008). I would like to emphasise that
currency swaps allowed companies with ECBs to swap their foreign currency
liabilities into rupees. However, since banks could not carry open positions
the risk was allowed to be transferred to any other resident corporate.
Normally such risks should be taken by corporates who have natural hedge or
have potential foreign exchange earnings. But often corporate assume these
risks due to interest rate differentials and views on currencies.

This period has also witnessed several relaxations in regulations relating to forex
markets and also greater liberalisation in capital account regulations leading to
greater integration with the global economy.

44
 • Cash settled exchange traded currency futures have made foreign currency a
separate asset class that can be traded without any underlying need or
exposure a n d on a leveraged basis on the recognized stock exchanges with
credit risks being assumed by the central counterparty
Since the commencement of trading of currency futures in all the three exchanges,
the value of the trades has gone up steadily from Rs 17, 429 crores in October 2008
to Rs 45, 803 crores in December 2008. The average daily turnover in all the
exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same
period. The turnover in the currency futures market is in line with the international
scenario, where I understand the share of futures market ranges between 2 – 3 per
cent.

Table 4.1ForexMarketActivity

April’05- April’06- April’07- April’08-

Mar’06 Mar’07 Mar’08 Mar’09
Total turnover (USD billion) 4,404 6,571 12,304 9,621
Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1
Spot/Total Turnover (%) 50.5 51.9 49.7 54.9
Forward/Total Turnover (%) 19.0 17.9 19.3 21.5
Swap/Total Turnover (%) 30.5 30.1 31.1 32.7
Source: RBI

45
5. National Exchanges
In enhancing the institutional capabilities for futures trading the idea of setting up
of National Commodity Exchange(s) has been pursued since 1999. Three such
Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE),
Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and
Multi Commodity Exchange (MCX), Mumbai have become operational. “National
Status” implies that these exchanges would be automatically permitted to conduct futures
trading in all commodities subject to clearance of byelaws and contract specifications by
the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002,
MCX and NCDEX, Mumbai commenced operations in October/ December 2003
respectively.

MCX

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

mutulised multi commodity exchange has permanent recognition from Government of
India for facilitating online trading, clearing and settlement operations for commodity
futures markets across the country. Key shareholders of MCX are Financial Technologies
(India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of
Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India,
Bank of India, Bank of Baroda, Canera Bank, Corporation Bank

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

domain knowledge of the commodity futures markets. Today MCX is offering
spectacular growth opportunities and advantages to a large cross section of the
participants including Producers / Processors, Traders, Corporate, Regional Trading
Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX

46
being nation-wide commodity exchange, offering multiple commodities for trading with
wide reach and penetration and robust infrastructure.

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

independent and demutualised multi commodity Exchange. MCX, a state-of-the-art
nationwide, digital Exchange, facilitates online trading, clearing and settlement
operations for a commodities futures trading.

NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by
Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing
Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL),
Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural
Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral
aspects of commodity economy, viz., warehousing, cooperatives, private and public
sector marketing of agricultural commodities, research and training were adequately
addressed in structuring the Exchange, finance was still a vital missing link. Punjab
National Bank (PNB) took equity of the Exchange to establish that linkage. Even today,
NMCE is the only Exchange in India to have such investment and technical support from
the commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested trading
platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust
delivery mechanism making it the most suitable for the participants in the physical
commodity markets. It has also established fair and transparent rule-based procedures and
demonstrated total commitment towards eliminating any conflicts of interest. It is the
only Commodity Exchange in the world to have received ISO 9001:2000 certification
from British Standard Institutions (BSI). NMCE was the first commodity exchange to
provide trading facility through internet, through Virtual Private Network (VPN).

47
 NMCE follows best international risk management practices. The contracts are
marked to market on daily basis. The system of upfront margining based on Value at Risk
is followed to ensure financial security of the market. In the event of high volatility in the
prices, special intra-day clearing and settlement is held. NMCE was the first to initiate
process of dematerialization and electronic transfer of warehoused commodity stocks.
The unique strength of NMCE is its settlements via a Delivery Backed System, an
imperative in the commodity trading business. These deliveries are executed through a
sound and reliable Warehouse Receipt System, leading to guaranteed clearing and
settlement.

NCDEX

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

driven commodity exchange. It is a public limited company registered under the
Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on
April 23,2003. It has an independent Board of Directors and professionals not
having any vested interest in commodity markets. It has been launched to provide a
world-class commodity exchange platform for market participants to trade in a
wide spectrum of commodity derivatives driven by best global practices,
professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures trading in

commodities. Besides, NCDEX is subjected to various laws of the land like the
Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and
various other legislations, which impinge on its working. It is located in Mumbai and
offers facilities to its members in more than 390 centres throughout India. The reach will
gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed,
Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil,
Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green
Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice,

48
 Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe),
Wheat, Yellow Peas, Yellow Red Maize & Yellow soyabean meal.

OBJECTIVES OF THE STUDY

 To understand the concept of the Derivatives and Derivative Trading.

 To know different types of Financial Derivatives.

 To know the role of derivatives trading in India.

 To analyse the performance of Derivatives Trading since 2001with special

reference to Futures & Options

 To know the investors perception towards investment in derivative market

RESARCH METHODOLOGY

Method of data collection:-

Secondary sources:-
It is the data which has already been collected by some one or an organization for
some other purpose or research study .The data for study has been collected from various
sources:
 Books
 Journals
 Magazines

49
  Internet sources

Second Phase is Collection of Primary Data and Analysis:

After collecting the Secondary data the next phase will be collection of primary data using
Questionnaires. The questionnaire will be filled by around 50 people who will be mainly from
Delhi/NCR region. The sample will consist of people who are employed or work as free lancers
dealing in derivative market to know their perception towards investment in derivative market.
The data collected will be then entered into MS Excel for analysis of the data collected from the
questionnaire.

RESEARCH DESIGN

Non probability
The non –probability respondents have been researched by selecting the persons who do the
trading in derivative market. Those persons who do not trade in derivative market have not been
interviewed.

Exploratory and descriptive research

The research is primarily both exploratory and descriptive in nature. The sources of
information are both primary and secondary. The secondary data has been taken by referring to
various magazines, newspapers, internal sources and internet to get the figures required for the
research purposes. The objective of the exploratory research is to gain insights and ideas. The
objective of the descriptive research study is typically concerned with determining the frequency
with which something occurs. A well structured questionnaire was prepared for the primary

50
research and personal interviews were conducted to collect the responses of the target
population.

SAMPLING METHODOLOGY

Sampling Technique
Initially, a rough draft was prepared a pilot study was done to check the accuracy of the
Questionnaire and certain changes were done to prepare the final questionnaire to make it more
judgmental.

Sampling Unit
The respondents who were asked to fill out the questionnaire in the National Capital Region are
the sampling units. These respondents comprise of the persons dealing in derivative market. The
people have been interviewed in the open market, in front of the companies, telephonic
interviews and through other sources also

Sample Size
The sample size was restricted to only 50 respondents.

Sampling Area
The area of the research was National Capital Region (NCR).

Time:
2 months
Statistical Tools Used:
Simple tools like bar graphs, tabulation, line diagrams have been used.

51
 ANALYSIS

Q. Education qualification of investors who investing in derivative market.

Education No. of result

Under graduate 6
Graduate 10
Post graduate 23
Professional 11

Q. Income range of investors who investing in derivative market.

Income range No. of Result

below 1,50,000 1
1,50,000-3,00,000 9

52
 3,00,000-5,00,000 14
above 5,00,000 26

Q. Normally what percentage of your monthly household income could be available for
investment
Investment No. of result
Between 5% to 10% 2
Between 11% to 15% 6
Between 16% to 20% 13
Between 21% to 25% 18
More than 25% 11

53
Q. What is your primary investment purpose?

Q. What kind of risk do you perceive while investing in the stock market?

54
 Risk in stock market No.of result
Uncertainty of returns 19
Slump in stock market 22
Fear of windup of company 6
Others 3

Q. Why people do not invest in derivative market?

Reasons No.of result

Lack of knowledge & understanding 27
Increase speculation 2
Risky & highly leveraged 17
Counter party risk 4

55
Q. What is the purpose of investing in derivative market?

Purpose of investment No. of Result

Hedge their fund 27
Risk control 9
More stable 1
Direct investment without buying & holding assets 13

Q. You participate in derivative market as

56
 Participation as No. of Result
investor 23
Speculator 2
Broker/Dealer 8
Hedger 17

Q. From where you prefer to take advice before investing in derivative market?

Advice From No. of Result

Brokerage houses 15
Research analyst 7
Websites 2
News Networks 23
Others 3

57
Q. In which of the following would you like to participate?

Participate in No. of Result

Stock index futures 19
Stock index Options 13
Future on individual stock 6
Currency futures 9
Options on individual stock 3

58
 Q. What contract maturity period would interest you for trading in?

Q. How often do you invest in derivative market?

59
Q. What was the result of your investment?
Result of No.of
investment result
Great results 4
Moderate but
acceptable 24
Disappointed 22

60
Q. What is best describes the overall approach to invest as a mean of achieving investors
goals.

OPTIONS NO. of Result

Relative level of stability in overall investment
portfolio 17
increasing investment value while minimizing
potential for loss of principal 19
Investment growth with moderate high levels of
risk 4
Maximum long term returns with high risk 10

61
 INTERPRETATION
 Most of the investors who invest in derivatives market are post graduate.
 Investors who invest in derivative market have a income of above 5,00,000
 Investors generally perceive slump in stock market kind of risk while investing in
derivative market.
 People are generally not investing in derivative market due to lack of knowledge
and difficulty in understanding and it is very risky also.
 Most of investor purpose of investing in derivative market is to hedge their fund.
 People generally participate in derivative market as a investor or hedger.
 People generally prefer to take advice from news network before investing in
derivative market.
 Most of investors participate in stock index futures.
 From this survey we come to know that most of investors make a contract of 3
month maturity period.
 Investors invest regularly in derivative market.
 The result of investment in derivative market is generally moderate but
acceptable.

62
 RECOMMENDATIONS & SUGGESTIONS

 A knowledge need to be spread concerning the risk and return of the derivative
market.

 More variation in stock index future need to be made looking a demand side of
investors.

 RBI should play a greater role in supporting derivatives

 There must be more derivative instruments aimed at individual investors.

 SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

LIMITAITONS OF STUDY

1. LIMITED TIME:
The time available to conduct the study was only 2 months. It being a wide topic, had
a limited time..
2. LIMITED RESOURCES:
Limited resources are available to collect the information about the commodity
trading
3. VOLATALITY:
Share market is so much volatile and it is difficult to forecast anything about it
whether you trade through online or offline
4. ASPECTS COVERAGE:
Some of the aspects may not be covered in my study.

63
 BIBLIOGRAPHY

Books referred:
 Options Futures, and other Derivatives by John C Hull
 Derivatives FAQ by Ajay Shah
 NSE’s Certification in Financial Markets: - Derivatives Core module
 Financial Markets & Services by Gordon & Natarajan

Reports:
 Report of the RBI-SEBI standard technical committee on exchange traded
Currency Futures
 Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

Websites visited:
 www.nse-india.com
 www.bseindia.com
 www.sebi.gov.in
 www.ncdex.com
 www.google.com
 www.derivativesindia.com

64
 ANNEXURE

SURVEY QUESTIONNAIRE OF INVESTORS

FOR
PERCEPTION TOWARDS INVESTMENT IN DERIVATIVE MARKET

Sir/Ma’am,
This questionnaire is meant for educational purposes only.
The information provided by you will be kept secure and confidential.

NAME- __________________________________________________
CONTACT- ______________________________________________
GENDER-________________________________________________
OCCUPATION-___________________________________________

1. Educational Qualification
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Undergraduate
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Graduate
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Post Graduate
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Professional Degree
Holder

2. Income Range:
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Below 1,50,000
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 1,50,000 – 3,00,000
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 3,00,000 – 5,00,000
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Above 5,00,000

3. Normally what percentage of your monthly household income could be available for
investment?

65
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Between 5% to 10%
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Between 11% to 15%
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Between 16% to 20%
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Between 21% to 25%
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect More than 25%

4. What is your primary investment purpose?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Retirement Planning
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Building up a corpus for
charity donations
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Supporting future
education of your children
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Other (Specify)
_____________________

5. What kind of risk do you perceive while investing in the stock market?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Uncertainty of returns
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Slump in stock market
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Fear of being windup of
company <INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Other
(Specify) _________________

6. Why people do not invest in derivative market? (Rank your preference 1-4)
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Lack of knowledge and
difficulty in understanding
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Increase speculation

66
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Very risky and highly
leveraged instrument
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Counter party risk

7. What is the purpose of investing in derivative market?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect To hedge their fund
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Risk control
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect More stable
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Direct investment without
buying and holding assets

8. You participate in derivative market as:

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Investor
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Speculator
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Broker/Dealer
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Hedger

9. From where you prefer to take advice before investing in derivative market?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Brokerage houses
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Research analyst
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Websites
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect News Networks
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Other (Specify)
_________________

10. In which of the following would you like to participate?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Stock Index Futures
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Stock Index Options

67
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Future on individual stock
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Options on individual
stock
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Currency futures

11. What contract maturity period would interest you for trading in?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 1 month
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 2 month
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 3 month
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 6 month
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 9 month
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 12 month

12. How often do you invest in derivative market?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 1-10 times in a year
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 11-50 times
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect More than 50 times
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Regularly

13. Which of the following statements best describes your overall approach to invest as a
mean of achieving your goals?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Having a relative level of
stability in my overall investment portfolio.
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Moderately increasing my
investment value while minimizing potential for loss of
principal.
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Pursue investment growth,
accepting moderate to high levels of risk and
principal fluctuation.

68
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Seek maximum long-term
returns, accepting maximum risk with principal
fluctuation.

14. What was the result of your investment?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Great results
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Moderate but acceptable
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Disappointed

ABBREVATIONS
A
AMEX- America Stock Exchange
B
BSE- Bombay Stock Exchange

69
BSI- British Standard Institute
C
CBOE - Chicago Board options Exchange
CBOT - Chicago Board of Trade
CEBB - Chicago Egg and Butter Board
CME - Chicago Mercantile Exchange
CNX- Crisil Nse 50 Index
CPE - Chicago Produce Exchange
CWC- Central Warehousing Corporation
D
DTSS- Derivative Trading Settlement System
F
FIIs- Foreign Institutional Investors
F & O – Future and Options
FMC- Forward Markets Commission
FRAs- Forward Rate Agreements
G
GAICL-Gujarat Agro Industries Corporation Limited
GSAMB- Gujarat State Agricultural Marketing Board
I
IMM - International Monetary Market
IPSTA- India Pepper & Spice Trade Association

M
MCX – Multi Commodity Exchange
N
NAFED-National Agricultural Co-Operative Marketing Federation Of India
NCDEX – National Commodities and Derivatives Exchange
NIAM- National Institute Of Agricultural Marketing
NMSE- National Multi Commodity Exchange

70
NOL- Neptune Overseas Limited
NSCCL- National Securities Clearing Corporation
NSDL- National Securities Depositories Limited
NSE - National Stock Exchange
O
OTC- Over The Counter
P
PHLX - Philadelphia Stock Exchange
PNB- Punjab National Bank
R
RBI- Reserve Bank Of India
S
SC(R) A - Securities Contracts (Regulation) Act, 1956
SEBI- Securities Exchange Board Of India
SGX- Singapore Stock Exchange
SIMEX - Singapore International Monetary Exchange
V
VPN- Virtual Private Network

71