UNIVERSITY OF MUMBAI

PROJECT ON DERIVATIVES Submitted In Partial Fulfillment of the requirements For the Award of the Degree of Bachelor of banking and insurance By AKASH VIJAY PANDEY

PROJECT GUIDE PROF. MRS. KEERTI CHUGH

BACHELOR OF BANKING AND INSURANCE SEMESTER V (2012-13) K.V.PENDHARKAR COLLEGE OF ARTS, SCIENCE & COMMERCE,

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DECLARATION
I AKASH VIJAY PANDEY Student of BBI Semester V (2012-13) hereby declare that I have completed this project on 25-07-2012

. The information submitted is true & original to the best of my knowledge.

Students Signature

Name of Student ( AKASH VIJAY PANDEY)

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CERTIFICATE

This is to certify that MR. AKASH VIJAY PANDEY Of TYBBI has successfully completed the project on 25-07-2012 under the guidance of PROF. MRS. KEERTI CHUGH

Project Guide Prof. KEERTI CHUGH

Co-Ordinator
Prof. Sneha Vaidya

External Examiner

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ACKNOWLEDGEMENT

This is to express my earnest gratitude and extreme joy at being bestowed with an opportunity to get an opportunity to get an interesting and informative project on DERIVATIVES. I would like to thank all the people who have helped me in completion of project, I would avail this opportunity to express my profound gratitude and indebtness to all those people. I am extremely grateful to my project guide Prof. Mrs. KEERTI CHUGH who has given an opportunity to work on such an interesting project. She proved to be a constant source of inspiration to me and provided constructive comments on how to make this report better. Credit also goes to my friends whose constant encouragement kept me in good stead. Lastly without fail I would thank all my faculties for providing all explicit and implicit support to me during the course of my project.

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INDEX

SRNO. 1. 2. 3. 4. 5.

TOPICS DEFINATIONS MEANING NEED OF THE STUDY OBJECTIVES OF THE STUDY SCOPE OF THE PROJECT

PAGE NO 7 8 9 10

11 12

6.

HISTORY OF DERIVATIVES PARTICIPANTS OF THE DERIVATIVE MARKET

7 8

15 18

TYPES OF DERIVATIVES

OTHER KINDS OF DERIVATIVES FEATURES

22

10

24

11

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS INTRODUCTION TO DERIVATIVE MARKET

28

12

29

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13.

TYPES OF DERIVATIVES MARKET

30

14.

FUNCTION OF DERIVATIVES MARKET

31

15.

HISTORY OF THE STOCK BROKING INDUSTRY

32

16.

BSE (BOMBAY STOCK EXCHANGE)

33

17.

NSE (NATIONAL STOCK EXCHANGE)

34

18.

MCX (MULTI COMMODITY EXCHANGE) NCDEX (NATIONAL COMMODITIES AND DERIVATIVES EXCHANGE) EMERGENCE OF THE DERIVATIVE TRADING IN INDIA FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES: BENEFITS OF DERIVATIVES

35

19.

36

20.

37

21.

38

22.

43

23.

RISK ASSOCIATED WITH DERIVATIVES:

45

24.

INDIAN DERIVATIVE MARKET

47

25.

CONCLUSION

49

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1. DEFINATIONS
According to JOHN.C.HUL A Derivative can be defined as a Financial Instrument whose value depends on (or derives from) the values of other, more basic underlying Variables. According to ROBERT L. MCDONALD A Derivative is simply a Financial Instrument (or even more simply an agreement between two people) which has a value determined by the price of something else.

With Securuties Laws (Second Amendment) Act 1999, Derivatives have been included in the definitions of Securities. The term Derivative have been defined in Securities Contract Regulation Act as:A Derivative include:a. A Security derived from a debt instrument, Share, Loan, whether Secured or unsecured, risk instrument or contract for differences or any form of securities. b. Contract which derives its value from the prices, or index of prices, of underlying securities. Derivative were developed primarily to manage, offset or Hedge against risk but some were developed primarily to provide the potential for high returns.

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2. MEANING
Derivatives are the financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc.

In the Indian Context the Security Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include

A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or other form of security. A contract, which derives its value from the prices, or index of prices of underlying securities.

In financial terms derivatives is a broad term for any instrumental whose value is derived from the value of one more underlying assets such as commodities, forex, precious metal, bonds, loans, stocks, stock indices, etc. Derivatives were developed primarily to manage offset, or hedge against risk but some were developed primarily to provide potential for high returns. In the context of equity markets, derivatives permit corporations and institutional

Investors to effectively manage their portfolios of assets and liabilities through instrument like stock index futures.

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3. NEED OF THE STUDY

In less than three decades of their coming into vogue, derivative markets have become the most important markets in the world. Today, derivatives have become part and parcel of day- to - day life of the ordinary people in major part of the world.

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.

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4. OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading. To analyze the Derivative markets in India. To analyze the operations of futures and options in India. To know different types of Financial Derivatives To know the role of derivatives trading in India. 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 market in India. To get knowledge about shortcomings in Indian derivative market. To analyze the trading system of market players. To analyse the performance of Derivatives Trading since 2001with special reference to Futures & Options

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5. 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.

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6. 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 1700s 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 1860s. 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
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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. 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 Dealers Association was set up in early 1900s 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.

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The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

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7. PARTICIPANTS OF THE DERIVATIVE MARKET:Market participants in the future and option markets are many and they perform multiple roles, depending upon their respective positions. A trader acts as a hedger when he transacts in the market for price risk management. He is a speculator if he takes an open position in the price futures market or if he sells naked option contracts. He acts as an arbitrageur when he enters in to simultaneous purchase and sale of a commodity, stock or other asset to take advantage of mispricing. He earns risk less profit in this activity. Such opportunities do not exist for long in an efficient market. Brokers provide services to others, while market makers create liquidity in the market.

Hedgers

Hedgers are the traders who wish to eliminate the risk (of price change) to which they are already exposed. They may take a long position on, or short sell, a commodity and would, therefore, stand to lose should the prices move in the adverse direction.

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 Speculators

If hedgers are the people who wish to avoid the price risk, speculators are those who are willing to take such risk. These people take position in the market and assume risk to profit from fluctuations in prices. In fact, speculators consume information, make forecasts about the prices and put their money in these forecasts. In this process, they feed information into prices and thus contribute to market efficiency. By taking position, they are betting that a price would go up or they are betting that it would go down.

The speculators in the derivative markets may be either day trader or position traders. The day traders speculate on the price movements during one trading day, open and close position many times a day and do not carry any position at the end of the day.

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 Arbitrageurs

Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a given commodity, or other item, that sells for different prices in different markets. The Institute of Chartered Accountant of India, the word ARBITRAGE has been defines as follows:Simultaneous purchase of securities in one market where the price there of is low and sale thereof in another market, where the price thereof is comparatively higher. These are done when the same securities are being quoted at different prices in the two markets, with a view to make profit and carried on with conceived intention to derive advantage from difference in prices of securities prevailing in the two different markets

Thus, arbitrage involves making risk-less profits by simultaneously entering into transactions in two or more markets.

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8. TYPES OF DERIVATIVES

Derivatives

Future

Option

Forward

Swaps

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

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

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

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

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

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 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

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 normally traded outside the exchanges.

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9. OTHER KINDS OF DERIVATIVES

The other kind of derivatives, which are not, much popular are as follows: BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.

LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.

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

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 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.

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10.

FEATURES

1) FEATURES OF FORWARD CONTRACT:

They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to

the same counter-party, which often results in high prices being charged. However forward contracts in certain markets have

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

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2) FEATURES OF FUTURE CONTRACT:

1. STANDARDIZATION:
Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The 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

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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.

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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).

4. EXPIRY
It 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.

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11.
FEATURE

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FORWARD CONTRACT FUTURE CONTRACT

Operational Mechanism

Traded directly between Traded on the exchanges. two parties (not traded on the exchanges).

Contract Specifications Counter-party risk

Differ trade. Exists.

from

trade

to Contracts contracts.

are

standardized

Exists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally guarantees their settlement.

Liquidation Profile

Low, as contracts are High, as contracts are standardized tailor made contracts exchange traded contracts.

catering to the needs of the needs of the parties. Price discovery Not efficient, as markets Efficient, as all buyers and sellers are scattered. come to a common platform to discover the price. Examples Currency India. market in Commodities, Futures and futures, Individual Index stock

Futures in India.
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12.

INTRODUCTION TO DERIVATIVE MARKET

According to dictionary, derivative means something which is derived from another source. Therefore, derivative is not primary, and hence not independent. In financial terms, derivative is a product whose value is derived from the value of one or more basic variables. These basic variable are called bases, which may be value of underlying asset, a reference rate etc. the underlying asset can be equity, foreign exchange, commodity or any asset.

For example: - the value of any asset, say share of any company, at a future date depends upon the shares current price. Here, the share is underlying asset, the current price of the share is the bases and the future value of the share is the derivative. Similarly, the future rate of the foreign exchange depends upon its spot rate of exchange. In this case, the future exchange rate is the derivative and the spot exchange rate is the base.

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13.

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

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14.

FUNCTION OF DERIVATIVES MARKET

The derivative market performs a number of economic functions: Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivative converge with the prices of the underlying at the expiration of the derivative contract. Thus, derivatives help in discovery of future as well as current prices. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Derivatives, due to their inherent nature, are linked to the underlying cash market. With the introduction of the derivatives, the underlying market witnesses higher trading volumes because of the participation by more players who would not otherwise participate for lack of arrangement to transfer risk. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivative market, speculators trade in the underlying cash market. The derivatives have a history of attracting many bright, creative, welleducated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Derivatives markets help increase savings and investment in the end. Transfer of risk enables market participants to expand their volumes.
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15.

HISTORY OF THE STOCK BROKING INDUSTRY

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago. In 1887, they formally established in Bombay, the "Native Share and Stock Brokers' Association" (which is alternatively known as "The Stock Exchange"). In 1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899. Thus, the Stock Exchange at Bombay was consolidated. Thus in the same way, gradually with the passage of time number of exchanges were increased and at currently it reached to the figure of 24 stock exchanges. This was followed by the formation of associations /exchanges in Ahmadabad (1894), Calcutta (1908), and Madras (1937). In order to check such aberrations and promote a more orderly development of the stock market, the central government introduced a legislation called the Securities Contracts (Regulation) Act, 1956. Under this legislation, it is mandatory on the part of stock exchanges to seek government recognition. As of January 2002 there were 23 stock exchanges recognized by the central Government. They are located at Ahmadabad, Bangalore, Baroda, Bhubaneswar, Calcutta, Chennai,(the Madras stock Exchanges ), Cochin, Coimbatore, Delhi, Guwahati, Hyderabad, Indore, Jaipur, Kanpur, Ludhiana, Mangalore, Mumbai(the National Stock Exchange or NSE), Mumbai (The Stock Exchange), popularly called the Bombay Stock Exchange, Mumbai (OTCExchange of India), Mumbai (The Inter-connected Stock Exchange of India), Patna, Pune, and Rajkot.

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16.

BSE (BOMBAY STOCK EXCHANGE)

The Stock Exchange, Mumbai, popularly known as "BSE" was established in 1875 as "The Native Share and Stock Brokers Association". It is the oldest one in Asia, even older than the Tokyo Stock Exchange, which was established in 1878. It is the first Stock Exchange in the Country to have obtained permanent recognition in 1956 from the Govt. of India under the Securities Contracts (Regulation) Act, 1956.

A Governing Board having 20 directors is the apex body, which decides the policies and regulates the affairs of the Exchange. The Governing Board consists of 9 elected directors, who are from the broking comm. Unity (one third of them retire ever year by rotation), three SEBI nominees, six public representatives and an Executive Director & Chief Executive Officer and a Chief Operating Officer.

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17.

NSE (NATIONAL STOCK EXCHANGE)

NSE was incorporated in 1992 and was given recognition as a stock exchange in April 1993. It started operations in June 1994, with trading on the Wholesale Debt Market Segment. Subsequently it launched the Capital Market Segment in November 1994 as a trading platform for equities and the Futures and Options Segment in June 2000 for various derivative instruments.

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18.

MCX (MULTI COMMODITY EXCHANGE)

MULTI COMMODITY EXCHANGE of India limited is a new order exchange with a mandate for setting up a nationwide, online multi-commodity market place, offering unlimited growth opportunities to commodities market participants. As a true neutral market, MCX has taken several initiatives for users in a new generation commodities futures market in the process, become the countrys premier exchange.

MCX, an independent and a de-mutualised exchange since inception, is all set up to introduce a state of the art, online digital exchange for commodities futures trading in the country and has accordingly initiated several steps to translate this vision into reality.

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19.

NCDEX (NATIONAL COMMODITIES AND DERIVATIVES EXCHANGE)

NCDEX started working on 15th December, 2003. This exchange provides facilities to their trading and clearing member at different 130 centres for contract. In commodity market the main participants are speculators, hedgers and arbitrageurs.

Facilities Provided By NCDEX NCDEX has developed facility for checking of commodity and also provides a ware house facility By collaborating with industrial partners, industrial companies, news agencies, banks and developers of kiosk network NCDEX is able to provide current rates and contracts rate. To prepare guidelines related to special products of securitization NCDEX works with bank. To avail farmers from risk of fluctuation in prices NCDEX provides special services for agricultural. NCDEX is working with tax officer to make clear different types of sales and service taxes. NCDEX is providing attractive products like weather derivatives

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20.

EMERGENCE OF THE DERIVATIVE TRADING IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24 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.Verma, to recommend measures for risk containment in derivative market in India.

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21.

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 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 ones 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.

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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 an 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 1990s 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.

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B.} Globalisation of markets:

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

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--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.

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C.} Technological advances:

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

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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 1970s, 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.

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22.

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.

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3.]

OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.

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.

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23.

RISK ASSOCIATED WITH DERIVATIVES:

While derivatives can be used to help manage risks involved in investments, they also have risks of their own. However, the risks involved in derivatives trading are neither new nor unique they are the same kind of risks associated with traditional bond or equity instruments.

MARKET RISK
Derivatives exhibit price sensitivity to change in market condition, such as fluctuation in interest rates or currency exchange rates. The market risk of leveraged derivatives may be considerable, depending on the degree of leverage and the nature of the security.

LIQUIDITY RISK
Most derivatives are customized instrument and could exhibit substantial liquidity risk implying they may not be sold at a reasonable price within a reasonable period. Liquidity may decrease or evaporate entirely during unfavorable markets.
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 CREDIT RISK
Derivatives not traded on exchange are traded in the over-the-counter (OTC) market. OTC instrument are subject to the risk of counter party defaults.

HEDGING RISK
Several types of derivatives, including futures, options and forward are used as hedges to reduce specific risks. If the anticipated risks do not develop, the hedge may limit the funds total return.

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24.

INDIAN DERIVATIVE 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 Indias (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

1991 14th 1995 18th 1996 11th May 1998 7th July 1999

Liberalisation process initiated December NSE asked SEBI for permission to trade index futures.

November SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps.

24th May 2000

SIMEX chose Nifty for trading futures and options on an Indian index.

25th May 2000

SEBI gave permission to NSE and BSE to do index futures trading.

9th June 2000 12th June 2000 25th 2000

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Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE.

September Nifty futures trading commenced at SGX.

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2nd June 2001 4th June 2001

Individual Stock Options & Derivatives The NSE introduced trading on index options based on the S&P CNX Nifty.

2nd July 2001 9th 2001 29th August 2008 31st August 2009 February 2010

Trading on stock options commences on NSE

November Trading on stock futures commences on NSE

Currency derivatives trading commences on the NSE Interest rate derivatives commences on NSE Launch of currency futures on additional currency pairs

28th October 2010 29th October 2010

Introduction of European style Stock Options Introduction of Currency Options

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25.

CONCLUSION

Derivatives allow firms and individuals to hedge risks and to take risks efficiently. They also can create risk at the firm level, especially if a firm uses Derivatives episodically and is inexperienced in their use. For the economy as a whole, a collapse of a large derivatives user or dealer may create systemic risks. On balance, derivatives help make the economy more efficient.

However, neither users of derivatives nor regulators can be complacent. Firms have to make sure that derivatives are used properly. This means that the risks of derivatives positions have to be measured and understood. Those in charge of taking derivatives positions must have the proper training. It also means that firms must have well-defined policies for derivatives use. A firms board must know how risk is managed within the firm and which role derivatives play. Regulators have to make sure to monitor carefully financial firms with large derivatives positions.

Though regulators seem to be doing a good job in monitoring banks and brokerage houses, the risks taken by insurance companies, hedge funds and government sponsored enterprises should be understood and monitored.
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