CURRENT SCENARIO OF DERIVATIVES MARKET IN INDIA

RESEARCH EXTRACT
A derivative instrument broadly is a financial contract whose payoff structure is
determined by the value of underlying commodity, security, interest rate, share
price index, exchange rate, oil price, or the like. So a derivative is an instrument
which derives its values from some underlying variable /asset. A derivative
instrument by itself does not constitute ownership. It is, instead, a promise to
convey ownership.
All derivatives are based on some cash products. The underlying asset of a
derivative instrument may be any product of the following types: 1.Commodities (grain, coffee, beans, orange juice etc.)
2.Precious metals (Gold, Silver, Copper)
3.Foreign exchange rate
4.Bonds of different types including medium to long-term negotiation debt
securities.
5.Short term debt securities like T- bills
6.Over the counter (OTC) money market products such as loans or deposits.
Financial derivatives came into the spotlight along with the rise in uncertainty of
post 1970, when the US announced an end to the Breton Woods System of fixed
exchange rates leading to introduction of currency derivatives followed by other
innovations, including stock index futures.
Indian-capital markets have gone through a remarkable transformation in last ten
years. In these years, Indian capital markets have been witness to more than 100%
increase in the companies listed on stock exchanges emergence of Securities and
Exchange Board of India (SEBI) as a truly national level of securities regulator, free
pricing of public issues, screen based trading systems, more than six times increase
in the turnover the stock exchanges, emergence of self regulatory organization in
the fields of
merchant banking, mutual funds, emergence of investors associations,
implementation of
trade guarantees besides others.

INTRODUCTION
BACKGROUND OF THE STUDY
The evolution occurred in stages. The Chicago Board of Trade (CBOT), which
opened in 1848, is, to this day, the largest futures market in the world. The general
rules framed by CBOT in 1865 became a pacesetter for many other markets. In
1870, the New York cotton exchange was founded.
The London metal exchange was established in 1877 and is now the leading market
in metal trading (both spot and forward). Thereafter many new futures market were
started. The first financial futures market was the international monetary, founded
in 1972 by the Chicago mercantile exchange. The London international financial
futures exchange followed this in 1982.
As already mentioned, some form of forward trading probably existed in India also.
The first organized forward markets came into existence in India in the late 19th
and early 20th century in Calcutta (for jute and jute goods) and Mumbai (for cotton).
Chronologically, Indias experience in organized forward trading is almost as long as
that of the United Kingdom, and certainly longer than many developed nations.
However, the tidal wave of price control, nationalization and state intervention in
markets, which swept through all economic policy making after independence, led
to a rapid decline in number of futures markets. Frequently markets were closed due
to the feeling that they were responsible for sudden movements of price in the
commodities.
STATEMENT OF THE PROBLEM
The problem is to analyze Derivative ways of minimizing the Risk in Indian Capital
market and to analyze the current scenario of Derivative markets in India.
Need and Importance of the Study
World financial market has witnessed a spectacular change in the field of derivative
markets in the past one decade, especially in the field of option, futures and swaps.
India also could not become aloof from the world trend and mainly after the
liberalization has set in motion. India introduced the different types in phased
manner. A derative market has gained momentum since its introduction in India and
has played a major role in Indian financial markets. Today the derivative volume in
India is Rs. 25000 crores. In this context the study of Current scenario of Indian
derivative market is very contextual and important as well. That is why this subject
is the topic of this dissertation.
Similarly, on the equity market, many retail investors who are uncomfortable about
the equity market would enter if they were given the alternative of buying
insurance, which controls their downside risk. This would enhance the action of the
savings of the country, which are routed through the equity market. More
importantly, derivative is one of the important tools of hedging risk. Therefore, the
study of current scenario of derivative market in India is very importance.
OBJECTIVES OF THE RESEARCH

The main objectives of the project are as follows: To study the current scenario of derivatives market in India.
To analyze whether the purpose for which derivatives are used has actually
been achieved.
To study the concept of derivatives and the purpose for which financial
institutions adopt derivatives.
Limitations of the study
The study is conducted in Bangalore only.
Since the study covers the overview of derivatives market, it cannot be
generalized.
Data collected is only from secondary sources.
REVIEW OF LITERATURE
PURPOSE
Literature review is one of the prime parts of dissertation. The very basic purpose of
the literature review is to gain insight on the theoretical background of the research
problem. It helps the researcher to gain strong theoretical basis of the problem
under study and also helps to explore whether any one has done research on the
related issue. Thats why literature review helps one to find out the path of problem
solving.
In this regard, the very basic purpose of literature review in this dissertation is
same as mentioned above.
METHODOLOGY
For simplicity, the literature review has been divided into the following parts.
Definition of derivatives
Perquisites for derivatives market
Types of Derivatives
Derivatives market in India
Type of Options
DEFINITION OF DERIVATIVES
Derivatives are the financial instruments, which derive their value from some other
financial instruments, called the underlying. The foundation of all derivatives market
is the underlying market, which could be spot market for gold, or it could be a pure
number such as the level of the wholesale price index of a market price.
A derivative is a financial instrument whose value depends on the
value of other basic underlying variables

John c hull
According to the Securities Contract (Regulation) Act, 1956, derivatives include:
A security derived from a debt instrument, share, and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of security.
A contract, which derives its value from the prices or index of prices of underlying
securities.
Therefore, derivatives are specialized contracts to facilitate temporarily for hedging
which is protection against losses resulting from unforeseen price or volatility
changes. Thus, derivatives are a very important tool of risk management.
Derivatives perform a number of economic functions like price discovery, risk
transfer and market completion.
The simplest kind of derivative market is the forward market. Here a
buyer and seller write a contract for delivery at a specific future date and
a specified future price. In India, a forward market exists in the form of the
dollar-rupee market. But forward market suffers from two serious problems;
counter party risk resulting in comparatively high rate of contract noncompliance and poor liquidity.
Futures markets were invented to cope with these two difficulties of forward
markets. Futures are standardized forward contracts traded on an organized stock
exchange. In essence, a future contract is a derivative instrument whose value is
derived from the expected price of the underlying security or asset or index at a
pre-determined future date.
PREREQUISITES FOR DERIVATIVES MARKET
There are five essential prerequisites for derivatives market to flourish in a country.
a) Large market capitalization
At a market capitalization of near $1.5 trillion, India is well ahead of many other
countries where derivatives markets have succeeded.
b) Liquidity in the underlying
A few years ago, the total trading volume in India used to be around Rs-300 crores a
day. Today, daily trading volume in India is around Rs-15000 crores a day. This
implies a degree of liquidity, which is around six times superior to the earlier
conditions. There is empirical evidence to suggest that there are many financial
instruments in the country today, which have adequate to support derivative
market.
c) Clearing house that guarantees trades

Counter party risk is one of the major factor recognized as essential for starting a
strong and healthy derivatives market. Trade guarantee therefore becomes
imperative before a derivatives market could start. The first clearinghouse
corporation guarantees trades have become fully functional from July 1996 in the
form of National Securities Clearing Corporation (NSCC). NSCC is responsible for
guaranteeing all open positions on the National Stock Exchange (NSE) for which it
does the clearing. Other exchanges are also moving towards setting up separate
and well-funded clearing corporations for providing trade guarantees.
d) Physical infrastructure
Indias equity markets are all moving towards satellite connectivity, which allows
investors and traders anywhere in the country to buy liquidity services from
anywhere else. This telecommunications infrastructure, Indias capabilities in
computer hardware and software, will enable the establishment of computer system
for creation of derivatives markets. Setting up of automated trading system as an
experience with various prospective exchanges will also be beneficial while setting
up the derivative market.
e) Risk-taking capability and Analytical skills
Indias investors are very strong in their risk-bearing capacity and can cope with the
risk that derivatives pose. Evidence of the volumes traded on the capital markets,
which are akin to a futures market, is indicative of this capacity. In contrast, in some
other countries, investors simply lack the risk-bearing capacity to sustain the
growth of even the equity market. It is expected that such a barrier will not appear
in India.
On the subject of analytical skills, derivatives require a high degree of analytical
capability for many subtle trading strategies to pricing. India has an enormous pool
of mathematically literate finance professionals, who would excel in this field.
Lastly, an obvious advantage for the Indian market is that we have enormous
experience with futures markets through the settlement cycle oriented equity which
is not truly a spot market but a futures market (including concepts like market-tomarket margin, low delivery ratios, and last-day-of settlement abnormalities in
prices). We also have active futures markets on six commodities. With this state of
development of the
capital markets it is felt that there is no major hurdle left for the creation of
development of the capital markets. Hence on July 2, 1996 the SEBI board gave an
in principal approval for the launch of derivatives markets in India.
Types of Derivatives
DERIVATIVES
FORWARDS
FUTURE
OPTIONS

SWAPS

One form of classification of derivatives is between commodity derivatives and

financial derivatives. Thus futures, option or swaps on gold, sugar, jute, pepper etc
are commodity derivatives.
While futures, options or swaps on currencies, gilt-edged securities, stock and share
stock market indices etc are financial derivatives.
Forwards
Future
Option

Commodity
Security
Call
Put

Security

Interest rate

Commodity

Currency

Types of Derivatives
A) OPTIONS:
The concept of options is not new one. In Fact, options have been in use for
centuries. The idea of an option existed in ancient Greece and Rome. The Romans
wrote options on the cargo that were transported by their ship. In the 17th century,
there was an active option markets in Holland. In fact, options were used in a large
measure in the
tulip bulb mania of that century. However, in the absence of mechanism to
guarantee the performance of the contract, the refusal of many put option writers to
take delivery of the tulip bulb and pay the high prices of the bulb they had originally
agreed to, led to bursting of the bulb bubble during the winter of 1637.A number of
speculators were wiped out in the process.
In India, options on stocks of companies were illegal until 25th January 1995
according to sec. 20 of Securities Contracts (Regulation) Act, 1956. When Securities
Laws (Amendment) Act, 1956 deleted sec. 20, thus making the introduction of
options as legal act.
An options contract is an agreement between a buyer and a seller. Such a contract
confers on the buyer a right but not an obligation to buy or sell a specified quantity
of the underlying asset at a fixed price on or up to a fixed day in the future on a
payment of a premium to the seller. The premium paid by the buyer to the seller is
the price of an option contract
Options on a futures contract have added a new dimension to future trading like
futures options provide price protection against adverse price move. Present day
options trading on the floor of an exchange began in April 1973. When the Chicago
Board of trade created the Chicago Board Options Exchange (CBOE) for the sole
purpose of trading Options on a limited number of NEW YORK STOCK EXCHAGE
listed equities
B) FORWARDS:
A forward is an agreement between two parties to exchange an agreed quantity of
asset at a specified future date at a predetermined price specified in the
agreements. The parties concerned agree the settlement date and price in advance.
The promised asset may be currency, commodity, instrument etc. It is the oldest

type of all the derivatives. The party who promises to buy but he specified asset at
an agreed price at a fixed future date is said to be in the Long position and the
party who promises to sell at an agreed price at a future date is said to be in short
position.
C) FUTURES:
It is similar to the forward contract in all the respect. In fact, a future is a
standardized form of forward contract. A future is a contract or an agreement
between two parties to exchange assets / currency or commodity at a certain future
date at an agreed price. The trader who promises to buy is said to be in long
position and the party who promises to sell said be in short position.
Futures contracts are contracts specifying a standard volume of a particular
currency to be exchanged on a specific settlement date. A future contract is an
agreement between a buyer and a seller. Such a contract confers on the buyer an
obligation to buy from the seller, and the seller an obligation to sell to the buyer a
specified quantity of an underlying asset at a fixed price on or before a fixed day in
future. Such a contract can be for delivery of an underlying asset.
To eliminate counter party risk and guarantee traders, futures markets use a
clearing house which employs initial margin, daily market to market margin,
exposures limits etc. to ensure contract compliance and guarantee settlement
standardized futures contracts generate liquidity. In addition, due to these
instruments being traded on recognized exchanges results in grater transparency,
fairness and efficiency. Due to
these inherent advantages, futures markets have been enormously successful in
comparison with forward markets all over the world
The difference between forward contract and future is that future is a standardized
contract in terms of quantity, date and delivery. It is traded on organized
exchanges. So it has secondary markets. Future contract is always settled daily,
irrespective of the maturity date, which is called marking to the market.
D) SWAP:
Swap is an agreement between two parties to exchange one set of financial
obligations with other. It is widely used throughout the world but is recent in India.
Swap may be interest swap or currency swaps.
Swaps give companies extra flexibility to exploit their comparative advantage in
their respective borrowing markets.
Swaps allow companies to focus on their comparative advantage in borrowing in a
single currency in the short end of the maturity spectrum vs. the long-end of the
maturity spectrum.
Swaps allow companies to exploit advantages across a matrix of currencies and
maturities.
DERIVATIVES MARKET IN INDIA
Prior to liberalization, in India financial markets, there were only a few financial
products and the stringent regulatory products and the stringent regulation

environment also eluded any possibility of development of a derivatives market in

country. All Indian corporate were mainly relying on term lending institution for
meeting their project financing or any other financing requirements and on
commercial banks for meeting working capital finance requirement. Commercial
banks are on their assets and liabilities. The only derivative product they were
aware of is the foreign exchange forward contract. But this scenario changed in the
post liberalization period. Conservative Indian business practitioners began to take
a different view of various aspects of their operations to remain competitive.
Financial risks were given adequate attention and treasury function has assumed
a significance role in all major corporate since then.
Initially, banks were allowed to pass on gains arising out of cancellation of forwards
contracts to the customers and customers were permitted to cancel and re-book the
forward contracts. This remarkable change was followed by the introduction of cross
currency forward contacts. But the major milestone in developing forex derivatives
market in India was the introduction of cross currency options. The RBIs objective of
introducing cross currency options was to provide a complicated hedging strategy
for the corporate in their risk management activities.
The concept of derivatives is of course not new to the Indian market. Though
derivatives in the financial markets have nothing to talk about home, in the
commodity markets they have a long history of over hundred years. In 1875, the
first commodity futures exchange was set up in Mumbai under the guidance of
Bombay Cotton Traders
Association. A clearinghouse for clearing and settlement of these traders was set
up in 1918. Over a period of twenty years during 1900-1920, other futures markets
were set up in various places. Futures market in raw jute in Kolkata (1912), wheat
futures market in Hapur (1913), and bullion futures market in Mumbai (1920).
When it comes to financial markets, derivatives in equities claim a long existence.
The official history of Bombay Stock Exchange (then known as Native Share and
Stock Brokers Association) reveals that the concept of options existed since 1898 as
is reflected from a quote given by one of the MPs-India being the original home of
options, a native broker would give a few points to the brokers of the other nations
in the manipulation of puts and calls.
However, such an early expertise gained by Indian traders in derivatives trading has
come to an end with the Government of Indias ban on forward contract during the
1960s on the ground of their intrinsic undesirability. But ironically, the same were
re- introduced by the government in the 1980s as essential instruments for
eliminating wide fluctuations in prices and more so because of the World Bank
UNCTAD report, which strongly urged the Indian government to start futures trading
in major cash crops, especially in view of Indias entry to WTO.
With the world embracing the derivative trading on large scale, the Indian market
obviously cannot remain aloof, especially after liberalization has been set in motion.
Now we are in the threshold of introducing trading in derivatives, beginning with the
stock index futures to be well set for the introduction of derivative trading. With L.C.
Gupta
committee having recently submitted its report on the subject, SEBI is engaged in
the process of assessing the feasibility and desirability of introducing such trading.

The NSE and BSE are two exchanges on which financial derivatives are traded. The
combined notional value of the daily volumes on both the bourses stand at around
RS. 150000 cr. In developed markets trading in the derivatives segment are thrice
as large as in the cash markets. In India, the figure is hardly 20% of cash markets.
Quite clearly our derivative markets have a long way to go.
According to the Executive Director of Association of NSE Member of India (Amni),
Vinod Jain, Volumes in derivatives segment are stagnating due to klack of growth
in the number of markets participants. Besides these products are still to catch up
with the masses who are keeping away from this segment due to lack of
understanding of the products and high contract price
a) COMMODITIES DERIVATIVES MARKETS
In order to give more thrust on agricultural sector, the National Agricultural Policy,
2000 has envisaged and domestic market reforms and dismantling of all controls
and regulations in agricultural commodity markets. It has also proposed to extend
the coverage of futures markets to minimize the wide fluctuations in commodity
market prices and for hedging the risk from price fluctuations.
As a result of these recommendations, there are presently, 15 exchanges carrying
out futures trading in as many as 30 commodity items. Out to these, two exchanges
viz. IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have been
upgraded to international exchanged to deal international contracts in peeper and
castor oil respectively. Moreover, permission has been given to two more exchange
viz. the First Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil
and oilcake), and
Keshave Commodity Exchange Ltd., Delhi (for potato), where futures trading
started very recently.
The government has also permitted four exchange viz., EICA, Mumbai. The Central
Gujarat Cotton Dealers Association, Vadodara; The South India cotton Association
Coimbattore; and the Ahmedabad Cotton Merchants Association, Ahmedabad, for
conducting forward (non-transferable specific delivery) contracts in cotton. Lately as
part of further liberalization of trade in agriculture and dismantling of ECA, 1955
futures trade in sugar has been permitted and three new exchanges viz., ECommodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and E-Sugar
India.com, Mumbai have been given approval for conducting sugar futures (Ministry
of Food and Consumer Affairs, 1999).
In the recent past, the GOI has set up a committee to explore and appraise matters
important to the establishment and financing of the proposed national commodity
exchange for the nationwide trading of commodity futures contracts. The usage of
warehouse receipts as a means for delivery of commodities under the contracts is
also being explored. The warehouse receipts system has been operationalized in
COFEI (coffee futures exchange of India) with effect from 1998. The Government of
India is on the move to establish a system of warehouse receipts in other
commodity stock exchanges at various places of the country.
Besides these domestic developments, during 1998, Reserve Bank of India
permitted the Indian Corporate Sector to access the exchanges subject to certain
conditions with a view to enable domestic metal manufacturers to compete with

global players. The de-regulation of oil-imports being on the cards, government

should create the right atmosphere for oil sector to participate in the international
oil-derivatives Markets.
Despite these developments, there are still many impediments that hold back the
farming community from entering the futures market and reap full benefits.
A brief description of commodity exchanges are those which trade in particular
commodities, neglecting the trade of securities, stock index futures and options etc.
In the middle of 19th century in the United States, businessmen began organizing
market forums to make the buying and selling of commodities easier. These central
marketplaces provided a place for buyers and sellers to meet, set quality and
quantity standards, and
establish rules of business.
Agricultural commodities were mostly traded but as long as there are buyers and
sellers, any commodity can be traded. In 1872, a group of Manhattan dairy
merchants got together to bring chaotic condition in New York market to a system in
terms of storage,
pricing, and transfer of agricultural products.
In 1933, during the Great Depression, the Commodity Exchange, Inc. was
established in New York through the merger of four small exchanges the National
Metal Exchange, the Rubber Exchange of New York, the National Raw Silk Exchange,
and the New York
Hide Exchange.
The major commodity markets are in the United Kingdom and in the USA. In India
there are 25 recognized future exchanges, of which there are three national level
multi- commodity exchanges. After a gap of almost three decades, Government of
India has allowed forward transactions in commodities through Online Commodity
Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar
to facilitate better risk coverage and delivery of commodities. The three exchanges
are:
National Commodity & Derivatives Exchange Limited (NCDEX)
Multi Commodity Exchange of India Limited (MCX)
National Multi-Commodity Exchange of India Limited (NMCEIL)
All the exchanges have been set up under overall control of Forward Market
Commission
(FMC) of Government of India.
National Commodity & Derivatives Exchange Limited (NCDEX)
National Commodity & Derivatives Exchange Limited (NCDEX) located in Mumbai is
a public limited company incorporated on April 23, 2003 under the Companies Act,

1956 and had commenced its operations on December 15, 2003.This is the only
commodity exchange in the country promoted by national level institutions. It is
promoted by ICICI Bank Limited, Life Insurance Corporation of India (LIC), National
Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange
of India Limited (NSE). It is a professionally managed online multi commodity
exchange. NCDEX is regulated by Forward Market Commission and is subjected to
various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward
Commission (Regulation) Act and various other legislations.
Multi Commodity Exchange of India Limited (MCX)
Headquartered in Mumbai Multi Commodity Exchange of India Limited (MCX), is an
independent and de-mutulised exchange with a permanent recognition from
Government of India. Key shareholders of MCX are Financial Technologies (India)
Ltd., State Bank of India, Union Bank of India, Corporation Bank, Bank of India and
Canara Bank. MCX facilitates online trading, clearing and settlement operations for
commodity futures
markets across the country.
MCX started offering trade in November 2003 and has built strategic alliances with
Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors
Association
of India, Pulses Importers Association and Shetkari Sanghatana.
National Multi-Commodity Exchange of India Limited (NMCEIL)
National Multi Commodity Exchange of India Limited (NMCEIL) is the first demutualized, Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it
was granted approval by the Government to organise trading in the edible oil
complex. It has operationalised from November 26, 2002. Central Warehousing
Corporation Ltd., Gujarat State Agricultural Marketing Board and Neptune Overseas
Limited are
supporting it. It got its recognition in October 2002.
Commodity exchange in India plays an important role where the prices of any
commodity are not fixed, in an organised way. Earlier only the buyer of produce and
its seller in the market judged upon the prices. Others never had a say. Today,
commodity exchanges are purely speculative in nature. Before discovering the
price, they reach to the producers, end-users, and even the retail investors, at a
grassroots level. It brings a price
transparency and risk management in the vital market.
A big difference between a typical auction, where a single auctioneer announces the
bids and the Exchange is that people are not only competing to buy but also to sell.
By Exchange rules and by law, no one can bid under a higher bid, and no one can
offer to sell higher than someone elses lower offer. That keeps the market as
efficient as possible, and keeps the traders on their toes to make sure no one gets
the purchase or sale before they do. A brief description of commodity exchanges are
those which trade in particular commodities, neglecting the trade of securities,
stock index futures and options

etc.
In the middle of 19th century in the United States, businessmen began organizing
market forums to make the buying and selling of commodities easier. These central
marketplaces provided a place for buyers and sellers to meet, set quality and
quantity standards, and
establish rules of business.
Agricultural commodities were mostly traded but as long as there are buyers and
sellers,
any commodity can be traded. In 1872, a group of Manhattan dairy merchants got
together to bring chaotic condition in New York market to a system in terms of
storage,
pricing, and transfer of agricultural products.
b) CURRENCY DERIVATIVES
Foreign exchange derivatives market is one of the oldest derivatives markets in
India. Presently, India has got a well-established dollar-rupee forward market with
contrast traded for one month, two months and three months expiration. Currency
derivatives markets have begun to evolve with the allowing of banks to pass on the
gains upon cancellation of a forward to the customer and permitting customer to
cancel and rebook forward contracts.
Introduction of cross currency options can be considered as another major step
towards developing forex derivatives markets in India.
Today, Indian corporate are permitted to purchase cross currency options to hedge
exposures arising out of trade. Authorized dealers who offer these products have to
necessarily cover their exposure in international markets i.e., they shall not carry
the risk in their own books. Cross currency options are essentially meant for buying
or selling any foreign currency in terms of US dollar. They are therefore, useful only
to those traders who invoice their exports and imports in currencies other than US
dollar or for corporate who borrow in currencies other than US dollar. As against this,
majority of Indian trade is invoiced in the US dollars. Thus, they have almost no
relevance in the Indian context.
Indian banks are allowed to use the foreign currency interest rate swaps, forward
rate agreements/interest rate options/swaps, and forward rate agreements/interest
rate
option/swaption/caps/floors to hedge interest rate and currency mismatch in their
balance sheets. Resident and the non-resident clients are also permitted to use the
above products as hedges for liabilities on their balance sheets.
Here it is worth remembering that globally, foreign exchange traders are becoming
as common as stock traders. But in India, forex dealers still play second fiddle to
stock traders and merely meet the needs of the exporters deposits. This may be
due to their risk averting behavior and perhaps lack of proper research. Such being

the position of the forex market, it is too premature to expect that once, foreign
currency-Indian rupee options are introduced, the market will pick up momentum.
This is all the more essential in a market where exchange rates though stated to be
market determined, are often found influenced by RBIs intervention in the
exchange market. As a result, exchange rate movements hardly obey the principle
of interest rate differentials. The incongruence in the domestic money rates as
derived from the USD/INR forwards yield curve supports this assertion. For example,
the one-year domestic term money is around 6-6.25% whereas that of the one-year
implied forward rate is around 5.40%. In such a scenario, it is difficult for a currency
trader to take a firm view on the exchange rate movement.
c) STOCK MARKET DERIVATIVES
Today trading on the spot market for equity in India has always been a futures
market with weekly/fortnightly settlements. These markets features the risks and
difficulties of futures market, But without the gains in price discovery and hedging
services that come with separation the spot market from the futures market. Indias
primary market is acquainted with two types of derivatives
Convertible bonds
Warrants
As these warrants are listed and traded, it could be said that options market of a
limited sort already exist in our market.
Besides, a wide range of interesting derivatives markets exists in the informal
sector. Contracts such as bhav-bhav teji-mandi etc. are traded in these markets.
These informal markets enjoy a very limited participation and have their presence
outside the conventional institutions of Indias financial system.
The first step towards introduction of derivatives trading in India in its current
format was the promulgation of the securities laws (Amendment) Ordinance, 1995
that withdrew the prohibition on options in securities. The real push to derivatives
market in India was however given by the SEBI. The security market watchdog, in
November 1996 by setting up a committee under the chairmanship of Dr L C Gupta
to develop
appropriate regulatory framework for derivatives trading in India.
In 2000, SEBI permitted NSE and BSE to commence trading in index futures
contracts based on S&P CNX Nifty and BSE 30(sensex) index. This was followed by
approval for trading in options based on these two indexes and options on individual
securities. Futures contracts on Individual stocks were launched on November
9,2001. Trading and settlement is done in accordance with the rules of the
respective exchanges. But the trading volumes were initially quite modest.
This could be due to ---- Initially, few members have been permitted by SEBI to trade on derivatives;
FIIS, MFS have been allowed to have a very limited participation;

Mandatory requirements for brokerage firms to have SEBI approved-certificationtest-passed brokers for undertaking derivatives trading and
Lack of clarity on taxation and accounting aspects under derivatives trading.
The current trading behavior in the derivatives segments reveals that single stock
futures continues to account for sizeable proportion. A recent press report indicates
that futures in Indian exchanges have reached global volumes. One possible reason
for such skewed behavior of the traders could be that futures closely resemble the
erstwhile badla system. Such distortions are not however in the interest of the
market.
SEBI has permitted trading in options and futures on individual stocks, but not on all
the listed stocks. It was very selective, stocks that are said to be highly volatile with
a low market capitalization are not allowed for option trading. This act of SEBI is
strongly resented by a section of the market. Their argument is that equity options
are indispensable to investors who need to protect their investment from volatility.
The higher the volatility of a stock the more necessary it is to list options on that
stock. They are highly vocal in arguing that SEBI should design an effective
monitoring, surveillance and risk management system at the level of the exchanges
and clearing house to avert and manage the default risks that are likely to arise
owing to high volatility in low market capital stocks instead of simply banning
trading in options on them. SEBI needs to examine these arguments. It may have to
take a stand to nip in the bud all kinds of manipulations by handling out severe
punishments to all such erring companies.
Today, mutual funds are permitted to use equity derivatives products for
hedging and portfolio rebalancing. However, such usage is not favored by fund
managers as they strongly apprehend that the dividing line between hedging and
speculation being thin, they may always get exposed to the questioning by the
regulatory authorities.
d) CREDIT DERIVATIVES AND OTHERS
A credit derivative is a financial transaction whose pay-off depends on whether or
not a credit event occurs.
A credit event can be:
Bankruptcy
Default
Upgrade
Downgrade
Interest rate movement
Mortgage defaults
Unforeseen pay-offs

A credit derivative, like any other derivative, derives its value from an case is the
credit. In the event of the underlying asset failing to perform as expected, credit
derivatives, ensures that someone other than the principal lender absorbs the
resulting financial loss.
Credit derivatives market in India though could be said as non-existent holds huge
potential. Some of the important factors/situation such as opening up of the
insurance sector to foreign private players, relief to investors, tax benefits to
corporate, proxy hedgers etc., could provide the momentum to the credit
derivatives market in India, boosting yields and bringing down risk for both the
corporates and banks.
Secondly, Indian banking system is saddled with huge NPAs, which it is of course,
eagerly trying to get rid off. The mounting pressure on profitability is making
banks more credit-averse. In such a situation, if markets can offer creditinsurance in the form of derivatives, everyone would jump for it.
TYPES OF OPTIONS
Inboard sense, an option is a claim without any liability. More specifically, an option
is a contract that gives the holder aright, without any obligation, to buy or sell an
asset at an agreed price on or before a specified period of time.
The option to buy an asset is known as a call option and the option to sell an asset
is called a put option. The price at which option is exercised is called an exercise
price or
a strike price. The asset on which the call or put option is created is referred to as
the underlying asset. Depending on when an option can be exercised, it is classified
as follows:
European Option: When an option is allowed to exercise only on the maturity
date, it is called a European Option.
American Option: When an option can be exercised any time before its maturity is
called an American Option.
Capped Option: When an option is allowed to exercise only during a specified
period of time prior to its expiration unless the option reaches the cap value prior to
expiration in which the option is automatically exercised.
The holder of an option has to pay a price for obtaining a call or put option. The
price will have to be paid whether the holder exercises his option and it is called
option premium.
Option Terminology
There are several important terms used in option they are: 1)Call option: - Gives the buyer the right, but not the obligation to buy a specific
futures contract at a predetermined price within a limited period of time.
A call option is a contract, which gives the owner the right to buy an asset for a
certain price on or before a specified date. For example, if you buy a call option on a

certain share of XYZ Company, you have the right to purchase 100 shares
(assuming of course, that the option involves 100 shares).
Suppose current share price (S) of Reliance Industries is Rs. 291. You expect that
price in a three months period will go up Rs. 300. But you also fear that the price
may also fall below Rs. 291. To reduce the chance of risk and at the same time to
have the opportunity of making profit, instead of buying the share, you can buy a 3month call option on Reliance Industries at an agreed exercise price (E) of, say,
RS.280. Ignoring the option premium, taxes, transaction costs and the time value of
money, the decision to exercise your option depends upon the share price after
three months. You will exercise option when the share price after three months is
above Rs. 280 and you will not exercise when the share price after three month is
below Rs. 240.
Thus option should be exercised when:
Share price at expiration > Exercise price = St>E
Do not exercise option when:
Share price at expiration <= Exercise price =St<E
The value of call option at expiration is:
Value of call option at expiration= Maximum [(share price exercise price), 0] Ct =
Max [(St E), 0]
The expression above indicates that the value of call option at expiration is the
maximum of the share price minus the exercise price and zero. The call option
holders opportunity to make profit is unlimited. It depends on the actual market
price of the underlying share when the option is exercised. Greater the market value
of the underlying asset, the larger is the value of the option. The following figure
shows the value of call option.
For the call option writer, he will gain when share price is below the strike price and
will lose when stock price is above the strike price. The call buyers gain is call
sellers loss. The figure 1.2 shows the pay-off of a call option writer.
2)Put option: - Gives the buyer the right, but not the obligation, to sell a specific
futures contract at a predetermined price within a limited period of time.
Put option is a contract that gives the holder a right to sell specified shares at an
agreed price on or before a given maturity. Thus, if you buy a put option on shares
of XYZ Company, you have the right to sell 100 shares of this company at the
specified price at any time between today and the specified date.
Suppose the current price (S) of Reliance Industries is Rs. 291 and you expect that
the price will fall within a three months. Therefore, you can buy a 3-month put
option on Reliance Industries at an agreed exercise price (E), say, Rs. 295. If the
price actually falls to (St) Rs. 280 after three months, you will exercise your option.
You will buy the share for Rs. 280 from the market and deliver it to the put-option
writer to receive Rs. 295. Your gain is Rs.15 ignoring the put option premium,
transaction cost and taxes. You will not exercise if the share price rises above
exercise price; the put option is worthless and its value is zero.

Thus, exercise the put option when

Exercise price >Share price at expiration = E > St
Do not exercise put option when
Exercise price <=Share price at expiration = E<St
The value of put option at expiration will be
Value of put option at expiration= Maximum [(Exercise price Share price), 0] Pt =
Max [(E-St), 0]
The put option buyers gain is the sellers loss. The potential loss of the put option
is limited to the exercise price. Since the buyer has to pay a premium to the seller
for
purchasing a put option, the potential profit of the buyer and the potential loss of
the
seller will reduce by the amount of premium.
Combination
Puts and calls represent basic options. They serve as a building for developing more
complex options. The algebra corresponding to combination of buying option and
equity stock is as follows:

Pay -offs just before expiration date

If St< E
If St > E

1)
Put option
E S1
0

2)
Equity stock
S1
S1

= Combination
E
S1

Thus if you buy a stock with a put option on that stock (exercisable at price E), your
payoff will be E if the price of the stock is less that E, otherwise your payoff will be
S1.
Consider a more complex combination that consists of
1.Buying stock
2.Buying a put option on that stock and
3.Borrowing an amount equal to the exercise price.
The payoff from this combination is identical to the payoff from buying a call option.
The algebra of this equivalence is shown as follows:
Pay off just before expiration date

If S1< E
If S1 >E

1) Buy the

equity stock

S1
S1

2)
Buy a put option
E-S1
0

3)
Borrow an amount equal

To exercise price
-E
-E

(1) + (2) + (3) = Buy a call option

0
S1-E

If C1 is the terminal value of the call option (remember that C1 = Max (S1-E, 0), P1
the terminal value of the put option (remember that P1= Max (E-S1, 0), S1 the price
of the stock, and E the amount borrowed, then we have
C1= S1+P1-E
This is referred to as the put call parity.
3)Holder: - The buyer of the option.
4)Premium: -The amount paid by the buyer of the option to the seller.
5)Writer: - The option seller.
6)Strike price: -The predetermined price at which a given futures contract bought or
sold. Also called the exercise price these levels are set at regular intervals.
7)At-the money: - An option is at-the money when the underlying futures price
equals or
nearly equals, the strike price.
For e.g.: - A T-bond Put or Call option is at-the-money if the option strike price is at
78 and the price of the T-Bond futures contract is at or neat 78.00
8) In-the money: - A call option is in-the money when the underlying futures price is
greater than the strike price.
For e.g.: - If T-Bond futures are at 80.00 and the T-Bond call option strike price is
78.00, the call is in-the money
Where as the put option is in-the money when the strike price of the option is
greater than the price of the underlying futures contract.
For e.g.: - If the strike price of the put option is 80.00 and T-Bond futures are trading
at 77.00 the put option is in- the money
9) Out-of-the money: - A call option is out-of-the money if the Strike price is greater
than the underlying futures price. For e.g.: - if T-Bond futures are at 80.00 and the TBond call option strike price is 82.00 the option is out-of-the money.
The put option is out-of-the money if the underlying futures price is greater than the
strike price
For e.g.: - if T-Bond futures are at 77.00 and the T- Bond put option strike price is
76.00 the put option is out-of-the money.
Call option
Put option

Futures > strike

Futures < strike
In-the money

At-the money
Futures = strike
Futures = strike

Futures < strike

Futures > strike
Out-of-the money
Factors Determining the Option Value:
The precise location of the option value depends on five key factors:
Exercise price
Expiration date
Stock price
Stock price variability

Interest rate
Exercise Price: Other things being constant, higher the exercise price, the lower the
value of call option. It should be remembered that the value of call option could
never be negative; regardless of how high the exercise price is set.
Expiration Date:
Other things being constant, the longer the time to expiration date, the more
valuable the call option. Consider two American calls with maturities of one year
and two years. The two-year call obviously is more valuable than one-year call
because it gives its holder one more year within which it can be exercised.
Stock Price: The value of a call option, other things being constant, increases with
the
stock price.
Stock Price Variability: A call option has value when there is possibility that the stock
price exceeds the exercise price before the expiration date. Other things being
equal, the higher the variability of the stock price, the greater the likelihood that
stock price will exceed the exercise.
REASONS FOR USING OPTIONS
The reasons for using options on futures are reflected in the structure of an option
contract.
1)An option, when purchased gives the buyer the right, but not the obligation, to
buy or sell a specific amount of a specific commodity at a specific price within a
specific period of time.
2)The decision to exercise the option is entirely that of the buyer.
3)The purchaser of the options can lose no more than the initial amount of money
invested (premium).
4)An option buyer is never subject to margin calls. This enables the purchaser to
maintain a market position, despite any adverse moves without putting up
additional funds.
MOTIVES for BUYING and SELLING OPTIONS
One may be buyer or seller of call or put option for a variety of reasons.
A call option buyer for e.g. is bullish that he is or she believes the price of the
underlying futures contract will rise. If price do rise, the call option buyer has three
course of action available.
First is to exercise the option and acquires the underlying futures contract at the
strike
price
Second is to offset the long call position with a sale and realize a profit.

Third is to let the option expires worthless and forfeit the unrealized profit.
The seller of the call option expects futures prices to remain relatively stable or to
decline modestly. If prices remain stable, the receipt of the option premium
enhances the rate of return on a covered position. If prices decline, selling the call
against a long futures position enables the writer to use the premium as a cushion
to provide protection to the extent of the premium received. For instance, if T-bond
futures were purchased at 80.00 and call option with an 80.00 strike price were sold
for 2.00, T-bond futures could decline to the 78.00 levels before there would be a
net loss in the position.
However, T-bond futures rise to 82.00 the call option seller forfeits the opportunity
for profit because the buyer would likely exercise the call against him and acquire a
future position at 80.00(strike price).
The perspective of the put buyer and put seller are completely different. The buyer
of the put option believes for the underlying futures will decline for e.g.: - if a TBond put option with a strike price of 82.00 is purchased for 2.00 while T-Bond
futures also are at 82.00, the put option will be profitable for the purchaser to
exercise if T-Bond futures decline below 80.00
METHODOLOGY
TYPE OF RESEARCH
The type of research is selected on the basis of problems identified. Here the
research type used is descriptive research. Descriptive research includes factfindings and enquiries of different kinds. The major purpose of descriptive research
is a description of the state of affairs, as it exists in the present system. In this
dissertation an attempt has been made to discover various issues related to
derivatives in the Indian market and how they help the hedge the risk.
ACTUAL COLLECTION OF DATA
Data Collection from secondary Sources
Secondary data were gathered from numerous sources. While preparation of this
project report, the secondary data have been collected through:
Data was generated from general library research sources, textbooks, trade
journals, articles from newspaper, treasury management, brochures,
interviews with different brokers of Bangalore stock Exchange and
Internet web site
www.nseindia.com
www.sherkhan.com
www.icfai.org
www.google.com

www.commodityindia.com
PRESENTATION AND ANALYSIS
Derivatives in India: A chronology
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 setup L.C. Gupta Committee to draft a policy framework for
index futures.
1 May 1998 a Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreemen t (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 Index Futures commenced at NSE.
25 September 2000 Nifty Futures trading commenced at SGX.
In July 2001 Trading of Nifty index Options and Stock Options commenc ed at NSE.
In Nov 2001 trading of stock Futures commenced at NSE.
Trading Mechanics in Indian Derivatives Market
a) Spot market
In a spot market transactions are settled on the spot. Once a trade is agreed
upon, the settlement- i.e. the actual exchange of money for goods takes place with
minimum possible delay.
There are two real-world implementations of a spot market. Rolling settlement and
real time gross settlement (RTGS). With rolling settlement trades are netted through
one day, and settled x working days later; this is called T+X rolling settlement. For
example: with T+5 rolling settlement, traders are netted through Monday, and the
net open position as of Monday evening is settled on the coming Monday. Similarly,
traders are netted through Tuesday, and settled on the coming Tuesday.
With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a
close approximation and RTGS is a true spot market.
b) Forward transaction
In a forward contract, two parties irrevocably agree to settle a trade at a future
date, for a stated price and quantity. No money changes hands at the time the trade
is agreed upon.

Suppose a buyer L and seller S agrees to do a trade in 100 grams of gold on 31 Dec
2002 at Rs. 10,000/tola. Here, Rs. 10,000/tola is the forward price of 31 Dec 2005
Gold. The buyer L is said to be long and the seller S is said to be short. Once the
contract has been entered into, L is obligated to pay S Rs. 10, 00,000 on Dec 31,
2005, and take delivery of 100 tolas of gold. Similarly S is obligated to be ready to
accept Rs.10, 00,000 on 31 Dec, and give 100 tolas of gold in exchange.
c) Exchange traded versus OTC derivatives
Derivatives, which trade on an exchange, are called exchange-traded. Trades on
the exchange generally take place with anonymity. Traders at an exchange
generally go through the clearing corporation.
A derivative contract that is privately negotiated is called OTC derivatives. OTC
trades have no anonymity, and they generally do not go through a clearing
corporation. Every derivative product can either trade OTC (i.e. through private
negotiation) or on an exchange. In one specific case the jargon demarcates this
clearly: OTC futures contracts are called forwards (or, exchange-traded forwards
are called futures). In other cases, there is no such distinguishing notation. There
are exchange-traded options as opposed to OTC options; but both are called
options.
d) Carry forward
Badla is a mechanism to avoid the discipline of a spot market; to do trades on the
spot market but not actually do settlement. The carry forward activities are mixed
together with the spot market. A well functioning spot market has no possibility of
carry- forward. Derivatives trades take place distinctively from the spot market. The
spot price is separately observed from the derivative price. A modern financial
system consists of a
spot market, which is a genuine spot market, and a derivatives market is separate
from the spot market.
e) Intermediation in Indian derivatives market
There are two kinds of brokerage firms on the index futures market: trading
members (TMs) and clearing members (CMs). NSCC only deals with clearing
members: NSCC bears the full of default by a clearing member. Trading members
obtain the right to trade through a clearing member; the CM adopts the full credit
risk of the TM. If a TM fails, NSCC holds the relevant CM responsible.
f) Margin Money
The aim of margin money is to minimize the risk of default by either counter-party.
The payment of margin ensures that the risk is limited to the previous days price
movement on each outstanding position. However, even this exposure is offset by
the initial margin holdings. Margin money is like a security deposits or insurance
against a possible future loss of value.
There are different types of margin like: Initial margin

The basic aim of initial margin is to cover the largest potential loss in one day. Both
buyer and seller have to deposit margins. The initial margin is deposited before the
opening of the position in the futures transaction.
Mark to Market Margin
Mark to market margin is collected in cash for all futures contracts and adjusted
against the available liquid net worth for option position. In the case of futures
contracts mark to margin may be considered as mark to market Settlement. All
daily losses must be met by depositing of further collateral known as variation
margin, which is required by
the close of business, the following day. Any profits on the contract are credited to
the clients variation margin account.
Maintenance margin
Some exchanges work on the system of maintenance margin, which is slightly less
than initial margin. The margin is required to be replenished to the level of initial
margin, only if the margin level drops below the maintenance margin limit.
Trading
NSE introduced for the first time in India, fully automated screen based trading. It
uses a modern, fully computerised trading system designed to offer investors across
the length and breadth of the country a safe and easy way to invest.
The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is
a fully automated screen based trading system, which adopts the principle of an
order driven market.
Trading System
The Futures and Options Trading System provides a fully automated trading
environment for screen-based, floor-less trading on a nationwide basis and an online
monitoring and surveillance mechanism. The system supports an order driven
market and
provides complete transparency of trading operations.
Orders, as and when they are received, are first time stamped and then
immediately processed for potential match. If a match is not found, then the orders
are stored in different 'books'. Orders are stored in price-time priority in various
books in the following sequence:
Best Price
Within Price, by time priority.
Trading on the derivatives segment takes place on all days of the week (except
Saturdays and Sundays and holidays declared by the Exchange in advance).
Trading Locations

Till the advent of NSE, an investor wanting to transact in a security not traded on
the nearest exchange had to route orders through a series of correspondent brokers
to the appropriate exchange. This resulted in a great deal of uncertainty and high
transaction costs. One of the objectives of NSE was to provide a nationwide trading
facility and to enable investors spread all over the country to have an equal access
to NSE.
NSE has made it possible for an investor to access the same market and order book,
irrespective of location, at the same price and at the same cost. NSE uses
sophisticated telecommunication technology through which members can trade
remotely from their offices located in any part of the country. NSE trading terminals
(F&O segment) are present in various cities and towns all over India.
Types of traders in a derivatives market
Hedgers, speculators and arbitrators are the types of traders in derivatives market.
Hedgers:
Hedgers are those who protect themselves from the risk associated with the price of
an asset by using derivatives. A person keeps a close watch upon the prices
discovered in trading and when the comfortable price is reflected according to his
wants, he sells futures contracts. In this way he gets an assured fixed price of his
produce.
In general, hedgers use futures for protection against adverse future price
movements in the underlying cash commodity. Hedgers are often businesses, or
individuals, who at one point or another deal in the underlying cash commodity.
Take an example: A Hedger pays more to the farmer or dealer of a produce if its
prices go up. For protection against higher prices of the produce, he hedges the risk
exposure by buying enough future contracts of the produce to cover the amount of
produce he expects to buy. Since cash and futures prices do tend to move in
tandem, the futures position will profit if the price of the produce rise enough to
offset cash loss on the produce.
Speculators:
Speculators are somewhat like a middleman. They are never interested in actual
owing the commodity. They will just buy from one end and sell it to the other in
anticipation of future price movements. They actually bet on the future movement
in the price of an asset.
They are the second major group of futures players. These participants include
independent floor traders and investors. They handle trades for their personal
clients or brokerage firms.
Buying a futures contract in anticipation of price increases is known as going long.
Selling a futures contract in anticipation of a price decrease is known as going
short. Speculative participation in futures trading has increased with the availability
of alternative methods of participation.
Speculators have certain advantages over other investments they are as follows:

If the traders judgment is good, he can make more money in the futures market
faster because prices tend, on average, to change more quickly than real estate or
stock prices.
Futures are highly leveraged investments. The trader puts up a small fraction of the
value of the underlying contract as margin, yet he can ride on the full value of the
contract as it moves up and down. The money he puts up is not a down payment on
the underlying
contract, but a performance bond. The actual value of the contract is only
exchanged on those rare occasions when delivery takes place.
Arbitrators:
According to dictionary definition, a person who has been officially chosen to make
a decision between two people or groups who do not agree is known as Arbitrator. In
commodity market Arbitrators are the person who takes the advantage of a
discrepancy between prices in two different markets. If he finds future prices of a
commodity edging out with the cash price, he will take offsetting positions in both
the markets to lock in a profit. Moreover the commodity futures investor is not
charged interest on the difference between margin and the full contract value
TABLE 1: THE GLOBAL DERIVATIVES INDUSTRY:
CHRONOLOGY OF INSTRUMENTS
1874
Commodity futures

1972
Foreign currency futures

1973
Equity options

1975
T-bond futures

1981
Currency swaps

1982
Interest rate swaps; T-note futures; Eurodollar

futures; Equity index futures; Options on T-bond

futures; Exchangelisted currency options

1983

Options on equity index; Options on T-note futures;

Options on currency futures; Options on equity

index

Futures; Interest rates caps and floors

1985
Eurodollar options; Swaption

1987
OTC compound options; OTC average options

1989
Futures on interest rate swaps; Quanto options

1990
Equity index swaps

1991
Differential swaps

1993
Captions; Exchange-listed FLEX options

1994
Credit default options

Table 2: DERIVATIVES TRADING VOLUME AT NSE

FROM OCT-05 TO MARCH-06

Particulars
Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06
Stock

futures
214398
216526
280283
265042
288715
473251
Index

Futures
170100
135478
183293
166127
156359
192035
Stock

Options
13575
12777
17244
17893

15268
22466
Index

Options
35586
31073
42987
38521
32331
47097
Graph1 Showing the Derivatives trading volume at NSE from Oct 2005
to Mar 2006
Derivatives trading Volume
Volume (Rs Cr)
500000

473251

450000

400000

350000

300000
280283
288715

265042

250000

214398
216526

200000
183293

192035

170100
166127

156359

150000
135478

100000

50000
42987
38521

47097
35586
32331
31073

22466
13575
12777
17244
17893
15268

Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06

stock Futures
Index Futures

Stock Options
Index Options

Table Showing trading Contracts from Oct 2005 to Mar 2006

Particulars
Oct-05 Nov-05 Dec-05 Jan-06 Feb-06
Mar-06

stock

Futures

6526919
6252736
7571377
7134199
7443178
10844400
Index

Futures

6844732
5238175
6613032
5760999
5186835
5952206
Stock

Options

389254
364188
456529
456055
401973
537261
Index

Options

1410519
1200557
1540180

1330466
1066396
1456351
Graph2 Showing the Derivatives trading Contracts at NSE from Oct 2005 to Mar
2006
Derivatives Contracts
11000000

10844400

10000000

9000000

8000000

7571377
7443178

7000000
6844732
7134199

6613032

Contracts
6526919

6252736
5952206

6000000

5760999

5238175
5186835
of
5000000

No

4000000

3000000

2000000
1540180

1410519
1456351

1330466

1200557

1066396

1000000

537261

389254
364188
456529
456055
401973

Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06

Index Futures
Stock Options

Index Options
stock Futures

Graph3 Showing the Derivatives trading volume at NSE of Oct 2005

Derivatives Trading Volume at NSE of Oct 05
250000

214398
200000
Cr)
170100

(Rs
150000

Volume
100000

50000
35586

13575

Stock Futures Index Futures Stock Options Index Options

Derivatives
Graph4 Showing the Derivatives trading volume at NSE of Nov 2005
Derivatives trading volume At NSE of Nov
05
Index
Options,
Graph5 Showing the Derivatives trading volume at NSE of Dec 2005
Derivatives Trading Volume at NSE of Dec 05
300000
280283

250000
(RsCr)
200000
183293
150000
Volume
100000

50000
42987

17244
0

Stock Futures Index Futures Stock Options Index Options

Derivatives
Graph6 Showing the Derivatives trading volume at NSE of Jan 2006
Derivatives Trading Volume at NSE of Jan 06
Stock Index
Options, Options,
17893 38521
Stock
Index Futures,
Futures,
166127
265042
Graph7 Showing the Derivatives trading volume at NSE of Feb 2006
Derivatives Trading Volume At NSE of Feb 06
350000

300000
288715

Cr)
250000

(Rs
200000
156359

Volume
150000
100000

50000
32331
15268

Stock Futures Index Futures Stock Options Index Options

Derivatives
Graph8 Showing the Derivatives trading volume at NSE of Mar 2006
Derivatives Trading Volume At NSE of Mar 06
500000
473251
450000
Cr)
400000
350000

(Rs
300000
Voiume
250000
192035
200000

150000

100000
47097

50000
22466
0

Stock Futures Index Futures Stock Options Index Options

Derivatives
Growth of Derivative Market in India
Table showing the turn over of various derivatives in Indian market
Particulars 2002-03 2003-04 2004-05
2001-02
Index

Futures
21482
43952
554446
772147
Stock

Futures
51516
286533
1305939
1484056
Index

Options
2466
5669
31794
69371
stock
18780
69643
167967
132054
Options
Growth of derivatives market
1750000

1500000
1305939
1484056
Over
1250000

1000000

Turn
750000
554446
772147
500000

286533

250000
167967
132054
51516
69643

31794
69371
0
42
43952

218746680
5669

2001-02
2002-03
2003-04
2004-05

Year

Index Futures
Stock Futures

Index Options
stock Options

ROLE OF DERIVATIVES IN INDIAN ECONOMY

Benefits that acquire to the Indian capital markets and the Indian economy from
derivatives are discussed here.
Derivatives will make possible hedging which otherwise is infeasible this is
illustrated by the dollar-rupee forward market. Imports and exports used to take
place in the country under the presumption that importer and exporters have to
bear currency risk. To the extent that importers and exporters are risk averse, the
existence of this risk would lead them to do international trade in smaller quantities
than they have liked to. Once the dollar-rupee forward market came about,
importers and exporters could hedge themselves against currency risk. Today the
use of such hedging is extremely common amongst companies that are exposed to
currency risk. This hedging facility has definitely helped importers and exporters do
international trade in larger quantities than before. The RBIs permission for the
dollar-rupee forward market is therefore part of the explanation for the enormous
growth in imports and exports that has taken place in the last five years.
Similarly, on the equity market, many retail investors who are uncomfortable about
the equity market would enter if they were given the alternative of buying
insurance, which controls their downside risk. This would enhance the action of the
savings of the country, which are routed through the equity market. The same
would be the case with international investors, who would place limit orders. These
improvements in the quality of the underlying market have been observed across a
variety of research studies done on foreign markets, which have compared market
quality before introduction of derivatives as compared with after.
a) Development of Indias financial industry
Today, derivatives are a major part of the global financial system. If India is able to
swiftly develop competence in the derivatives area, then there is an enormous
opportunity for India as a center of international finance. One of the largest futures
market on Japans Nikkei 225 index, today, is in Singapore. In that same sense, it is
quite possible for Indian markets to be trading derivatives on underlying price,
which are not from India. This would bring revenues into Indias financial industry
and help enhance Indias integration into the world economy.
Conversely, if India does not develop such markets locally, the derivatives market in
the Indian instruments might develop outside India that will undermine the
regulatory framework under which other Indian markets work. In addition, Indian
investors who cannot access such off-shore markets will be denied the benefits of
advance risk hedging mechanism putting them at disadvantage be able to enhance
the
fraction of their portfolio that they allocate to India once hedging instruments
become available.
Derivatives will enable a clear separation between speculators who wish to bear
risks versus hedgers who wish to buy insurance services. Today speculators act on
the cash market, which generates its own difficulties. With derivatives market it will
be possible for risk to be transferred to the people who are most apt to bear it, and
to do all these activities away from the basic cash market.

Derivatives will lead to an improvement in the quality of the cash market. The
liquidity and market efficiency of the underlying cash market will improve once
derivatives come about the causality underlying this transformation of the quality of
the underlying market is as follows: Derivatives markets will move some of the noise traders in the present speculation
securities away from the cash market. Due to this shift, it is expected that the
volatility of the cash market instrument will reduce. It is generally believed that
derivatives will improve the quality of information production and analysis, by giving
higher profit rates to people who successfully understand valuation. Similarly, it is
expected that derivatives will lead to multi-crore arbitrage markets with
arbitrageurs who constantly close small mis-pricings between the derivatives and
the cash market. Due to the very nature of arbitrage business to attain risk free
position, such arbitrage will be liquidity demanding. This irreversibility arises
because once a market is well established; it is difficult to get it to move. For
example, Japanese regulators know more about financial economies today, but the
Nikkei 225 market is still in Singapore.
That could easily happen to Indias derivatives market also. Market prices for Indias
market are available worldwide through information vendor feeds such as Reuters,
knight-ridder etc. and there is nothing preventing an exchange in other country
from having options and futures on any Indian underlying. If the derivatives markets
on Indian underlying move offshore, it would be unfair to Indian citizens who would
be unable to access these markets under the present regime of barriers to
international flows of funds.
b) Challenges
The challenges in todays context for starting the derivatives market is to foster the
development of strong, healthy and vibrant derivatives industry, which compliments
the securities, market existing in the country. The pressure for an early development
of Indias derivatives is two fold:
To the extent that Indias economy lives for one more year without derivatives, it
hinders the economic progress of the country. For example,
if the dollar-rupee forward market had come about sooner, then Indias
imports and exports might have seen higher growth much before.
If Indian markets do not develop derivatives quickly, the markets for derivatives
of Indian instrument will move offshore. In derivatives, competition amongst
markets from all over the world to obtain trading volume from innovations in
contract design is fierce.
BENEFITS AND RISK ASSOCIATED WITH DERIVATIVES
Economic function of derivatives
Derivatives play the following important roles in every economy where they are
traded.
Price discovery and planning

Prices of an organized derivatives market reflect the combined views and perception
of buyers and sellers, not only of the current demand and supply, but also of their
expiration. At the time of expiration the prices of derivatives converge with the price
of the underlying assets. This process of price discovery is applicable to both futures
and options. Information generated by futures trading through price discovery
process helps in planning of all users at every stage. To the extent that these
markets improve planning and efficiency as well as reduce operating costs, benefits
will accrue to consumers in the economy.
Risk shifting
The derivative market allows and facilitates risks to be transferred from those who
have them but may not want them. The risk in case of derivatives is primarily price
risk. This risk represent a cost, which must be borne by someone if the dealer,
lender, borrower, merchant or middlemen has to assume risk, then they will pay the
opposite party less or charge them more or a combination of the two. If the risk is
assumed directly by the dealer or merchant they are compensated for bearing the
risk.
Numerous general economic benefits flow from the risk shifting of hedging function.
These include reduced finance charges in carrying inventory of all kinds including
portfolio of investments. The larger banks that finance producers, distributors and
processors give their best terms for the value of the inventory that is fully protected
by an adequate hedge.
Enhance liquidity in the underlying markets
Derivatives due to their inherent nature are linked to the underlying cash markets. It
has been observed the world over that introduction of derivatives increases the
trading volume in the underlying. Markets players reluctant to participate due to the
absence of risk shifting mechanism can now participate in the cash market.
Interplay between the underlying derivatives market generates additional activity in
the underlying market increasing liquidity in the underlying.
Shifts the speculative trading to a more controlled environment
In the absence of an organized derivatives market, speculators operate in the
underlying cash markets. This acts as an establishing factor for the underlying
marker since the underlying market act also as proxy futures and options market.
Margining, monitoring and surveillance of the activities of the various participants is
difficult in these kind of mixed markets. Derivatives market provides a mechanism
for the speculators to be identified separately and surveillance of these participants
and their positions can be done in a better manner. This reduce imbalance in the
underlying markets. Thus the derivatives markets will help in controlling the
activities of speculators and reduce the risks now prevalent in the underlying
securities market in India.
FINDINGS AND CONCLUSION
FINDINGS AND SUGGESTIONS
Some of the few suggestions are as follows: Regulations should be transparent and subject the same disclosure standards as
those applying to other participants in the financial markets. Tough after the

commencement of the commodity market in India it has become transparent to

some extent, more transparency is required.
Increase the limits on trading of derivatives by foreign institutional investors.
Increase the number of stocks on which options and fut ures are traded.
Contact size at NSE is 100 decided by SEBI
SEBI should promote the use of the derivatives and educate the investors on how
derivatives can reduce risk if used widely.
Availability of futures on all agricultural commodities would boos t private sector
participation in sourcing agricultural produce from villages and transport them
across the country as also store them to transport across the time or period. This in
turn helps mitigate the crisis emanating from the vagaries of monsoon.
Indian currency derivatives market is basically an Over The Counter (OTC) market.
It suffers from poor participation from corporate, and fewer market makers. It
therefore, calls for increased product familiarization, market participation and
development of supporting regulation, legal and tax framework.
There is a need to establish research wings in all major banks for predicting
intraday and short-term movements in the exchange rate so that traders can
initiate deals with confidence.
CONCLUSION
The basic function of a financial system is to "facilitate the allocation and
development of economic resources, both intertemporarily and across time, in an
uncertain environment". Risk is therefore an inherent feature of every financial
decision. In that context, derivative products offer a means to transfer the risk
inherent to financial decisions. Derivatives trading also add to the market
completeness. Trading in derivatives also facilitates price discovery of the
underlying cash securities via information dissemination. Besides these economic
benefits, derivatives, like any other financial instruments, contain certain risks such
as market risk, credit risk etc. Therefore, the consensus is that if used properly,
derivatives can be a valuable risk management tool but strict monitoring is needed
to prevent (as far as possible) their perceived `misuse' for speculative purposes.
While the very core of derivative products is to manage risk, it is important to
appreciate that all derivatives are highly geared, or leveraged, transactions.
Traders/investors are able to assume large positions - with similar sized risks - with
very little up-front outlay and the risk to the investor is high. A thorough grasp of
product technicalities is only one aspect of the knowledge and skills that traders
require. Every trader has a view of the market and their end objective is, of course,
profit from that view. And the most effective route to achieving this is to form a view
that proves to be correct; having positioned one's self to obtain the maximum profit
from it. If a trader has a bullish he could go long in the futures market or choose to
purchase a call option.
Since derivatives also suffer from risk, as do the underlying securities, derivatives
need to be handled cautiously on account of sheer size. These characteristics make

derivatives double-edged swords. This drives home the importance of adequate

regulation that care of the concerns associated with derivatives trading.
Increase in companies listed on stock exchanged emergence of securities and
exchange board of India (SEBI) as truly national level securities regulator, free
pricing of public issues, screen based trading system, more than six times increases
in turnover
the stock exchanges, emergence of self regulatory organization in the fields of
merchant banking, mutual funds, emergence of investor associations,
implementation of trade guarantees besides others.
SEBIS consistent efforts at improving the market infrastructure, providing level
playing field and ensuring transparent, fair and efficient trading at stock exchanges
have started to yield beneficial results. Depository legislation has also been
approved by the parliament and depository operations have commenced. In the
four years. SEBI has consistently tried to bring in international practices approval
granted for setting up derivatives market is a big step to bring Indian capital
markets. Increased sophistication of capital market participants and the need of
market participants for risk hedging instruments are strong factors in favor of
derivatives market in India.
To summarize the role of regulation is the cushion and help other market monitoring
mechanism such as competition or reputation to maintain a fair and orderly
financial markets in which innovation is encouraged. Its objective is thus to support
and encourage all the necessary structural changes in the products or institutions
architecture that allows market participants to increase the benefits extract from
the economic functions of derivatives at controlled risk levels. Thus, one could view
the role of regulation as that of a player of last resort that guarantees that the
economic benefits associated to the derivative trading activity remains on the
efficient risk/return frontier.
Terminologies
OTC
: Over thecounter
SEBI
: Securities Exchange Board of India
CBOT
: Chicago Board of Trade
CBOE
: Chicago Board Option Exchange
NSCC
: National securities clearing Corporation
TM
: Trading members
CM
: Clearing members

NEAT
: National Exchange for Automated Trading
F& O
: Futures & Option
FUTINX
: Futures Index
FUTSTK
: Futures Stock
OPTIDX
: Option Index
OPTSTK
: Option Stock
FUTINT
: Future Interest
NSE
: National Stock Exchange

BSE
: Bombay stock Exchange
NYSE
: New York Stock Exchange
COFEI
: Coffee Futures Exchange of India
NCDEX
: National Commodity & Derivatives Exchange of India
MCX
: Multi Commodity Exchange Of India Limited
NMCEIL
: National Multi Commodity Exchange Of India Limited
FMC
: Forward market Commission
NABARD
: National Bank For Agriculture & Rural Development
NPA

: Non-Performing Assets
FRA
: Forward rate agreements
RTGS
: Real time Gross Settlements
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