STOCK MARKETS IN INDIA

Stock exchanges are intricately interwoven in the fabric of nation’s economic life.
With out a stock exchange, the savings of the community the sinews of the economic
progress and productive efficiency would remain under utilized.

The risk of mobilization and allocation of savings might have been attempted by a
much less specialized institution than stock exchanges in the olden days. As the business
and the industry expanded and economy assumed more complex nature, a need for
“permanent finance” arose. Entrepreneurs require money for long-term where as
investors demanded liquidity and facility to convert their investments into cash at any
given time. The solution to this problem gave way for the origin of stock exchanges,
which is a ready market for investment and liquidity.

MEANING OF STOCK EXCHANGE

Stock exchanges mean any body of individuals, whether incorporated or not,

constituted for the purpose of regulating or controlling the business buying and selling or
dealing in securities. Securities include:

 Shares, Scrip’s, Bonds, Debentures and other marketable

securities.
 Government securities.
 Rights or interests in securities.

It is an association of member brokers of the purpose of self-regulation and

protecting the interests of its members. With the stock exchanges becoming corporate
bodies with demutualization the control and ownership will be in different hands.

It can operate only if it recognized by the government under the securities

contract Act, 1956. The reorganization is granted under section 3 of the Act by the central
government, ministry of finance.
 The powers of the central government under the Act are far-reaching and include
the following in particular:

 Grant and withdrawal of recognition, approval or change of byelaws.

 Call for periodical returns from the stock exchange.
 Direct enquires on the members or on the stock exchanges.
 Liability of the exchange to submit annual reports.
 Directing the stock exchange to make certain rules.
 Supersede the governing board of the exchange.
 Suspend the governing board of the exchange.
 Impose any other conditions or regulations for trading.

BYELAWS

Besides the Act, 1956, the securities contract rules were also made in 1957 to
regulate certain matters relating to trading on the stock exchanges. There are also byelaws
of the exchanges, which are concerned with the following subjects:

Opening / closing of the stock exchanges, administration timing of the trading,

regulation of blank transfers, regulation of badla or carryover business, control of the
settlement and other activities of the stock exchange, fixation of margins, fixation of
market prices or making up prices, regulation of taravani business, etc, regulation of
brokers trading, brokerage charges, trading rules on the exchange, arbitration and
settlement of disputes, settlement and clearing of the trading etc.

REGULATION OF STOCK EXCHANGES

 The securities contract Act is the basis for operations of the stock exchanges in
India. No exchange can operate legally without the government permission or
recognition. Stock exchanges are given monopoly in certain areas under section 19 of the
Act, 1956 to ensure that the control and regulation are facilitated. Recognition can be
granted to a stock exchange provided certain conditions are satisfied and the necessary
information is supplied to the government. Recognition can also be withdrawn, if
necessary.

NATURE AND FUNCTIONS OF STOCK EXCHANGE

As economic development proceeds, the scope for acquisition and ownership of

capital and private individuals also grows. Also with it, the opportunity for stock
exchanges to render the service of stimulating private savings and canalizing such
savings into productive investments exists on a vastly great scale. These are the
services, which the stock exchange alone can render efficiently.

Stock exchanges are the market, which exists to facilitate purchase and sale of
securities of companies and the securities or bonds issued by the government in course
of its borrowing operations. The task facing the stock exchanges is to device the means
to reach down to the masses, to draw the savings of the man in the street into productive
investment to create conditions in which many millions of people from cities, towns and
villages will find it possible to make use of these facilities. For these far-reaching
changes both institutional as well as operational has to be undertaken.

Aim of the stock exchange authorities is to make it nearly perfect in the social
and ethical sense as it is in the economy. To protect the interest of the investing public,
the authorities of the stock exchange have been increasingly subjecting not only its
members to a high degree of discipline but also those who use the facilities.
 The stock exchange provides liquidity to the listed companies. By giving
quotations to the listed companies, they help trading and raise funds from the market.
Savings of investors flow in to public loans and to joint stock-enterprises because of this
ready marketability and unequalled facility for transfer of ownership of stocks, shares
and securities provided by the recognized stock exchanges. As a result, over the
hundred and twenty years during which the stock exchanges have existed in this country
and through their medium, the central and state government have raised crores of rupees
by floating public loans; Municipal corporations, improvement trusts, Local bodies and
state finance corporation have obtained from the public their financial requirements, and
industry, trade and commerce- the back bone of the country’s economy- have secured
capital of crores of rupees through the issue of stocks, shares and debentures for
financing their day-to-day activities, organizing new venture and completing projects
of expansion, diversification and modernization. By obtaining the listing and trading
facilities, public investment is increased and companies were able to raise more funds.
The quoted companies with wide public interest have enjoyed some benefits and asset
valuation has become easier for tax and other purposes.

SETTLEMENT GUARANTEE FUND

The Exchange has introduced Trade Guarantee Fund on 25/01/2001. This will
insulate the trading member from the counter-party risks while trading with another
member. In other words, the trading member and his investors will be assured of the
timely completion of the pay-out of funds and securities notwithstanding the default, if
any, of any trading member of the Exchange. Several pay-ins worth of crores of rupees in
all the settlements have been successfully completed after the introduction of Trade
Guarantee Fund, without utilizing any amount from the Trade Guarantee Fund.
 The Trade Guarantee Fund had strict rules and regulations to be complied with by
the members to avail the guarantee facility. The HOST system facilitated monitoring the
compliance of members in respect of such rules and regulations.

History of Stock Exchanges in India:

The only stock exchanges operating in the 19th century were those of Mumbai set
up in 1875 and Ahmedbad set up in 1894. These were organized as voluntary non-profit
making associations of brokers to regulate and protect their interests. Before the control
on securities trading became a central subject under the constitution in 1950, it was a
state subject and the Bombay securities contracts act of 1925 used to regulate trading in
securities. Under this Act, the Bombay stock exchange was recognized in 1927 and
Ahmedabad in 1937. During the war boom, a number of stock exchanges were organized
even in Mumbai, Ahmedabad and other centers, but they were not recognized. Soon after
in became a central subject, central legislation was proposed and a committee headed by
A.D.Gorwala went into the bill for securities regulation. On the basis of the committee’s
recommendations and public discussion, the securities contracts Act became law in 1956.

SEBI Reforms on Stock Exchanges

The SEBI regulations of stock exchanges and their members had started as early
as February 1992 and the reforms later introduced have been on a continuous basis. It
was started with the licensing and registration of Brokers and sub-brokers in the
recognized stock exchanges. This was later extended to under writers, portfolio managers
and other categories of players in the stock market including foreign securities forms
FFIs, OCBs, Debenture Trustees, Collecting Bankers, etc.

The other reforms are briefly summarized below

1. Compulsory Audit and inspection of stock exchanges and their member
brokers and their Accounts.
 2. Transparency in the prices and brokerage charged by brokers by showing
them in their contract notes.
3. Capital adequacy norms have been lay down for members of various stock
exchanges separately and depending on their turn over of trade and other
factors.
4. Guidelines have been laid down for dealings of FFIs and Foreign broker
firms in the Indian stock exchanges through Indian brokers.
5. New guidelines for corporate members have been laid down with limited
liability of directors and opening up of their member ship to more than 1
stock exchange with out the limiting requirement of experience of 5 years
in one exchange, as imposed earlier.
6. Board of directors of the stock exchanges has to be reconstituted so as
to include non-brokers, public representatives, and government
representatives to the extend of 50% of the total number of members.

Stock Exchanges in India

Stock Exchanges are an organized marketplace, either corporation or mutual

organization, where members of the organization gather to trade company stocks or other
securities. The members may act either as agents for their customers, or as principals for
their own accounts. Stock exchanges also facilitates for the issue and redemption of
securities and other financial instruments including the payment of income and dividends.
The record keeping is central but trade is linked to such physical place because modern
markets are computerized. The trade on an exchange is only by members and stock
broker do have a seat on the exchange.
STOCK EXCHANGES IN INDIA

1946 1961 1971 1975 1980 1985 1990 1995

No. of stock exchanges 7 7 8 8 9 14 20 22
No.of listed comp. 1125 1203 1599 1552 2265 4344 6229 8593
Capital of listed 270 753 1812 2614 3973 9723 32041 59583
comp.in Rs.

N0 OF STOCK EXCHANGES
 No. of Stock Exchanges

25

20

15
No. of Stock Exchanges

10

0
1946 1961 1971 1975 1980 1985 1991 1995

NO OF LISTED COMPANIES

No. of Listed Cos.

10000
9000
8000
7000
6000
5000 No. of Listed Cos.
4000
3000
2000
1000
0
1946 1961 1971 1975 1980 1985 1991 1995
 CAPITAL OF LISTED COMPANIES

Capital of Listed Cos. (Cr. Rs.)

70000

60000
50000

40000 Capital of Listed

30000 Cos. (Cr. Rs.)

20000

10000

0
1946

1971

1975

1985

1995
1961

1980

1990

REGIONAL STOCK EXCHANGES

There are 23 stock exchanges in India. Among them two are national level stock
exchanges namely Bombay Stock Exchange (BSE) and National Stock Exchange of India
(NSE). The rest 21 are Regional Stock Exchanges (RSE).

List of Stock Exchanges in India

 Bombay Stock Exchange

 National Stock Exchange
 Regional Stock Exchanges
 Ahmedabad Stock Exchange
  Bangalore Stock Exchange
 Bhubaneshwar Stock Exchange
 Calcutta Stock Exchange
 Cochin Stock Exchange
 Coimbatore Stock Exchange
 Delhi Stock Exchange
 Guwahati Stock Exchange
 Hyderabad Stock Exchange
 Jaipur Stock Exchange
 Ludhiana Stock Exchange
 Madhya Pradesh Stock Exchange
 Madras Stock Exchange
 Magadh Stock Exchange
 Mangalore Stock Exchange
 Meerut Stock Exchange
 OTC Exchange Of India
 Pune Stock Exchange
 Saurashtra Kutch Stock Exchange
 Uttar Pradesh Stock Exchange
 Vadodara Stock Exchange
The Regional Stock Exchanges started clustering from the year 1894, when the
first RSE, the Ahmedabad Stock Exchange (ASE) was established. In the year 1908, the
second in the series, Calcutta Stock Exchange (CSE) came into exultance. During the
early sixties, there were only few recognized RSEs in India namely Calcutta, Madras,
Ahmedabad, Delhi, Hyderabad and Indore. The number remained unchanged for the next
two decades. 1980s was the turning point and many RSEs were incorporated. The latest is
Coimbatore Stock Exchange and Meerut Stock Exchange.

Opportunities for Foreign Investors in Indian Stock markets

Direct Investment
 Foreign companies are now permitted to have a majority stake in their Indian
affiliates except in a few restricted industries. In certain specific industries, foreigners can
even have holding up to 100 per cent.

Investment through Stock Exchanges

Foreign Institutional Investors (FII) upon registration with the Securities and
Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) are allowed to
operate in Indian stock exchanges subject to the guidelines issued for the purpose by
SEBI.

SUMMARY

 India's oldest and first stock exchange: Mumbai (Bombay) Stock

Exchange. Established in 1875. More than 6,000 stocks listed.
 Total number of stock exchanges in India: 22
 They are in: Ahmedabad, Bangalore, Calcutta, Chennai, Delhi etc.
 There is also a National Stock Exchange (NSE) which is located in
Mumbai.
 There is also an Over the Counter Exchange of India (OTCEI) which
allows listing of small and medium sized companies.

The regulatory agency which oversees the functioning of stock markets is the
Securities and Exchange Board of India (SEBI), which is also located in Bombay.
 SIGNIFICANCE OF THE STUDY

The present study on Derivative futures is very much appreciable on the grounds that it
gives deep insights about the stock futures market. It would be essential for the perfect
way of trading in stock futures. The study elucidates the role of derivative futures in
Indian financial markets.

Studies of this type are more useful to academicians and scholars to make
further insights into the various aspects of derivative futures in similar organizations.

An investor can choose the right underlying for investment, which is risk free.
The study included the changes in daily price movement and buying and selling signals to
the selected stocks. This helps the investor to take right decisions regarding trading in
derivative stock futures.

INTRODUCTION

As Indian securities markets continue to evolve, market participants,

investors and regulators are looking at different ways in which the risk
management may be efficiently met through the introduction of Derivative
markets.

Through the use of derivative products, it is possible to partially or fully

transfer price risks by locking in asset prices. As instruments of risk management,
these generally do not influence the fluctuations in the underlying asset prices.

Derivatives are risk management instruments, which derive their value form an
underlying asset. The underlying asset can be bullion, index, share, bonds,
currency, interest etc. banks, securities firms, companies and investors to hedge
risks, to gain access to cheaper money and to make profit, uses derivatives.
Derivatives are likely to grow even at a faster rate in future.
 However, the advent of modern day derivative contracts is attributed to the
need for farmers to protect themselves from any decline in the price of their crops
due to delayed monsoon, or overproduction. The first ‘futures’ contracts can be
traced to the Yodoya rice market in Osaka, Japan around 1650. These were
evidently standardized contracts, which made them much like today’s futures.

The Chicago Board of trade (CBOT), the largest derivative exchange

in the world, was established in 1848 where forward contracts on various
commodities were standardized around 1865. From then on, futures
contracts have remained more or less in the same form, as we know them
today.

DERIVATIVES

Derivatives are defined as financial instruments whose value derived from

the prices of one or more other assets such as equity securities, fixed-income
securities, foreign currencies, or commodities. Derivative is also a kind of contract
between two counter parties to exchange payments linked to the prices of
underlying assets.

DEFINITION

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A)
defines “derivative” to include-
 1. A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other from of
security.

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

The above definition conveys that

Derivatives are financial products and derive its value from the underlying assets.

Derivatives are derived from a matter financial contract called the underlying.

DIFFERENCE BETWEEN DERIVATIVES AND SHARES

The subtle, but crucial, difference is that while shares are assets, derivatives
are usually contracts (the major exception to this are warrants and convertible
bonds, which are similar to shares in that they are assets).

INVESTING IN DERIVATIVES

If one is interested in getting directly involved with futures or options, then

the idea “to incest” is inappropriate they are traded. This implies that one monitors
the price more closely, and uses more sophisticated trading techniques (for
example, the use if stop orders). There are a number of brokers that specialize in
private client futures/options trading; list of these can usually be requested from
futures exchanges.

USAGE OF DERIVATIVES

Any person who has funds invested, (e.g. an insurance policy or a pension
fund), are mostly exposed to derivatives in some or other way. Due to its great
flexibility, derivatives are used by many different types of investors. From this
stand point, derivatives will allow the modern investor the full range of investment
 strategy: speculation, hedging, arbitrage and all of the possible combinations
thereof.

MEASURES OF DERIVATIVES

The value of a derivatives contract equals the difference between the value
of the underlying asset and the cost of financing a purchase of the asset, Further
the value also depends on the price of the underlying asset and the level of interest
rates.

PARTICIPANTS OF DERIVATIVES
The following are the three broad categories of participants in the derivative
market.
Hedgers

Hedgers are parties who ate exposed to risk because they have a prior position in
the commodity or the financial instrument specified in the futures contract. They
use futures or options marked to reduce or eliminate this risk. Since one can take
neither a long position nor a short position in the futures contract, there are two
basic hedge positions:

1. The short (sell) hedge: A party who has a long cash position, current or
potential, may sell (short) the futures.

2. The long (buy) hedge: A party who is not currently in cash but who expects
to be in cash in the future may buy a futures contract to eliminate uncertainty
about the price.

Speculators

Speculators are those who do not have any position on which they enter in
futures and options market. They only have a particular view on the market, stock,
commodity etc. In short speculators put their money a risk in the hope of profiting
from an anticipated price change. They consider various factors such as demand
supply, market positions, open interests, economic fundamentals and other data to
take their positions.

They play very important role in the proper functioning of futures market.
The futures market offers the following attraction to the speculator:

• Leverage

• Ease of transactions

• Lower transaction costs

ARBITRAGEURS

An arbitrageur is basically risk averse. To earn risk free profits by exploiting

market imperfections. Arbitrageurs make profit from price differential existing in
to markets by simultaneously operating in the two different markets. There are
two main kinds of arbitrage transactions. They are

 A futures-futures arbitrage: It occurs when a dealer exploit the price

differential between two future markets.

 A cash-futures arbitrage: It occurs when a dealer exploits price

misalignment between the cash market and the futures market.

FUNCTIONS OF DERICATIVE MARKET

The following are the various functions that are performed by the
derivatives markets. They are:

 Price in an organized derivatives market reflects the perception of market

participations about the futures and let the prices of underlying to the
perceived future level.
  Derivatives market helps to transfer risks from those who have them but
may not like them to those who have an appetite for them.

 Derivative trading acts as a catalyst for new entrepreneurial activity.

 Derivatives markets help increase savings and investment in the long run.

TYPES OF DERIVATIVES

The following are the most common types of derivatives. They are

FORWARDS

A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price.

FUTURES

A futures contract is an agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price. Futures contracts are special
types of forward contracts in the sense that the former are standardized exchange-
traded contracts. These are one of the most popular and widely used derivative
instruments.

OPTIONS

Options are of tow types – calls and puts.

 Calls give the buyer the right but not the obligation to buy a given quantity
of the underlying asset, at a given price on or before a given future date.

 Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on ore before a given date.

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

LEAPS

The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of up to three years.

BASKETS

Basket options are options on portfolios of underlying assets. The

underlying asset is usually a moving average of a basket of assets. Equity index
options are a form of basket options.

SWAPS

Swaps are private agreements between two parties to exchange cash flows
in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:

INTEREST RATE SWAPS:

These entail swapping only the interest related cash flows between the
parties in the swap currency.

CURRENCY SWAPS:

These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the
opposite direction.
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.
CHRONOLOGY OF DERIVATIVE MARKET IN INDIA:

DATE PARTICULARS
14 DEC 1996 NSE asked SEBI for permission to trade Index Futures.
18 NOV 1996 Formed L.C.Gupta Committee to design framework for
Index Futures.
7 JULY 1999 RBI gave permission of OTC Forward Rate
Agreements and Interest Rate Swaps.
24 MAY 2000 SIMEX chose NIFTY for trading futures and options
on India Index.
25 MAY 2000 SEBI gave permission to NSE to do Index Futures
trading.
9 JUN 2000 Trading of BSE Futures.
22 JUN 2000 Trading of NSE Futures and Index Options market.
JULY 2001 Stock Options introduced.
NOV 2001 Stock Futures.
3 OCT 2003 Commodity Futures.

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the

SC (R) A, the SEBI Act and the regulations framed there under the rules and
byelaws of stock exchanges.

REGULATIONS FOR DERIVATIVES TRADING

SEBI set up a 24 member committed under Chairmanship of Dr. L. C.

Gupta develop the appropriate regulatory frame work for derivative trading in
India. The committee submitted its report in March 1998. On May 11, 1998 SEBI
accepted the recommendations of the committee and approved the phased
introduction of Derivatives trading in India beginning with Stock Index Futures.
SEBI also approved he ‘Suggestive bye-laws’ recommended by the committee for
regulation and control of trading and settlement of Derivatives contracts.

The provision in the SC (R) A governs the trading in the securities. The
amendment of the SC(R) A to include ‘DERIVATIVES’ within the ambit of
‘Securities’ in the SC (R) A Made trading in Derivatives possible within the frame
work of the Act.

1. Eligibility criteria as prescribed in the L.C. Gupta committee report may

apply to SEBI for grant of recognition under Section 4 of the SC(R)A 1956
to start Derivatives Trading. The exchange shall regulate the sales practices
of its members and will obtain approval of SEBI before start of Trading in
any derivative contract.

2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically
become the members of the derivative segment. The members of the
derivative segment need to fulfill the eligibility conditions as lay down by
the L. C. Gupta Committee.

4. The clearing and settlement of derivates trades shall be through a SEBI

approved Clearing Corporation / Clearing house. Clearing Corporation /
Clearing House complying with the eligibility conditions as lay down By
the committee have to apply to SEBI for grant of approval.

5. Derivatives broker / dealers and Clearing members are required to seek

registration from SEBI.

6. The minimum contract value shall not be less than Rs.2Lakh. Exchanges
should also submit details of the futures contract they purpose to introduce.

7. The trading members are required to have qualified approved user and sales
person who have passed a certification programme approved by SEBI
THE ECONOMIC ROLE OF DERIVATIVES

Derivative markets provide three essential economic functions:

 Risk management
 Price discovery
 Transactional efficiency
Risk management:
The principal benefit of the Derivative market is that it provides the
opportunity for risk management through Hedging.

Risks involved in derivatives:

Risk can be defined as “The possibility or probability of loss”. Derivatives

are used to separate risks from traditional instruments and transfer these risks. The
fundamental risks involved in derivatives business includes following:

Credit risk:

This is the risk of a counterpart to perform its obligations as per the

contract. Also known as default or counterpart risk, it differs with different
instruments.

Market risk:

Market risk is a risk of financial loss as a result of adverse movements of

prices of the underlying asset.

Liquidity risk:

The inability of a firm to arrange a transaction at prevailing market prices is

termed as liquidity risk.
 • Related to liquidity of separate products.

• Related to the funding of activities of the firm including derivatives.

Legal risk:

Derivatives cut a cross judicial boundaries therefore the legal aspects

Associated with the deal should be looked into carefully.

Risk management/Hedging strategies can be broadly grouped into three

categories:

1. Inventory hedging to protect the value of existing portfolio of assets.

2. Anticipatory hedging to sell/buy derivatives especially forwards and

futures instead of the anticipated inflows (assets)/ outflows (liabilities). A
classic example is that of exporters and importers who sells/buys currency
futures/options.

3. Return enhancement hedge using derivatives to create synthetic securities,

which means cash assets.

Price discovery:

The second major function of derivative market is price discovery. This is a

process of providing equilibrium prices that reflect current and prospective
demands on current and prospective supplies, and making these prices visible to
all.

Transactional efficiency:
 Derivative markets allow institution to transact more efficiently than
otherwise. They reduce the direct cost of transacting in cash/financial markets are
also provided, through clearing houses, an efficient mechanism to deal with
counter party risk.

INTRODUCTION TO FUTURES:

A Futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Future markets were designed to solve the
problems that exist in forward markets. But unlike forward contracts, the futures
contracts ate standardized and exchange traded. To facilitate liquidity in the futures
contracts, the exchange specifies certain standard features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purposes in settlement) and a standard timing of such settlement.

The standardized items in a futures contract are:

o Quantity of the underlying

o Quality of the underlying
o Date and Month of Delivery
o The units of Price quotations and Minimum price changes
o Location of settlement

TYPES OF FUTURES:

On the basis of the underlying asset they derive, the futures are divided into
following types.
STOCK FUTURES
The stock futures are the futures that have the underlying asset as the individual
securities. The settlement of the stock futures is of cash settlement and the settlement
price of the future is the closing price of the underlying security.

 INDEX FUTURES
Index futures are the futures, which have the underlying asset as an Index. The

Index futures are also cash settled. The settlement price of the Index futures shall be

the closing value of the underlying index on the expiry date of the contract.

 COMMODITY FUTURES

In this case, the underlying asset is a commodity. It can be an agricultural commodity like wheat corn,
or even a precious asset like gold, silver etc.

 FINANCIAL FUTURES

In this case, the underlying assets are financial instruments like money
market paper, Treasury Bills, notes, bonds etc.

 CURRENCY FUTURES

Currency futures are those in which the underlying assets are major
convertible currencies like the U.S. dollar, the Pound Sterling, the Euro and the
Yen etc.

PARTIES IN THE FUTURES CONTRACT:

There are two parties in a future contract, the Buyer and the Seller.

 The buyer of the futures contract is one who is LONG on the futures
contract and

 The seller of the futures contract is one who is SHORT on the futures
contract.
The pay off for the buyer and the seller of the futures contract are as follows.

PAYOFF FOR A BUYER OF FUTURES:

PROFIT

E2

F E1
LOSS

L
CASE 1:

The buyer bought the future contract at (F); if the futures price goes to E1
then the buyer gets the profit of (FP).

CASE 2:

The buyer gets loss when the future price goes less then (F), if the futures
price goes to E2 then the Buyer gets the loss of (FL).
 PAYOFF FOR A SELLER OF FUTURES:

PROFIT
P

E2

E1 F

LOSS

F-FUTURES PRICE
E1, E2-SETTLEMENT PRICE

CASE 1:

The Seller sold the future contract at (f); if the futures price goes to E1 then
the Seller gets the profit of (FP).

CASE 2:

The Seller gets loss when the future price goes grater than (F), if the futures
price goes to E2 then the Seller gets the loss of (FL).
MARGINS:

Margins are the deposits, which reduce counter party risk, arise in a futures
contract. These margins are collected in order to eliminate the counter party risk.
There are three types of margin.

INITIAL MARGINS:

Whenever a futures contract is signed, both buyer and seller are required to
post initial margin. Both buyer and seller are required to make security deposits
that are intended to guarantee that they will infact be able to fulfill their obligation.
These deposits ate Initial margins and they are often referred as performance as
performance margins. The amount of margin is roughly 5% to 15% of total
purchase price of futures contract.

MARKING OF MARKET MARGIN:

The process of adjusting the equity in an investor’s account in order to
reflect the change in the settlement price of futures contract is known as MTM
Margin.

MAINTENANCE MARGIN:
The investor must keep the futures account equity equal to or grater than
certain percentage pf the amount deposited as Initial Margin. If the equity goes
less than that percentage of Initial margin, then the investor receives a call for an
additional deposit of cash known as Maintenance Margin to bring the equity up to
the Initial margin.
PRICING THE FUTURES:

The fair value of the futures contract is derived from a model known as the

Cost of Carry model. This model gives the fair value of the futures contract.

Cost of Carry Model:

F=S (1+r-q) t

Where

F – Futures Price

S – Spot price of the Underlying

R – Cost of Financing

q – Expected Dividend Yield

t – Holding Period.

FUTURES TERMINOLOGY:

SPOT PRICE:

The price at which an asset trades in the spot market.

FUTURES PRICE:

The price at which the futures contract trades in the futures market.

CONTRACTCYCLES:
 It is the period over which a contract trades. The index futures contracts
on the NSE have near month (one-month), middle month (two-months) and far
month (three-months) expiry cycles, which expire on the last Thursday of the
month. Thus a January expiration contract expires on the last Thursday of January
and a February expiration contract ceases trading on the last Thursday of
February. On the Friday following the last Thursday, a new contract having a
three-month expiry is introduced for trading.

EXAMPLE – 1:

DEC 31ST JAN 27TH FEB 24TH MAR 31ST

FAR MONTH

MIDDLE MONTH

NEAR MONTH

EXAMPLE – 2:

JAN 28TH FEB 24TH MAR 31ST APR 28TH

FAR MONTH

MIDDLE MONTH

NEAR MONTH
EXPIRY DATE:
It is the date specified in the futures contract. This is the last day on which
the correct will be traded, at the end of which it will cease to exist.

CONTRACT SIZE:
The amount of asset that has to be delivered less than one contract,
For instance, the contract size on NSE’ s futures market is 200 Niftiest.

BASIS:
In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery reflects that
futures prices normally exceed spot prices.

COST OF CARRY:
The relationship between futures process and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the income earned
on the asset.

OPEN INTEREST:
Open Interest means the ‘Total outstanding long or short positions in the
market at any specific time’. As total long positions for market would be equal to
short positions, for calculation of open interest, only one side of the contract is
counted.
CHOICE OF FUTURES:

Choice of futures consists of 3 decisions. They are

• Which futures commodity

 • Which expiration month

• Whenever to be long or short

TECHNICAL ANALYSIS:

Technical analysis is a process of identifying trend reversals at

an earlier stage to formulate the buying and selling strategy with the help of
several indicators.

The technical analysis mainly focuses the attention on the past

history of prices. Generally technical analysts choose to study two basic market
data-price and volume. They mainly predict short-term price movement rather
than long-term movement.

History of Technical Analysis:

The technical analysis is based on the doctrine given by

Charles H. Dow in 1984, in the Wall Street Journal. He wrote a series of articles in
the Wall Street Journal. A. J. Nelson, a close friend of Charles Dow formulized the
Dow theory for economic forecasting.

Technical Tools:

Generally used technical tools are, Dow theory, volume of trade, short
selling, bars and line charts, moving averages and oscillators.

Dow Theory:

Dow developed his theory to explain the movement of indices of Dow Jones
Averages on the basis of certain hypotheses. The first hypothesis is that, no single
individual or buyer can influence the major trend of the market. His second
hypothesis is that the market discounts everything. His third hypothesis is that the
theory is not infallible.

The theory According to Dow Theory the trend is divided into primary,
intermediate and short-term trend. The primary trend may be the broad upward or
downward movement that may last for a year or two. The intermediate trends are
corrective movements, which may last for three weeks to three months. The short-
term trend refers to the day-to-day price movement.

Volume of trade:

Dow gave special emphasis on volume. Volume expands along with the bull
market and narrows down in the market. If the volume falls with rise in price or
vice-versa, it is a matter of concern for the investor and the trend may not persist
for a longer time.

Short selling:

Short selling is a technical indicator known as short interest. Short sales refer to
the selling of shares that are not owned. The bears are the short sellers who sell
now in the hope of purchasing at a lower price in the future to make profits.

Moving Average:

The market indices do not rise or fall in straight line. The upward and downward
movements are interrupted by counter moves. The underlying trend can be studied
by smoothening of the data. To smooth the data moving average technique is used.
If it is five day moving average, on the sixth day the body of the data moves to
include the sixth day observation eliminating the first day’s observation. Likewise
continues. For this calculation, closing price of the stock is used.

Oscillators:

Oscillator shows the share price movement across a reference point from one
extreme to another. The momentum indicates:

• Overbought and oversold conditions of the scrip or the market.

• Signaling the possible trend reversal.

• Rise or decline in the momentum.

Bar Charts:

In bar charts, two dots are entered to represent the highest and lowest price at
which the stock is traded. A line is drawn to connect both the points a horizontal
nub is drawn to mark the closing prices.

CHART PATTERNS:

These are used as a supplement to other information and confirmation of signals

provided by trend lines. Some of the chart patterns are discussed here.

1. V Formation:

The name itself indicates that in the “V” formation there is a long sharp decline
and a fast reversal. The “V” pattern occurs mostly in popular stocks where the
market interest changes quickly from hope to fear and vice-versa. In the case of
inverted “^” the rise occurs first and declines. These changes are shown in the
following diagram.

Price

Days

2. Double Top and Bottom:

This type of formation signals the end of one trend and the beginning of another.
The double top pattern resembles the letter ‘M’. The double top may indicate the
onset of the Bear Market.
In a double bottom, the price of the falls to a certain level and increase with
diminishing activity. Then it falls again to the same or to lower price and turns up
to a higher level. The double bottom resembles the letter ‘W’.

Technical analysis views this pattern as a sign for Bull Market. These patterns are
shown in the following charts.

Price Price

Days Days

3. Head and Shoulders:

In the head and shoulder pattern there are three rallies resembling the left shoulder,
a head and a right shoulder. A neckline is drawn connecting lows of the tops.
When the stock price cuts the neckline from above, it signals the Bear market.
4. Inverted head and shoulders:
Here the reverse of the previous pattern holds true. It indicates end of bear market
and the beginning of the bull market. These patterns have to be confirmed with the
volume and trend of the market.
These patterns are shown in the following charts.
 Neckline

Price Neckline Price

Days Days