EXECUTIVE SUMMARY

This project report has been undertaken with a view to study the
derivative markets and products and the players in this market.

I had conducted this research to find out the derivative

products available in Indian market and whether investing in the
derivative market is beneficial. A brief summary of the project report
is follows:

The project begins with Research methodology where it covers

methodology used obtaining information about company and also
emphasis how data obtained in relation to that.

The first chapter is on the company profile where it covers its

organisation structure, nature of business, subsidiaries of the
company and also highlights on the firms competitors and its joint
ventures in abroad.

The next three chapters cover details on derivatives, financial

derivatives in India and commodity derivatives in India.

The fifth chapter covers analysis on NSE and MCX data which gives
the information on the derivative market movement. In NSE I have
taken past 10 years data and on MCX I have taken samples of
commodities contract traded in past years for data analysis.

At last, the project concludes with findings and suggestions towards

the derivatives market.

1
RESARCH METHODOLOGY

NEED OF THE STUDY

The study has been done to know the different types of

derivatives and also to know the derivative products in India.

This study also covers the recent developments in the derivative

market taking into account the trading in past years. Through this

study I came to know the trading done in derivatives and their use

in the stock markets.

OBJECTIVES OF THE STUDY

 To understand the concept of the Derivatives and Derivative

Trading.

 To know different types of Financial Derivatives & commodity

derivatives

 To know the role of derivatives trading in India.

 To analyse the performance of Derivatives Trading since

2001with special reference to Futures & Options, commodities.

2
SCOPE OF THE PROJECT

The project covers the derivatives market, its instruments and

derivative products in Indian market. For better understanding

various strategies with different situations and actions have been

given. It includes the data collected in the recent years and also the

market in the derivatives in the recent years. This study extends to

the trading of derivatives done in the National Stock Markets and.

Method of data collection:-

Primary data:
 Discussion with broker and the investors

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

Time:
1 month

Statistical Tools Used:

Simple tools like bar graphs, tabulation, line diagrams have been
used.

3
LIMITAITONS OF STUDY

1. LIMITED TIME:
The time available to conduct the study was only 1 months. It
being a wide topic had a limited time.
2. LIMITED RESOURCES:
Limited resources are available to collect the information about
the commodity trading also in the financial derivatives market.
3. VOLATALITY:
Share market is so much volatile and it is difficult to forecast any
thing about it whether you trade through online or offline.

4
 PROFILE OF THE COMPANY

Company originally incorporated on October 18, 1995 as

Probity Research as an independent provider of information, analysis
and research covering Indian businesses, financial markets and
economy, to institutional customers. Company became a public
limited company on April 28, 2000 and the name of the Services
Private Limited at Mumbai under the Companies Act, 1956 with The
Registration No. 11 93797. Company commenced there operations
Company was changed to Probity Research and Services Limited.
The name of the Company was changed to India Infoline.com Limited
on May 23, 2000 and later to India Infoline Limited on March 23,
2001.

In 1999, company identified the potential of the Internet to

cater to a mass retail segment and transformed company’s business
model from providing information services to institutional customers
to retail customers. Hence company launched the Internet portal,
www.indiainfoline.com in May 1999 and started providing news and
market information, independent research, interviews with business
leaders and other specialized features.

In May 2000, the name of the Company was changed to India

Infoline.com Limited to reflect the transformation of their business.
Over a period of time, India infoline Ltd have emerged as one of the
leading business and financial information services provider in India.

In the year 2000, company leveraged the position as a

provider of Financial information and analysis by diversifying into
transactional services, primarily for online trading in shares and
securities and online as well as offline distribution of personal

5
financial products, like mutual funds and RBI Bonds. These activities
were carried on by company’s wholly owned subsidiaries.
India Infoline Ltd broking services was launched under the
brand name of 5paisa.com through their subsidiary, India Infoline
Securities Private Limited and www.5paisa.com, the e-broking portal,
was launched for online trading in July 2000. It combined competitive
brokerage rates and research, supported by Internet technology
besides investment advice from an experienced team of research
analysts, we also offer real time stock quotes, market news and price
charts with multiple tools for technical analysis.

Vision
The vision is to be the most respected company in the financial
services space.

India Infoline Ltd

India Infoline Ltd is listed on both the leading stock exchanges
in India, viz. the Stock Exchange, Mumbai (BSE) and the National
Stock Exchange (NSE). The India Infoline group, comprising the
holding company, India Infoline Ltd and its subsidiaries, straddles the
entire financial services space with offerings ranging from Equity
research, Equities and derivatives trading, Commodities trading,
Portfolio Management Services, Mutual Funds, Life Insurance, Fixed
deposits, Gold bonds and other small savings instruments to loan
products and Investment banking. India Infoline also owns and
manages the websites, www.indiainfoline.com and www.5paisa.com.

India Infoline Ltd, being a listed entity, is regulated by SEBI

(Securities and Exchange Board of India). It undertakes equities
research which is acknowledged by none other than Forbes as 'Best
of the Web' and '…a must read for investors in Asia'. India Infoline's
research is available not just over the internet but also on
international wire services like Bloomberg (Code: IILL), Thomson First

6
Call and Internet Securities where it is amongst the most read Indian
brokers.

Its various subsidiaries are in different lines of business and

hence are governed by different regulators. The subsidiaries of India
Infoline Ltd are:

India Infoline Securities Pvt Ltd

India Infoline Securities Pvt Ltd is a 100% subsidiary of India

Infoline Ltd, which is engaged in the businesses of Equities broking
and Portfolio Management Services. It holds memberships of both
the leading stock exchanges of India viz. the Stock Exchange,

7
Mumbai (BSE) and the National Stock Exchange (NSE). It offers
broking services in the Cash and Derivatives segments of the NSE as
well as the Cash segment of the BSE. A SEBI authorized Portfolio
Manager; it offers Portfolio Management Services to clients. These
services are offered to clients as different schemes, which are based
on differing investment strategies made to reflect the varied risk-
return preferences of clients.

India Infoline Commodities Pvt Ltd

India Infoline Commodities Pvt Ltd is a 100% subsidiary of India

Infoline Ltd, which is engaged in the business of commodities
broking. Our experience in securities broking empowered us with the
requisite skills and technologies to allow us offer commodities
broking as a contra-cyclical alternative to equities broking. We enjoy
memberships with the MCX and NCDEX, two leading Indian
commodities exchanges, and recently acquired membership of
DGCX. We have a multi-channel delivery model, making it among the
select few to online as well as offline trading facilities.

India Infoline Distribution Co Ltd (IILD)

India Infoline.com Distribution Co Ltd is a 100% subsidiary of

India Infoline Ltd and is engaged in the business of distribution of
Mutual Funds, IPOs, Fixed Deposits and other small savings products.
It is one of the largest 'vendor-independent' distribution houses and
has a wide pan-India footprint of over 232 branches coupled with a
huge number of 'feet-on-street', which helps source and service
customers across the length and breadth of India. Its unique value
proposition of free doorstep expert advice coupled with free pick-up
and delivery of cheques has been met with an enthusiastic response
from customers and fund houses alike. Our business has expanded
to include the online distribution of mutual funds, wherein users can

8
view and compare different product offerings and download
application forms which they can later submit to the product
provider. Mortgages & Loans IILD has also entered the business to
distribution of mortgages and loan products during the year 2005-
2006. The business is still in the investing phase and we plan to roll
the business out across its pan-Indian network to provide it with a
truly national scale in operations.

India Infoline Insurance Services Ltd

India Infoline Insurance Services Ltd is also a 100% subsidiary

of India Infoline Ltd and is a registered Corporate Agent with the
Insurance Regulatory and Development Authority (IRDA). It is the
largest Corporate Agent for ICICI Prudential Life Insurance Co Ltd,
which is India's largest private Life Insurance Company.

India Infoline Investment Services Ltd

India Infoline Investment Service Ltd is also a 100% subsidiary

of India Infoline Ltd. It has an NBFC licence from the Reserve Bank of
India (RBI) and offers margin-funding facility to the broking
customers.

India Infoline Insurance Brokers Ltd

India Infoline Insurance Brokers Ltd is a 100% subsidiary of

India Infoline Ltd and is a newly formed subsidiary which will carry
out the business of Insurance broking. Company have applied to
IRDA for the insurance broking licence and the clearance for the
same is

9
 INTRODUCTION TO DERIVATIVE

The origin of derivatives can be traced back to the need of

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

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

On the other hand, a merchant with an ongoing requirement of

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

10
 In 1848, the Chicago Board Of Trade, or CBOT, was established
to bring farmers and merchants together. A group of traders got
together and created the ‘to-arrive’ contract that permitted farmers
to lock into price upfront and deliver the grain later. These to-arrive
contracts proved useful as a device for hedging and speculation on
price charges. These were eventually standardized, and in 1925 the
first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities

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

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

The Forwards Contracts (Regulation) Act, 1952, regulates the

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

11
regulatory authorities for securities and commodity derivative
markets.

Derivatives are securities under the SCRA and hence the

trading of derivatives is governed by the regulatory framework under
the SCRA. The Securities Contracts (Regulation) Act, 1956 defines
“derivative” to include-
A security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract differences or any
other form of security.

TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Traded Derivatives

National Stock Exchange Bombay Stock Exchange NCDEX MCX

Index Future Index Option Stock Future Stock Option

TYPES OF DERIVATIVES

12
FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset

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

BASIC FEATURES OF FORWARD CONTRACT

 They are bilateral contracts and hence exposed to counter -

party risk.
 Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and the asset type and
quality.
 The contract price is generally not available in public domain.
 On the expiration date, the contract has to be settled by
delivery of the Asset.
 If the party wishes to reverse the contract, it has to
compulsorily go to the same counter-party, which often
results in high prices being charged.

13
 However forward contracts in certain markets have become
very standardized, as in the case of foreign exchange, thereby
reducing transaction costs and increasing transactions volume. This
process of standardization reaches its limit in the organized
futures market. Forward contracts are often confused with futures
contracts. The confusion is primarily because both serve
essentially th e same economic functions of allocating risk in
the presence of future price uncertainty. However futures are a
significant improvement over the forward contracts as they
eliminate counterparty risk and offer more liquidity.

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded

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

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

BASIC FEATURES OF FUTURE CONTRACT

14
 1. Standardization:
Futures contracts ensure their liquidity by being highly standardized,
usually by specifying:
 The underlying. This can be anything from a barrel of sweet
crude oil to a short term interest rate.
 The type of settlement, either cash settlement or physical
settlement.
 The amount and units of the underlying asset per contract.
This can be the notional amount of bonds, a fixed number of
barrels of oil, units of foreign currency, the notional amount of
the deposit over which the short term interest rate is traded,
etc.
 The currency in which the futures contract is quoted.
 The grade of the deliverable. In case of bonds, this specifies
which bonds can be delivered. In case of physical commodities,
this specifies not only the quality of the underlying goods but
also the manner and location of delivery. The delivery month.
 The last trading date.
 Other details such as the tick, the minimum permissible price
fluctuation.

2. Margin:
Although the value of a contract at time of trading should be zero, its
price constantly fluctuates. This renders the owner liable to adverse
changes in value, and creates a credit risk to the exchange, who
always acts as counterparty. To minimize this risk, the exchange
demands that contract owners post a form of collateral, commonly
known as Margin requirements are waived or reduced in some cases
for hedgers who have physical ownership of the covered commodity
or spread traders who have offsetting contracts balancing the
position.

15
Initial Margin: is paid by both buyer and seller. It represents the loss
on that contract, as determined by historical price changes, which is
not likely to be exceeded on a usual day's trading. It may be 5% or
10% of total contract price.

Mark to market Margin: Because a series of adverse price

changes may exhaust the initial margin, a further margin, usually
called variation or maintenance margin, is required by the exchange.
This is calculated by the futures contract, i.e. agreeing on a price at
the end of each day, called the "settlement" or mark-to-market price
of the contract.

To understand the original practice, consider that a futures

trader, when taking a position, deposits money with the exchange,
called a "margin". This is intended to protect the exchange against
loss. At the end of every trading day, the contract is marked to its
present market value. If the trader is on the winning side of a deal,
his contract has increased in value that day, and the exchange pays
this profit into his account. On the other hand, if he is on the losing
side, the exchange will debit his account. If he cannot pay, then the
margin is used as the collateral from which the loss is paid.

3. Settlement

Settlement is the act of consummating the contract, and can be

done in one of two ways, as specified per type of futures contract:
 Physical delivery - the amount specified of the underlying asset
of the contract is delivered by the seller of the contract to the
exchange, and by the exchange to the buyers of the contract.
In practice, it occurs only on a minority of contracts. Most are
cancelled out by purchasing a covering position - that is,
buying a contract to cancel out an earlier sale (covering a

16
 short), or selling a contract to liquidate an earlier purchase
(covering a long).
 Cash settlement - a cash payment is made based on the
underlying reference rate, such as a short term interest rate
index such as Euribor, or the closing value of a stock market
index. A futures contract might also opt to settle against an
index based on trade in a related spot market.

Expiry is the time when the final prices of the future are
determined. For many equity index and interest rate futures
contracts, this happens on the Last Thursday of certain trading
month. On this day the t+2 futures contract becomes the t forward
contract.
DISTINCTION BETWEEN FUTURES AND FORWARDS
CONTRACTS

FORWARD
FEATURE FUTURE CONTRACT
CONTRACT
Traded directly
Operational between two
Traded on the exchanges.
Mechanism parties (not traded
on the exchanges).
Contract
Differ from trade to Contracts are standardized
Specification
trade. contracts.
s
Exists. However, assumed
by the clearing corp., which
Counter- becomes the counter party
Exists.
party risk to all the trades or
unconditionally guarantees
their settlement.

17
 Low, as contracts
are tailor made
High, as contracts are
Liquidation contracts catering
standardized exchange
Profile to the needs of the
traded contracts.
needs of the
parties.
Efficient, as markets are
Not efficient, as centralized and all buyers
Price
markets are and sellers come to a
discovery
scattered. common platform to
discover the price.
Commodities, futures, Index
Currency market in
Examples Futures and Individual stock
India.
Futures in India.

OPTIONS:
A derivative transaction that gives the option holder the right
but not the obligation to buy or sell the underlying asset at a price,
called the strike price, during a period or on a specific date in
exchange for payment of a premium is known as ‘option’. Underlying
asset refers to any asset that is traded. The price at which the
underlying is traded is called the ‘strike price’.
There are two types of options i.e., CALL OPTION & PUT OPTION.

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

For example: suppose in January an investor buys a March call

option contract on infosys technologies ltd. Shares with an exercise
price of rs.1700. With this the investor obtains the right to buy 200

18
shares of infy at the rate of rs.1700 per share on a particular day in
the month of March. If on expiry to the option the price of the share
in the market in March is being quoted at higher than rs.1700, the
investor would like to exercise the call. By buying shares at rs.1700
and selling them at prevailing higher price, the investor can make a
profit. If on the hand, the price of the share is quoted at rs.1700 or
lower, the investor would not benefit by buying the share. In any
case the writer of the call option is obliged to sell the shares at
rs.1700 per share, if called upon.

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

Put and calls are almost always written on equities, although

occasionally preference shares, bonds and warrants become the
subject of options.

For Example: Suppose in January an investor buys a March put

option contract on Infosysys technologies Ltd shares with an exercise
price of Rs.1700. with this the investor obtains the right to sell 200
shares of infosys at the rate of Rs1700 per share on a particular day
in the month of March. If on expiry of the option the price of the
share in the market in March is being quoted at less than Rs.1700
the investor would like to exercise the put. By selling shares at
rs1700 and buying them at prevailing lower price, the investor can
make a profit. If on the hand, the price of the share is quoted at
Rs1700 or higher, the investor would not benefited by selling the

19
share. In any case the writer of the put option is obliged to buy the
shares at rs1700 per share, if put option is purchased.

OPTION TERMINOLOGY

Index option
This is an option having the index (both Senex and Nifty) as the
underlying asset

Stock option
Stock option is nothing but the option on individual stocks.

American options
In this the holder of the option can exercise his right at any time in
the expiry date.
European option
These are which can be exercised only on the expiration date.

Premium
This is the money which is paid buy the buyer of an option to the
seller. That means, any buyer of the option s (both call and put) has
to pay some amount of money to the exchange for the purpose of
the security. This can be paid to the seller of the option s by the
exchange.

Strike price

The price specified in the option contract at which buying or selling

will take place is known as strike price. It can be also known as
exercise price.

Expiration date

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It is the date on which the options are exercised. It is also known as
maturity date or exercise date.

Comparison of spot price and exercise price of the asset

There are mainly three terminologies used while comparing the spot
price and exercise price. Spot price is the price which is prevailing in
the market. Following are the some of the situations which gives the
clear picture about the spot and exercise price.

In-the-money

If the price of the stock in the spot market is higher than the exercise
price then the call option is said to be in-the-money. But in the case
of put option, if the spot price is less than the exercise price then it is
In-the-money contract.
At-the-money
If the spot price matches with the exercise price then both options
call as well as put are at-the money contracts.

Off-the-money
In the case of call option, if spot price is less than the exercise price
then it is called as out-of-the-money and in case of put option if spot
price is more than the exercise price then it is called as out-of the
money.

Comparison of spot and strike price

Situation Call option Put option
In-the-money Spot>Strike Spot<strike
At-the-money Spot=Strike Spot=strike
Out-of-the-money Spot<strike Spot>Strike

Intrinsic value and Time value

21
Intrinsic value refers to the amount by which it is in money if it is in-
the-money. As a result, the option out of the money has zero intrinsic
value.

Traders in future and option market

The derivatives instruments are used for various purposes. As

indicated earlier, they are primarily used for purpose of managing
the risk by those managing funds. The trading of these instruments
also allows the market participants the opportunities of making
profits either by taking risks, i.e., arbitrage. Accordingly, there are
varied types of traders who trade in the futures and options market.
The three major classes of such traders are
 Hedgers
 Speculators
 Arbitrager
Hedgers:

As already observed hedging is the prime reason which had led

to emergence of derivatives. The availability of derivatives allows
the undertaking of many activities at a substantial lower risk. So,
hedgers are an important part of the traders in the derivative
market.
Hedgers are who wish to eliminate the risk to which they are already
exposed. They may take a long position or short sell a commodity
and would therefore stand to lose should the prices move in the
adverse direction. In import and export the risk faced by the trader is
called forex risk. These types of forex risks can be hedged with
derivatives
The firm may alternatively consider hedging though buying an option
contract. But option contract involve an initial cost. If call is not
exercised the premium paid for it becomes net loss. Following is the

22
example of how the investor will hedge his position using the
derivatives market.

The basic logic is “if long in cash underlying – short future and
if short in cash under lying – long future “. Let understand this by a
small example. If you have bought 100 shares of company and wants
hedge against market movements, you should short appropriate
amount of index futures. This will reduce your overall exposure to
events affecting the whole market. In case a war breaks out, the
entire market will fall. So your loss in company A would be offset by
the gains in your short position in index future.

Some examples of where hedging strategies are useful include

reducing the equity exposure of a mutual fund by selling index
futures; investing funds raised by new schemes in index futures so
that market exposure is immediately taken and Partial liquidation of
portfolio by selling the index future instead of the actual shares
where the cost of transaction is higher.

Speculators:

If the hedgers are the people who whish to avoid the price risk
speculators are those who are willing to take such risks. These are
the people who take position in the market and assume risks to
profit from fluctuations in prices. He consumes information make
forecast about the prices and put their money in these forecasts. By
taking position they are betting that a price would go up or they are
betting that it would go down. Depending upon his perception he
may take long or short positions on futures or options or may hold
both long and short positions on futures or options or may hold both
long and short position on the derivative.

23
 In the absence of derivatives speculation activity would
become very difficult as it might require huge funds to be invested.
For example, if an investor believes that the price of a particular
stock is likely to raise substantially then he would need a very huge
amount to buy the shares, keep them and sell them when the price
rises. With derivatives, it is much easier to do so because derivatives
are highly levered instruments.

The speculators in the derivatives market may either be day

traders or position traders. The daily traders speculate on the price
movements in the trading day and they do not carry position at the
end of the day. Whereas, the position traders keep their position for
a longer duration may be for few days or weeks. They go by the
fundamental analysis.

Arbitrageurs:

Arbitrageurs thrive on market imperfections. According to ecai

of India, defined the word arbitrage as follows:
“Simultaneously purchase of securities in one market where the
price there of is low and sale there of in another market, where the
price there of is comparatively higher. These are done when the
same securities are being quoted at different prices in the two
markets, with a view to make a profit and carried on with the
conceived intension to derive advantage from difference in prices of
securities prevailing in the two markets.”

Thus, arbitrage involves making risk less profit by

simultaneously entering into transactions in two or more markets.

SWAPS

24
 Swaps are transactions which obligates the two parties to the
contract to exchange a series of cash flows at specified intervals
known as payment or settlement dates. They can be regarded as
portfolios of forward's contracts. A contract whereby two parties
agree to exchange (swap) payments, based on some notional
principle amount is called as a ‘SWAP’. In case of swap, only the
payment flows are exchanged and not the principle amount. The two
commonly used swaps are:

INTEREST RATE SWAPS:

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

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle

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

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a

borrower to access one market and then exchange the liability for
another type of liability. It also allows the investors to exchange one

25
type of asset for another type of asset with a preferred income
stream.

OTHER KINDS OF DERIVATIVES

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

BASKETS:

Baskets options are option on portfolio of underlying asset.

Equity Index Options are most popular form of baskets.

LEAPS:

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

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

WARRANTS:

Options generally have lives of up to one year; the majority of

options traded on options exchanges having a maximum maturity of
nine months. Longer-dated options are called warrants and are
generally traded over-the-counter.

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

26
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.

HISTORY OF DERIVATIVES

The history of derivatives is quite colourful and surprisingly a

lot longer than most people think. Forward delivery contracts, stating
what is to be delivered for a fixed price at a specified place on a
specified date, existed in ancient Greece and Rome. Roman
emperors entered forward contracts to provide the masses with their
supply of Egyptian grain. These contracts were also undertaken
between farmers and merchants to eliminate risk arising out of
uncertain future prices of grains. Thus, forward contracts have
existed for centuries for hedging price risk.

27
 The first organized commodity exchange came into existence
in the early 1700’s in Japan. The first formal commodities exchange,
the Chicago Board of Trade (CBOT), was formed in 1848 in the US to
deal with the problem of ‘credit risk’ and to provide centralised
location to negotiate forward contracts. From ‘forward’ trading in
commodities emerged the commodity ‘futures’. The first type of
futures contract was called ‘to arrive at’. Trading in futures began on
the CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange
traded’ derivatives contract, known as the futures contracts. Futures
trading grew out of the need for hedging the price risk involved in
many commercial operations.

The Chicago Mercantile Exchange (CME), a spin-off of CBOT,

was formed in 1919, though it did exist before in 1874 under the
names of ‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and
Butter Board’ (CEBB). The first financial futures to emerge were the
currency in 1972 in the US. The first foreign currency futures were
traded on May 16, 1972, on International Monetary Market (IMM), a
division of CME. The currency futures traded on the IMM are the
British Pound, the Canadian Dollar, the Japanese Yen, the Swiss
Franc, the German Mark, the Australian Dollar, and the Euro dollar.
Currency futures were followed soon by interest rate futures. Interest
rate futures contracts were traded for the first time on the CBOT on
October 20, 1975. Stock index futures and options emerged in 1982.
The first stock index futures contracts were traded on Kansas City
Board of Trade on February 24, 1982.The first of the several
networks, which offered a trading link between two exchanges, was
formed between the Singapore International Monetary Exchange
(SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to

ancient Greece and Rome. Options are very popular with speculators
in the tulip craze of seventeenth century Holland. Tulips, the brightly

28
coloured flowers, were a symbol of affluence; owing to a high
demand, tulip bulb prices shot up. Dutch growers and dealers traded
in tulip bulb options. There was so much speculation that people
even mortgaged their homes and businesses. These speculators
were wiped out when the tulip craze collapsed in 1637 as there was
no mechanism to guarantee the performance of the option terms.

The first call and put options were invented by an American

financier, Russell Sage, in 1872. These options were traded over the
counter. Agricultural commodities options were traded in the
nineteenth century in England and the US. Options on shares were
available in the US on the over the counter (OTC) market only until
1973 without much knowledge of valuation. A group of firms known
as Put and Call brokers and Dealer’s Association was set up in early
1900’s to provide a mechanism for bringing buyers and sellers
together.

On April 26, 1973, the Chicago Board options Exchange (CBOE)

was set up at CBOT for the purpose of trading stock options. It was in
1973 again that black, Merton, and Scholes invented the famous
Black-Scholes Option Formula. This model helped in assessing the
fair price of an option which led to an increased interest in trading of
options. With the options markets becoming increasingly popular,
the American Stock Exchange (AMEX) and the Philadelphia Stock
Exchange (PHLX) began trading in options in 1975.

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

29
 The CBOT and the CME are two largest financial exchanges in
the world on which futures contracts are traded. The CBOT now
offers 48 futures and option contracts (with the annual volume at
more than 211 million in 2001).The CBOE is the largest exchange for
trading stock options. The CBOE trades options on the S&P 100 and
the S&P 500 stock indices. The Philadelphia Stock Exchange is the
premier exchange for trading foreign options.

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

INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards

a world where prices fluctuate every day. The introduction of risk
management instruments in India gained momentum in the last few
years due to liberalisation process and Reserve Bank of India’s (RBI)
efforts in creating currency forward market. Derivatives are an
integral part of liberalisation process to manage risk. NSE gauging
the market requirements initiated the process of setting up
derivative markets in India. In July 1999, derivatives trading
commenced in India

30
 Chronology of instruments
1991 Liberalisation process initiated
14 December NSE asked SEBI for permission to trade index
1995 futures.
18 November SEBI setup L.C.Gupta Committee to draft a policy
1996 framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate
agreements (FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options
on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index
futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September Nifty futures trading commenced at SGX.
2000
2 June 2001 Individual Stock Options & Derivatives

Need for derivatives in India today

In less than three decades of their coming into vogue,

derivatives markets have become the most important markets in the
world. Today, derivatives have become part and parcel of the day-to-
day life for ordinary people in major part of the world. Until the
advent of NSE, the Indian capital market had no access to the latest
trading methods and was using traditional out-dated methods of
trading. There was a huge gap between the investors’ aspirations of
the markets and the available means of trading. The opening of
Indian economy has precipitated the process of integration of India’s
financial markets with the international financial markets.
Introduction of risk management instruments in India has gained
momentum in last few years thanks to Reserve Bank of India’s

31
efforts in allowing forward contracts, cross currency options etc.
which have developed into a very large market.

Myths and realities about derivatives

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

(I) Derivatives increase speculation and do not serve any economic

purpose:
Numerous studies of derivatives activity have led to a broad
consensus, both in the private and public sectors that derivatives
provide numerous and substantial benefits to the users. Derivatives
are a low-cost, effective method for users to hedge and manage their

32
exposures to interest rates, commodity prices or exchange rates.
The need for derivatives as hedging tool was felt first in the
commodities market. Agricultural futures and options helped farmers
and processors hedge against commodity price risk. After the fallout
of Bretton wood agreement, the financial markets in the world
started undergoing radical changes. This period is marked by
remarkable innovations in the financial markets such as introduction
of floating rates for the currencies, increased trading in variety of
derivatives instruments, on-line trading in the capital markets, etc.
As the complexity of instruments increased many folds, the
accompanying risk factors grew in gigantic proportions. This
situation led to development derivatives as effective risk
management tools for the market participants.

Looking at the equity market, derivatives allow corporations

and institutional investors to effectively manage their portfolios of
assets and liabilities through instruments like stock index futures and
options. An equity fund, for example, can reduce its exposure to the
stock market quickly and at a relatively low cost without selling off
part of its equity assets by using stock index futures or index
options.
By providing investors and issuers with a wider array of tools for
managing risks and raising capital, derivatives improve the allocation
of credit and the sharing of risk in the global economy, lowering the
cost of capital formation and stimulating economic growth. Now that
world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between
global markets, increasing market liquidity and efficiency and
facilitating the flow of trade and finance
(ii) Indian Market is not ready for derivative trading
Often the argument put forth against derivatives trading is that the
Indian capital market is not ready for derivatives trading. Here, we

33
look into the pre-requisites, which are needed for the introduction of
derivatives and how Indian market fares:
PRE-REQUISITES INDIAN SCENARIO
Large market India is one of the largest market-capitalised
Capitalisation countries in Asia with a market capitalisation of
more than Rs.765000 crores.

High Liquidity in The daily average traded volume in Indian capital

the underlying market today is around 7500 crores. Which
means on an average every month 14% of the
country’s Market capitalisation gets traded. These
are clear indicators of high liquidity in the
underlying.

Trade guarantee The first clearing corporation guaranteeing trades

has become fully functional from July 1996 in the
form of National Securities Clearing Corporation
(NSCCL). NSCCL is responsible for guaranteeing
all open positions on the National Stock Exchange
(NSE) for which it does the clearing.

A Strong National Securities Depositories Limited (NSDL)

Depository which started functioning in the year 1997 has
revolutionaries the security settlement in our
country.

A Good legal In the Institution of SEBI (Securities and Exchange

guardian Board of India) today the Indian capital market
enjoys a strong, independent, and innovative
legal guardian who is helping the market to
evolve to a healthier place for trade practices.

Comparison of New System with Existing System:

34
 Many people and brokers in India think that the new system of
Futures & Options and banning of Badla is disadvantageous and
introduced early, but I feel that this new system is very useful
especially to retail investors. It increases the no of options investors
for investment. In fact it should have been introduced much before
and NSE had approved it but was not active because of politicization
in SEBI.
The figure shows how advantages of new system (implemented from
June 20001) v/s the old system i.e. before June 2001
New System Vs Existing System for Market Players
Speculators

Existing system New system

Approach Peril & Prize

Approach Peril & Prize
1. Buy and sell stocks Maximum
1. Delivery based Both profit
on delivery basis loss to the
trading & carry &loss to the
2. Buy call & put extent
forward transaction extent of
option by paying premium paid
2. Index futures can be price change
premium
hold till expiry
Advantages:
 Greater Leverage as to pay only the premium.
 Greater variety of strike price options at a given time.

Arbitrageurs

Existing system New system

Approach Peril & Prize Approach Peril

1. Buying &Prize
stock in one Make money 1. B group more Risk free
and selling whichever promising as game
in another way the still in weekly
exchange market settlement
2. If future moves 2. Cash & carry
contract arbitrage 35
more or less continues
than fair
price
 Fair Price = Cash Price + Cost of Carry.

Hedgers

Existing system New system

Approach Peril & Prize Approach Peril &

1. Fix price to buy Prize
Difficult to offload No leverage by paying
holding adverse available to premium Additional
market conditions risk reward 2. For long, buy Cost is only
as circuit filters dependent on ATM put option. If Premium
limit to crucial loss market price market goes up,
long position
benefit else
exercise the
option
3. Sell deep OTM
call option with
Small Investors
underlying share

Existing system New system

Approach Peril & prize Approach Peril & prize

1. If bullish buy 1. Plane buy or 1 buy call or put 1. Down side
Stocks else sell implies option based on remains
sell it unlimited market out look protected &
profit or loss 2Hedge position up side un
if holding limited
underlying stock

Advantages:
 Losses Protected.

36
 FACTORS CONTRIBUTING TO THE GROWTH OF
DERIVATIVES:

Factors contributing to the explosive growth of derivatives are

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

A) PRICE VOLATILITY:

A price is what one pays to acquire or use something of value.

The objects having value may be commodities, local currency or
foreign currencies. The concept of price is clear to almost everybody
when we discuss commodities. There is a price to be paid for the
purchase of food grain, oil, petrol, metal, etc. the price one pays for
use of a unit of another persons money is called interest rate. And
the price one pays in one’s own currency for a unit of another
currency is called as an exchange rate.

Prices are generally determined by market forces. In a market,

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

The changes in demand and supply influencing factors

culminate in market adjustments through price changes. These price
changes expose individuals, producing firms and governments to
significant risks. The break down of the BRETTON WOODS agreement
brought an end to the stabilising role of fixed exchange rates and the
gold convertibility of the dollars. The globalisation of the markets

37
and rapid industrialisation of many underdeveloped countries
brought a new scale and dimension to the markets. Nations that
were poor suddenly became a major source of supply of goods. The
Mexican crisis in the south east-Asian currency crisis of 1990’s has
also brought the price volatility factor on the surface. The advent of
telecommunication and data processing bought information very
quickly to the markets. Information which would have taken months
to impact the market earlier can now be obtained in matter of
moments.

Even equity holders are exposed to price risk of corporate

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

B) GLOBALISATION OF MARKETS:

Earlier, managers had to deal with domestic economic

concerns; what happened in other part of the world was mostly
irrelevant. Now globalisation has increased the size of markets and
as greatly enhanced competition .it has benefited consumers who
cannot obtain better quality goods at a lower cost. It has also
exposed the modern business to significant risks and, in many cases,
led to cut profit margins
In Indian context, south East Asian currencies crisis of 1997
had affected the competitiveness of our products vis-à-vis
depreciated currencies. Export of certain goods from India declined
because of this crisis. Steel industry in 1998 suffered its worst set
back due to cheap import of steel from south East Asian countries.
Suddenly blue chip companies had turned in to red. The fear of china
devaluing its currency created instability in Indian exports. Thus, it is
evident that globalisation of industrial and financial activities

38
necessitates use of derivatives to guard against future losses. This
factor alone has contributed to the growth of derivatives to a
significant extent.

C) TECHNOLOGICAL ADVANCES:

A significant growth of derivative instruments has been driven

by technological breakthrough. Advances in this area include the
development of high speed processors, network systems and
enhanced method of data entry. Closely related to advances in
computer technology are advances in telecommunications.
Improvement in communications allow for instantaneous worldwide
conferencing, Data transmission by satellite. At the same time there
were significant advances in software programmes without which
computer and telecommunication advances would be meaningless.
These facilitated the more rapid movement of information and
consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the

economy as a whole resources are rapidly relocated to more
productive use and better rationed overtime the greater price
volatility exposes producers and consumers to greater price risk. The
effect of this risk can easily destroy a business which is otherwise
well managed. Derivatives can help a firm manage the price risk
inherent in a market economy. To the extent the technological
developments increase volatility, derivatives and risk management
products become that much more important.

D) ADVANCES IN FINANCIAL THEORIES:

Advances in financial theories gave birth to derivatives. Initially

forward contracts in its traditional form, was the only hedging tool
available. Option pricing models developed by Black and Scholes in

39
1973 were used to determine prices of call and put options. In late
1970’s work of Lewis Eddington extended the early work of Johnson
and started the hedging of financial price risks with financial futures.
The work of economic theorists gave rise to new products for risk
management which led to the growth of derivatives in financial
markets.
The above factors in combination of lot many factors led to growth of
derivatives instruments

BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1] RISK MANAGEMENT:

Futures and options contract can be used for altering the risk
of investing in spot market. For instance, consider an investor who
owns an asset. He will always be worried that the price may fall
before he can sell the asset. He can protect himself by selling a
futures contract, or by buying a Put option. If the spot price falls, the
short hedgers will gain in the futures market, as you will see later.
This will help offset their losses in the spot market. Similarly, if the
spot price falls below the exercise price, the put option can always
be exercised.
2] PRICE DISCOVERY:

Price discovery refers to the markets ability to determine true

equilibrium prices. Futures prices are believed to contain information
about future spot prices and help in disseminating such information.
As we have seen, futures markets provide a low cost trading
mechanism. Thus information pertaining to supply and demand
easily percolates into such markets. Accurate prices are essential for
ensuring the correct allocation of resources in a free market

40
economy. Options markets provide information about the volatility or
risk of the underlying asset.

3] OPERATIONAL ADVANTAGES:

As opposed to spot markets, derivatives markets involve lower

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

4] MARKET EFFICIENCY:

The availability of derivatives makes markets more efficient;

spot, futures and options markets are inextricably linked. Since it is
easier and cheaper to trade in derivatives, it is possible to exploit
arbitrage opportunities quickly and to keep prices in alignment.
Hence these markets help to ensure that prices reflect true values.

5] EASE OF SPECULATION:

Derivative markets provide speculators with a cheaper

alternative to engaging in spot transactions. Also, the amount of
capital required to take a comparable position is less in this case.
This is important because facilitation of speculation is critical for
ensuring free and fair markets. Speculators always take calculated
risks. A speculator will accept a level of risk only if he is convinced

41
that the associated expected return is commensurate with the risk
that he is taking.
The derivative market performs a number of economic functions.
 The prices of derivatives converge with the prices of the
underlying at the expiration of derivative contract. Thus
derivatives help in discovery of future as well as current prices.
 An important incidental benefit that flows from derivatives
trading is that it acts as a catalyst for new entrepreneurial
activity.
 Derivatives markets help increase savings and investment in
the long run. Transfer of risk enables market participants to
expand their volume of activity.

Grounds on which derivative instruments have been

criticized:

Despite the advantages of derivative instruments, some

industry experts have raised doubts over their rapid growth and
have criticized them on the following grounds.

1) Speculative and gambling motives:

One of the strongest arguments against derivatives is
that they promote speculative activities in the market. The
world over, the volume of derivative trading has increased in
multiples of the value of the underlying assets while a mere
one or two percent of the transactions are settled by actual
delivery. The rest of the trading is done with speculative and
gambling motives.
2) Increase in risk:
Derivatives are supposed to be a risk management
instrument. However, it has been argued that it is not the
complete truth. Derivative instruments that are traded off-

42
 exchange or the OTC market carry more risk factor. They
expose the trading parties to operational risk, counter-party
risk and legal risk.

3) Instability of the financial system:

It has been argued that derivatives have increased the
risk factor not only for the trading parties but also the entire
financial system. The rapid growth in the trading volumes of
derivative instruments has given rise to the fear of micro and
macro financial crisis. The speculative and gambling motives of
the market participants have made the financial system
unstable.

4) Price instability:
It has been said that derivative instruments help in
balancing price fluctuations, reduce the price spread, integrate
the price structure with respect to time and remove shortages
in the markets. However, the critics have doubt about this.
They argue that derivatives have caused price fluctuations and
increased the price spread thereby resulting in price instability.

5) Displacement effect:
Another doubt over their rapid growth of the derivative
market is that it will affect the business volumes in the primary
market or the new issue market. When majority of the
investors move toward the derivatives market raising fresh
capital in the primary market will be difficult. This will give rise
to the phenomenon called displacement effect.

6) Increased regulatory burden:

As already pointed out, derivatives have increased the
risk factor which has made the financial system unstable. The
speculative and gambling motives of the market participants

43
 have increased the burden on the government and the
regulatory authorities to exercise control, supervision and
monitoring of the market movements so that frauds, scams
and situations of crisis can be avoided.

Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp

growth over the last few years, which have accompanied the
modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in
information technology have contributed to a great extent to these

44
developments. While both exchange-traded and OTC derivative
contracts offer many benefits, the former have rigid structures
compared to the latter. It has been widely discussed that the highly
leveraged institutions and their OTC derivative positions were the
main cause of turbulence in financial markets in 1998. These
episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared

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

Some of the features of OTC derivatives markets embody risks to

financial market stability.

The following features of OTC derivatives markets can give rise to

instability in institutions, markets, and the international financial
system: (I) the dynamic nature of gross credit exposures; (ii)
information asymmetries; (iii) the effects of OTC derivative activities
on available aggregate credit; (iv) the high concentration of OTC
derivative activities in major institutions; and (v) the central role of
OTC derivatives markets in the global financial system. Instability

45
arises when shocks, such as counter-party credit events and sharp
movements in asset prices that underlie derivative contracts, occurs
which significantly alter the perceptions of current and potential
future credit exposures. When asset prices change rapidly, the size
and configuration of counter-party exposures can become
unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and

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

FINANCIAL DERIVATIVES MARKET IN INDIA

In today's date, both in terms of trading volumes and sales

turnover, the National Stock Exchange of India (NSE) is the largest
derivatives exchange in India. The average sales turnover for a day
at the NSE currently crosses Rs 50,000 crores. The derivatives
trading on the National Stock Exchange (NSE) started with S&P CNX

46
NIFTY index futures on June 12, in the year 2000. S&P CNX NIFTY is
the benchmark index of the National Stock Exchange. The trading in
index options at the NSE started on June 4, in the year 2001 and
trading in options on individual stocks started on July 2, the same
year. Individual securities future contracts were launched on
November 9, that year. As to the present date, the derivative
contracts at the National Stock Exchange have a maximum of 3 –
month expiration cycle. At any given point of time, three derivative
contracts are available for trading with respect to the expiration
cycle. They are of 1 – month, 2 – month and 3 – month time period
for expiry. A new contract is introduced on the next trading day
which is Friday. The near month contract expires on Thursday.

NATIONAL STOCK EXCHANGE OF INDIA

Since its inception in 1992, National Stock Exchange of India

has been at the vanguard of change in the Indian securities market.
This period has seen remarkable changes in markets, from how
capital is raised and traded, to how transactions are cleared and
settled.

The market has grown in scope and scale in a way that could
not have been imagined at the time. Average daily trading volumes
have jumped from Rs. 17 crore in 1994-95 when NSE started its Cash
Market segment to Rs.11, 325 crore in 2008-09. Similarly, market
capitalization of listed Indian firms went up from Rs.363, 350 crore at
the end of March 1995 to Rs.2, 896, 194 crore at end March 2009.
Indian equity markets are today among the most deep and vibrant
markets in the world.

This transformation was the result of a number of initiatives

led by the Government, market regulators and infrastructure
providers like exchanges and depositories. NSE’s efforts in this area

47
have included the creation of the first clearing corporation in the
country in the form of the National Securities Clearing Corporation
Limited (NSCCL). NSCCL today provides central counterparty services
and manages settlement risk for multiple products, and is a major
factor in the confidence market participants have in the ability of
Indian markets to handle extreme shocks without causing any
defaults.
NSCCL is also the first clearing corporation in the country to receive.

NSE has many other firsts to its name, including the first
systematic process of member inspections, a sophisticated market
surveillance system, and a country wide high capacity data network
supporting close to 200,000 dealer terminals.

The year 2008-09 was an eventful year for NSE, as it saw the
launch of new and important products for the securities market.
Introduction of Mini Nifty Futures and Options contracts on S&P CNX
Nifty during the year has given retail investors an increased ability to
participate in index futures and options trading. NSE also started
publishing the first volatility index in the country India VIX*. Market
participants now have an important tool to assess volatility and
create trading strategies to exploit volatility movements. In May
2008, NSE developed a new trading application, NOW, or ‘NEAT on
Web’. The NOW platform allows trading members to connect to the
exchange through the internet, and has resulted in a significant
reduction in both the access cost and turnaround time for providing
access. This year also saw a watershed in the Indian currency market
in the form of a currency futures contract. NSE was the first stock
exchange in the country to launch the contract on August 29, 2008
in USDINR pair. The contract was an instant success, and currently
has daily trading volumes in excess of Rs. 2,000 crore and open
interest in excess of Rs. 1,000 crore. Other significant developments
include Long term Options Contracts on S&P CNX Nifty, Short selling

48
and Securities Lending and Borrowing Scheme, Direct Market Access
(DMA), Futures and Options contracts on S&P CNXDefty index and
the NSE E-Bids for Debt Segment. Further NSE also ventured into a
new segment by promoting a Power Exchange (Power Exchange
India Ltd -PXIL) along with NCDEX.

Today, NSE offers a wide range of products for multiple markets,

including equity shares, Exchange Traded Funds (ETF), Mutual Funds,
Debt instruments, Index futures and Options, Stock Futures and
Options and Currency futures. Our Exchange has more than 1,400
companies listed in the Capital Market and more than 95% of these
companies are actively traded. The debt market has more than
3,954 securities available for trading. Index futures and options trade
on seven different indices and on more than 230 stocks in stock
futures and options. In currency futures contracts are currently
traded in the USDINR pair. Globally, NSE is ranked first in single stock
futures in terms of number of contracts traded, and third in stock
index futures and stock index options. We also rank third in terms of
number of equity shares traded and are the eighth largest
derivatives exchange in the world.

Market Segments and Products

NSE provides a trading platform for of all types of securities for

investors under one roof – Equity, Corporate Debt, Central and State
Government Securities, T-Bills, Commercial Paper (CPs), Certificate
of Deposits (CDs), Warrants, Mutual Funds (MFs) units, Exchange
Traded Funds (ETFs), Derivatives like Index Futures, Index Options,
Stock Futures, Stock Options and Currency Futures. The Exchange
provides trading in 4 different segments viz., Wholesale Debt Market
(WDM) segment, Capital Market (CM) segment, Futures & Options

49
(F&O) segment and the Currency Derivatives Segment (trading on
which commenced on August 29, 2008).

Futures & Options: (F&O) segment of NSE provides trading in

derivatives instruments like Index Futures, Index Options, Stock
Options, and Stock Futures. The futures and options segment of NSE
has made a mark for itself globally. In the Futures and Options
segment, trading in S&P CNX Nifty Index, CNX IT index, Bank Nifty
Index, CNXNifty Junior, CNX 100 index, Nifty Midcap 50 index, S&P
CNX Defty and single stocks are available. The average daily
turnover in the F&O Segment of the Exchange during 2008-09 was
Rs.45, 311 crore (US $ 8,893 million).

Currency Derivatives Segment: (CDS) at NSE commenced

operations on August 29, 2008, with the launch of Currency futures
trading in US Dollar-Indian Rupee (USDINR). On the very first day of
operations a total number of 65,798 contracts valued atRs.291 crore
were traded on the Exchange.

Since then trading activity in this segment has been witnessing

a rapid growth. During August 29, 2008 to March 31, 2009 the
segment reported a trading value of Rs.162, 272 crore (US $ 31,849
million). A total number of 518 trading members which includes 22
banks have taken membership in this market segment as at end
March 2009.

Trading Value
(Rs.crore)
Segment/ye 2005-06 2006-07 2007-08 2008-09

50
ar
Capital Market 1569558 1945287 3551038 275203
Future& 4824250 7356271 13090478 11010482
Option
CDS* 162272
WDM 475523 219106 282317 33592
Total 6869332 9520664 16923833 14260729
*CDS-Currency Derivatives Segment

Futures & Options Segment

In the year 2008, NSE ranked as the eighth largest derivatives

exchange in the world, the second largest exchange in terms of
number of contracts traded in single stock futures and the third
largest in terms number of contracts traded in the index futures
category. The derivatives trading at NSE commenced on June 12,
2000 with futures trading on S&P CNX Nifty Index. Subsequently, the
product base has been increased to include trading in options on
S&P CNX Nifty Index, futures and options on CNX IT Index, Bank Nifty
Index, CNX Nifty Junior, CNX 100, Nifty Midcap 50 Indices, S&P CNX
Defty and 234 single stocks (Table 6-1) as of March 2009. The
various products on the derivative segment of NSE and their date of
launch is shown in the table below.

51
Products available for trading on derivatives segment
Products on derivatives segment Date of Lunch
S&P CNX Nifty Future June12,2000
S&P CNX Nifty Option June 4,2001
Single Stock Option July 2, 2001
Single Stock Future November 9,2001
Interest Rate Future June 24,2003
CNX IT Futures & Option August29,2003
Bank nifty Future & Option June 13,2005
CNX Nifty Junior Future &Option June 01,2007
CNX 100 Future & Option June 01,2007
Nifty Midcap 50 Futures & Option October 05,2007
Mini Nifty Futures & Option on S&P CNX January 01,2008
Nifty
Long term Options on S&P CNX Nifty March 03,2008
S&P CNX Defty Futures &Options December10,2008

DERIVATIVES PRODUCTS TRADED IN DERIVATIVES SEGMENT

OF BSE

The BSE created history on June 9, 2000 when it launched

trading in Sensex based futures contract for the first time. It was
followed by trading in index options on June 1, 2001; in stock options
and single stock futures (31 stocks) on July 9, 2001 and November 9,
2002, respectively. Currently, the number of stocks under single
futures and options is 1096. BSE achieved another milestone on
September 13, 2004 when it launched Weekly Options, a unique
product unparalleled worldwide in the derivatives markets. It
permitted trading in the stocks of four leading companies namely;
Satyam, State Bank of India, Reliance Industries and TISCO (renamed
now Tata Steel). Chhota (mini) SENSEX7 was launched on January 1,
2008. With a small or 'mini' market lot of 5, it allows for
comparatively lower capital outlay, lower trading costs, more precise
hedging and flexible trading. Currency futures were introduced on
October 1, 2008 to enable participants to hedge their currency risks
through trading in the U.S. dollar-rupee future platforms. Table 2

52
summarily specifies the derivative products and their date of
introduction on the BSE

Products Traded in Derivatives Segment of the BSE

Product Traded with underlying Introduction Date

asset
Index Futures- Sensex June 9,2000
Index Options- Sensex June 1,2001

Stock Option on 109 Stocks 3 July 9, 2001

Stock futures on 109 Stocks November 9,2002
5Weekly Option on 4 Stocks September 13,2004

Chhota (mini) SENSE January 1, 2008

Futures & Options on Sectoral indices N.A
namely BSE TECK, BSE FMCG, BSE
Metal, BSE
Bankex and BSE Oil & Gas.

8 Currency Futures on US Dollar Rupee October 1,2008

CURRENCY DERIVATIVES

The Reserve Bank of India in its Annual Policy Statement for

the Year 2007-08 proposed to set up a Working Group on Currency
Futures to study the international experience and suggest a suitable
framework to operationalise the proposal, in line with the current
legal and regulatory framework. This Group submitted its report in
April, 2008. Following this, RBI and Securities and Exchange Board of
India (SEBI) jointly constituted a Standing Technical Committee to
inter-alia evolve norms and oversee implementation of Exchange

53
Traded Currency Derivatives. The Committee submitted its report on
May 29, 2008. This report laid down the framework for the launch of
Exchange Traded Currency Futures in terms of the eligibility norms
for existing and new Exchanges and their Clearing
Corporations/Houses, eligibility criteria for members of such
Exchanges/Clearing Corporations/Houses, product design, risk
management measures, surveillance mechanism and other related
issues.

The Regulatory framework for currency futures trading in the

country, as laid down by the regulators, provide that persons
resident in India are permitted to participate in the currency futures
market in India subject to directions contained in the Currency
Futures (Reserve Bank) Directions, 2008, which have come into force
with effect from August 6, 2008.

The membership of the currency futures market of a

recognised stock exchange has been mandated to be separate from
the membership of the equity derivative segment or the cash
segment. Banks authorized by the Reserve Bank of India under
section 10 of the Foreign Exchange Management Act, 1999 as ‘AD
Category - I bank’ are permitted to become trading and clearing
members of the currency futures market of the recognized stock
exchanges, on their own account and on behalf of their clients,
subject to fulfilling certain minimum prudential requirements
pertaining to net worth, non-performing assets etc.

NSE was the first exchange to have received an in-principle

approval from SEBI for setting up currency derivative segment.
National Stock Exchange was the first exchange to launch Currency
futures trading in India. The Currency Derivatives segment at NSE
commenced operations on August 29, 2008 with the launch of
currency futures trading in US Dollar-India Rupee (USD-INR).

54
Trading in Currency Futures segment commenced on August 29,
2008. On the very first day of operations a total number of 65,798
contracts valued at Rs.291 crore were traded on the Exchange. Since
then trading activity in this segment has been witnessing a rapid
growth. The total traded volume from August 2008 till March 2009
was Rs.162, 272 crore (US $ 31,849 million). Total numbers of
contracts traded during the August 2008 to March 2009 were
32,672,768. The business growth of Currency Futures Segment is
shown

Source: NSE Fact book 2008-09

COMMODITY DERIVATIVES IN INDIA

The Indian economy is witnessing a mini revolution in

commodity derivatives and risk management. Commodity options
trading and cash settlement of commodity futures had been banned
since 1952 and until 2002 commodity derivatives market was
virtually non-existent, except some negligible activity on an OTC
basis. Now in September 2005, the country has 3 national level

55
electronic exchanges and 21 regional exchanges for trading
commodity derivatives. As many as eighty (80) commodities have
been allowed for derivatives trading. The value of trading has been
booming and is likely to cross the $ 1 Trillion mark in 2006 and, if all
goes well, seems to be set to touch $5 Trillion in a few years.

Requirement of commodity derivatives

India is among the top-5 producers of most of the

commodities, in addition to being a major consumer of bullion and
energy products. Agriculture contributes about 22% to the GDP of
the Indian economy. It employees around 57% of the labour force on
a total of 163 million hectares of land. Agriculture sector is an
important factor in achieving a GDP growth of 8-10%. All this
indicates that India can be promoted as a major centre for trading of
commodity derivatives.

It is unfortunate that the policies of FMC during the most of

1950s to 1980s suppressed the very markets it was supposed to
encourage and nurture to grow with times. It was a mistake other
emerging economies of the world would want to avoid. However, it is
not in India alone that derivatives were suspected of creating too
much speculation that would be to the detriment of the healthy
growth of the markets and the farmers. Such suspicions might
normally arise due to a misunderstanding of the characteristics and
role of derivative product.

It is important to understand why commodity derivatives are

required and the role they can play in risk management. It is
common knowledge that prices of commodities, metals, shares and
currencies fluctuate over time. The possibility of adverse price
changes in future creates risk for businesses. Derivatives are used to
reduce or eliminate price risk arising from unforeseen price changes.

56
A derivative is a financial contract whose price depends on, or is
derived from, the price of another asset.

Two important derivatives are futures and options.

(1) Commodity Futures Contracts: A futures contract is an

agreement for buying or selling a commodity for a predetermined
delivery price at a specific future time. Futures are standardized
contracts that are traded on organized futures exchanges that
ensure performance of the contracts and thus remove the default
risk. The commodity futures have existed since the Chicago Board of
Trade (CBOT, www.cbot.com) was established in 1848 to bring
farmers and merchants together. The major function of futures
markets is to transfer price risk from hedgers to speculators. For
example, suppose a farmer is expecting his crop of wheat to be
ready in two months time, but is worried that the price
Of wheat may decline in this period. In order to minimize his risk, he
can enter into a futures contract to sell his crop in two months’ time
at a price determined now. This way he is able to hedge his risk
arising from a possible adverse change in the price of his
commodity.

(2) Commodity Options contracts: Like futures, options are also

financial instruments used for hedging and speculation. The
commodity option holder has the right, but not the obligation, to buy
(or sell) a specific quantity of a commodity at a specified price on or
before a specified date. Option contracts involve two parties – the
seller of the option writes the option in favour of the buyer (holder)
who pays a certain premium to the seller as a price for the option.
There are two types of commodity options: a ‘call’ option gives the
holder a right to buy a commodity at an agreed price, while a ‘put’
option gives the holder a right to sell a commodity at an agreed price
on or before a specified date (called expiry date).

57
 The option holder will exercise the option only if it is beneficial
to him; otherwise he will let the option lapse. For example, suppose a
farmer buys a put option to sell 100 Quintals of wheat at a price of
$25 per quintal and pays a ‘premium’ of $0.5 per quintal (or a total
of $50). If the price of wheat declines to say $20 before expiry, the
farmer will exercise his option and sell his wheat at the agreed price
of $25 per quintal. However, if the market price of wheat increases
to say $30 per quintal, it would be advantageous for the farmer to
sell it directly in the open market at the spot price, rather than
exercise his option to sell at $25 per quintal.

Futures and options trading therefore helps in hedging the

price risk and also provide investment opportunity to speculators
who are willing to assume risk for a possible return. Further, futures
trading and the ensuing discovery of price can help farmers in
deciding which crops to grow. They can also help in building a
competitive edge and enable businesses to smoothen their earnings
because non hedging of the risk would increase the volatility of their
quarterly earnings. Thus futures and options markets perform
important functions that can not be ignored in modern business
environment. At the same time, it is true that too much speculative
activity in essential commodities would destabilize the markets and
therefore, these markets are normally regulated as per the laws of
the country.

History of Indian commodity derivatives market

The history of organized commodity derivatives in India goes

back to the nineteenth century when the Cotton Trade Association
started futures trading in 1875, barely about a decade after the
commodity derivatives started in Chicago. Over time the derivatives
market developed in several other commodities in India. Following

58
cotton, derivatives trading started in oilseeds in Bombay (1900), raw
jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in
Bullion in Bombay (1920). However, many feared that derivatives
fuelled unnecessary speculation in essential commodities, and were
detrimental to the healthy functioning of the markets for the
underlying commodities, and hence to the farmers. With a view to
restricting speculative activity in cotton market, the Government of
Bombay prohibited options business in cotton in 1939. Later in 1943,
forward trading was prohibited in oilseeds and some other
commodities including food-grains, spices, vegetable oils, sugar and
cloth. After Independence, the Parliament passed Forward Contracts
(Regulation) Act, 1952 which regulated forward contracts in
commodities all over India. The Act applies to goods, which are
defined as any movable property other than security, currency and
actionable claims.

The Act prohibited options trading in goods along with cash

settlements of forward trades, rendering a crushing blow to the
commodity derivatives market. Under the Act, only those
associations/exchanges, which are granted recognition by the
Government, are allowed to organize forward trading in regulated
commodities. The Act envisages three-tier regulation: (i) The
Exchange which organizes forward trading in commodities can
regulate trading on a day-to-day basis; (ii) the Forward Markets
Commission provides regulatory oversight under the powers
delegated to it by the central Government, and (iii) the Central
Government - Department of Consumer Affairs, Ministry of Consumer
Affairs, Food and Public Distribution - is the ultimate regulatory
authority. The already shaken commodity derivatives market got a
crushing blow when in 1960s, following several years of severe
draughts that forced many farmers to default on forward contracts
(and even caused some suicides), forward trading was banned in
many commodities considered primary or essential. As a result,

59
commodities derivative markets dismantled and went underground
where to some extent they continued as OTC contracts at negligible
volumes. Much later, in 1970s and 1980s the Government relaxed
forward trading rules for some commodities, but the market could
never regain the lost volumes.

Modern Commodity Exchanges

To make up for the loss of growth and development during the

four decades of restrictive government policies, FMC and the
Government encouraged setting up of the commodity exchanges
using the most modern systems and practices in the world. Some of
the main regulatory measures imposed by the FMC include daily
mark to market system of margins, creation of trade guarantee fund,
back-office computerization for the existing single commodity
Exchanges, online trading for the new Exchanges, demutualization
for the new Exchanges, and one-third representation of independent
Directors on the Boards of existing Exchanges etc.

Responding positively to the favourable policy changes,

Several Nation-wide Multi-Commodity Exchange (NMCE) have been
set up since 2002 using modern practices such as electronic trading
and clearing. Selected Information about the two most important
commodity exchanges in India [Multi-Commodity Exchange of India
Limited (MCX), and National Multi-Commodity & Derivatives
Exchange of India Limited (NCDEX)] is given below.

Multi-Commodity Exchange of India Limited (MCX)

MCX an independent and de-mutualised multi commodity

exchange has permanent recognition from Government of India for
facilitating online trading, clearing and settlement operations for
commodity futures markets across the country. Key shareholders of

60
MCX are Financial Technologies (India) Ltd., State Bank of India,
NABARD, NSE, HDFC Bank, State Bank of Indore, State Bank of
Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd.,
Union Bank of India, Bank Of India, Bank Of Baroda, Canara Bank,
Corporation Bank. Headquartered in Mumbai, MCX is led by an
expert management team with deep domain knowledge of the
commodity futures markets. Through the integration of dedicated
resources, robust technology and scalable infrastructure, since
inception MCX has recorded many first to its credit .Inaugurated in
November 2003 by Shri Mukesh Ambani, Chairman & Managing
Director, Reliance industries Ltd, MCX offers futures trading in the
following commodity categories: Agri Commodities, Bullion, Metals-
Ferrous & Non-ferrous, Pulses, Oils & Oilseeds, Energy, Plantations,
Spices and other soft commodities. MCX has built strategic alliances
with some of the largest players in commodities eco-system, namely,
Bombay Bullion Association, Bombay Metal Exchange, Solvent
Extractors' Association of India, Pulses Importers Association,
Shetkari Sanghatana, United Planters Association of India and India
Pepper and Spice Trade Association.

Today MCX is offering spectacular growth opportunities and

advantages to a large cross section of the participants including
Producers / Processors, Traders, Corporate, Regional Trading
Canters, Importers, Exporters, Cooperatives, Industry Associations,
amongst others MCX being nation-wide commodity exchange,
offering multiple commodities for trading with wide reach and
penetration and robust infrastructure, is well placed to tap this vast
potential.

The following figure shows the commodity derivative products traded

in the MCX

61
National Commodity & Derivatives Exchange Limited
(NCDEX)

National Commodity & Derivatives Exchange Limited (NCDEX)

is a professionally managed online multi commodity exchange
promoted by ICICI Bank Limited (ICICI Bank), Life Insurance
Corporation of India (LIC), National Bank for Agriculture and Rural
Development (NABARD) and National Stock Exchange of India
Limited (NSE). Punjab National Bank (PNB), CRISIL Limited (formerly
the Credit Rating Information Services of India Limited), Indian
Farmers Fertiliser Cooperative Limited(IFFCO) and Canara Bank by
subscribing to the equity shares have joined the initial promoters as
shareholders of the Exchange. NCDEX is the only commodity
exchange in the country promoted by national level institutions. This
unique parentage enables it to offer a bouquet of benefits, which are
currently in short supply in the commodity markets. The institutional
promoters of NCDEX are prominent players in their respective fields
and bring with them institutional building experience, trust,
nationwide reach, technology and risk management skills.

NCDEX is a public limited company incorporated on April 23,

2003 under the Companies Act, 1956. It obtained its Certificate for
Commencement of Business on May 9, 2003. It has commenced its
operations on December 15, 2003.NCDEX is a nation-level,

62
technology driven de-mutualized on-line commodity exchange with
an independent Board of Directors and professionals not having any
vested interest in commodity markets. It is committed to provide a
world-class commodity exchange platform for market participants to
trade in a wide spectrum of commodity derivatives driven by best
global practices, professionalism and transparency .NCDEX is
regulated by Forward Market Commission in respect of futures
trading in commodities.

Besides, NCDEX is subjected to various laws of the land like the

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

NCDEX currently facilitates trading of thirty six commodities -

Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed
Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar
Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green
Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD
Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver,
Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow
Peas, Yellow Red Maize & Yellow Soybean Meal. At subsequent
phases trading in more commodities would be facilitated.

BUSINESS GROWTH IN DERIVATIVES SEGMENT (NSE)

1. INDEX FUTURES

63
 Year No. of contracts Percentage change
2009-10 178306889 -18%
2008-09 210428103 26%
2007-08 156598579 48%
2006-07 81487424 28%
2005-06 58537886 63%
2004-05 21635449 21%
2003-04 17191668 88%
2002-03 2126763 52%
2001-02 1025588 -
Number of contracts per year

INTERPRETATION:
From the figure shown in the table and graph it is clear that there is
a steady growth in the index futures contracts traded. From the year
2001-02 to 2008-09 it has shown the growth every year but in the
year 2009-10 it decline it may because of recovery of the rescission
period.

INDEX FUTURES TURNOVER

Year Turnover (Rs. Crores) Percentage

change
2009-10 3934388.67 9%
2008-09 3570111.40 -7%
2007-08 3820667.27 34%

64
 2006-07 2539574 40%
2005-06 1513755 49%
2004-05 772147 28%
2003-04 554446 92%
2002-03 43952 -
2001-02 21483 -

Index futures Turnover in Rs. Crores

INTERPRETATION:
From the above data and the figure above its very clear that from
the year 2001-02 to 2007-08 the turnover was increasing. In the year
2008-09 it declined but in the next year it recovered the previous
year’s condition.
2. STOCK FUTURES

Year No. of contracts Percentage change

2009-10 145591240 -52%
2008-09 221577980 8%
2007-08 203587952 48%
2006-07 104955401 23%
2005-06 80905493 42%
2004-05 47043066 31%
2003-04 32368842 67%
2002-03 10676843 82%
2001-02 1957856 -
2000-01 0 -

65
 Number of contracts per year in stock future

INTERPRETATION:
From the figure shown in the table it is very clear that there has
been a huge and dramatic increase in the stock future. Over the
period from 2001-02 to 2009-10 there were no NSE stock future in
the year 2001-02 for the year 2009-10 the total contract traded were
a whopping 145591240. Initially the number of contracts traded goes
by 82% in the year 2002-03, 67%in 2003-04. In the next few year
though the rise was not as pronounced as in the years mentioned
above there is still substantial increase. It is only in the year 2009-10
that the contract traded registered a decline but this could be
attributed to the market condition.

STOCK FUTURES TURNOVERS

Year Turnover (Rs. Crores) Percentage change
2009-10 5195246.64 33%
2008-09 3479642.12 -117%
2007-08 7548563.23 49%
2006-07 3830967 27%
2005-06 2791697 47%
2004-05 1484056 12%
2003-04 1305939 78%

66
 2002-03 286533 82%
2001-02 51515 -
2000-01 - -

Stock Futures Turnover per year (Rs. in crores)

INTERPRETATION:
There has been a steady increase in the stock future turnover over
the years. But compare to 2007-08 the decrease in the year 2008-09
is very significant. The decrease is whopping 117%. It recovered in
the year 2009-10 with an increase of 33%. Through this we clearly
observe that movement of stock future has always been in tendon
with market condition.

3. INDEX OPTIONS

Year No. of contracts Percentage change

2009-10 341379523 38%
2008-09 212088444 74%
2007-08 55366038 55%
2006-07 25157438 49%
2005-06 12935116 75%
2004-05 3293558 47%
2003-04 1732414 74%
2002-03 442241 60%
2001-02 175900 -

67
 2000-01 - -

Index Option Number of contracts per year

INTERPRETATION:
Index option traded in the derivatives market always been positive.
With this chart we can observe that in the year 2008-09 there was a
significant increase in number of contract traded.

INDEX OPTIONS TURNOVER

Year Turnover(Rs. Crores) Percentage change

2009-10 8027964.20 54%
2008-09 3731501.84 63%
2007-08 1362110.88 42%
2006-07 791906 57%
2005-06 338469 64%
2004-05 121943 57%
2003-04 52816 82%
2002-03 9246 59%
2001-02 3765 -
2000-01 - -

Index Option Turnover per year ( Rs. Crores)

68
INTERPRETATION:
From the above data and the bar chart we can observe that in ever
year the turnover was in the increasing way. Comparing with 2008-
09 to 2009-10 we can find 54% growth recorded.

4. STOCK OPTIONS

Year No. of contracts Percentage change

2009-10 14016270 5%
2008-09 13295970 29%
2007-08 9460631 44%
2006-07 5283310 1%
2005-06 5240776 4%
2004-05 5045112 -11%
2003-04 5583071 37%
2002-03 3523062 71%
2001-02 1037529 -
2000-01 0 -

Number of contracts traded per year in stock option

69
INTERPRETATION:
From the above chart and data we can observe very volatile growth
in stock options. By comparing with yearly growth rate 2009-10
growth rate is comparatively very less.

STOCK OPTIONS TURNOVER

Year Turnover (Rs. crores) Percentage change

2009-10 506065.18 55%
2008-09 229226.81 -57%
2007-08 359136.55 46%
2006-07 193795 7%
2005-06 180253 6%
2004-05 168836 -29%
2003-04 217207 54%
2002-03 100131 75%
2001-02 25163 -
2000-01 - -

Stock Option Turnover (Rs. in Crores) per year

70
INTERPRETATION:
From the above table and the graph in stock option turnover we can
find that growth in stock option contract traded in the year 2008-09
is 29% but in the turnovers is significantly negative and it was -57%.
Where as the growth in contracts traded was 5% in the year in 2009-
10 but growth in turnover is 55% positive which shows positive
future trend.

5. OVERALL TRADING

Year No. of contracts Percentage change

2009-10 679293922 3%
2008-09 657390497 35%
2007-08 425013200 49%
2006-07 216883573 27%
2005-06 157619271 51%
2004-05 77017185 26%
2003-04 56886776 71%
2002-03 16768909 75%
2001-02 4196873 98%
2000-01 90580 -

Overall Trading on No. of Contracts

71
INTERPRETATION:
From the above table and graph in over all trading the growth is
significantly less in the year 2009-10. But we can observe that the
growth over the past is very significant, because growth is
7498%more comparing with 2001-02 and 2009-10 which shows
robust growth.

6. OVERALL TURNOVER

Percentage
Year Turnover (Rs. cr.)
change
2009-10 17663664.57 38%
2008-09 11010482.20 -19%
2007-08 13090477.75 44%
2006-07 7356242 34%
2005-06 4824174 47%
2004-05 2546982 16%
2003-04 2130610 79%
2002-03 439862 77%
2001-02 101926 98%
2000-01 2365 -

Overall Turnover per year (Rs in crores)

72
INTERPRETATION:
From the above table and graph we find that expect in the year
2008-09 overall turnover is positive in all the years. Overall contract
traded was 35% in 2008-09 but negative 19%. The overall contract
traded shown 3%in 2009-10 but overall turnover is positive 35%
which is the positive indicator.

7. AVERAGE DAILY TURNOVERS

Year Av. daily turnover (Rs. Percentage change

Crores)
2009-10 72392.07
37%
2008-09 45310.63
-15%
2007-08 52153.30
43%
2006-07 29543
35%
2005-06 19220
47%
2004-05 10167
17%
2003-04 8388
79%
2002-03 1752 77%
2001-02 410
97%
2000-01 11 -

Average Daily Turnover

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INTERPRETATION:
From the above table and graph we can observe that in the NSE
derivatives segment overall daily turnover registered positive growth
except in the year 2008-09. In 2008-09 the average daily turnover
declined by 15% it may be because of unfavourable market condition
or may be recession period. In the next year the turnover has shown
the recovery and the positive growth of 37%.

THE DATA ANALYSIS ON MCX

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BULLION IN MCX

The bullion includes precious metals like gold, silver, platinum etc

GOLD

Traded Percentage
Year Contracts(in change
lots)
2003-04 632843
2004-05 2600407 76%
2005-06 9957351 74%
2006-07 7604891 -31%
2007-08 14024217 46%
2008-09 12144967 -15%

INTERPRETATION:

From the above table and graph Gold contract traded in MCX had
increased by 76% in the year 2004-05 from 2003-04. In the year
2006-07 it had declined by 31% and again in the year 2007-08 it had
increased by 46% and again it had declined in 2008-09. We could
assign the cause for increased contracts in gold in the year 2007-08
to market sentiments.

SILVER

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 Traded Percentage
Year
Contracts(in lots) change
2003-04 1389775
2004-05 5844765 76%
2005-06 9498544 38%
2006-07 9183273 -3%
2007-08 10972676 16%
2008-09 11555501 5%

INTERPRETATION:

From the above data and chart Gold and silver contracts almost
traded parallel. In the year 2006-07 silver contracts had declined by
3% whereas gold by 31% and in 2008-09 it had raised by 5%,
whereas gold declined by 15% with this we can conclude that market
has more positive for silver than gold.

METAL SECTORE IN MCX

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ALUMINIUM

Traded
Year Contracts(in Percentage change
lots)
2003-04 1576
2004-05 194970 99%
2005-06 307495 37%
2006-07 111804 -175%
2007-08 610478 82%
2008-09 355556 -72%

INTERPRETATION:

From the above table and graph Aluminium contracts traded in the
MCX is showing clear volatility. It had experienced 175% decline in
contracts traded in 2006-07. It had increased by 82% in 2007-08 and
again it had declined 72% in 2008-09 which shows that traders have
to be more cautious before investment.

NICKEL

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 Traded Percentage
Year
Contracts(in lots) change
2003-04 740
2004-05 13939 95%
2005-06 30982 55%
2006-07 2169749 99%
2007-08 2022276 -7%
2008-09 9792850 79%

ITERPRETATION:

From the data and chart above the nickel market shown huge
growth.
Except in the year 2007-08 in all the year’s contracts traded in the
market has shown positive signal. Growth in contract traded is very
significant in 2008-09 because it has recovered from 7% decline and
registered 79% growth which shows positive signals steadily.

ENERGY SECTORE
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NATURAL GAS

Traded Percentage
Year Contracts(in change
lots)
2006 1953756
2007 1732759 -13%
2008 747506 -132%
2009 11124296 93%

INTERPRETATION:
From the above table and graph in energy segment contracts traded
in the year 2008-09 is whopping 11124296 which is 93% higher than
previous year. The negative market sentiments in past 2 years 2007,
2008 contracts trade declined drastically but market potentials are
strong in this segment.

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CRUDE OIL

Traded Percentage change

Year Contracts(in
lots)
2004-05 5157811
2005-06 4466538 -15%
2006-07 13938813 68%
2007-08 20507001 32%
2008-09 41091240 50%

INTERPRETATION:

From the above table and graph Crude oil is one of the valuable
commodities traded in the derivatives market. The contract has been
traded showing positive results. It has grown steadily. In the year
2008-09 contracts traded in the MCX increased by 50% from the
year 2007-08. This shows positive signal for future.

PLANTATION SECTORE

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RUBBER

Traded Percentage
Year
Contracts(in lots) change
2004-05 10574
2005-06 181010 94%
2006-07 53551 -238%
2007-08 56036 4%
2008-09 1368 -3996%

INTERPRETATION:

From the above table and graph we can observe that contracts
traded in the MCX for Rubber is presently in the negative zone. In the
spot market Rubber has good demand in MCX the contacts traded
were very less. In the year 2007-08 it shown positive growth after in
next year we can observe sudden decline in the number of contracts
traded.

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OIL AND OIL SEEDS

CRUDE PALM

Traded Percentage
Year Contracts(in change
lots)
2003-04 37
2004-05 8682 100%
2005-06 3658 -137%
2006-07 134570 97%
2007-08 263224 49%

INTERPRETATION:

From the above table and graph except in the year 2005-06
contracts traded in crude palm has been growing year after year.
Because increased demand for crude palm and uncertain price in
spot market has contributed to the growth of contracts traded in
crude palm.

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SOYA BEEN

Traded Percentage change

Year
Contracts(in lots)
2003-04 5452
2004-05 28317 81%
2005-06 51644 45%
2006-07 17946 -188%
2007-08 302 -5842%
2008-09 37201 99%

INTERPRETATION:
From the above table and graph we can observe the volatility in the
contracts traded. From 2003-06 market was in the positive zone. In
2008-09 it fell down to -5842%. In 2008-09 market recovered by
99%.

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CEREALS

MAIZE

Traded Percentage change

Year Contracts(in
lots)
2003-04 788
2004-05 1843 57%
2005-06 6188 70%
2006-07 103 -5908%
2007-08 45 -129%
2008-09 99 55%

INTERPRETATION:
From the above graph and table the contracts traded on maize
registered huge fall. In the year 2008-09 we can observe the very
slow growth of 55% compare to the past years contracts traded. The
contract traded in 2003-06 in the positive side after that this has not
recovered.

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WHEAT

Traded Percentage change

Year Contracts(in
lots)
2003-04 3097
2004-05 24689 87%
2005-06 92548 73%
2006-07 337 -27362%
2007-08 86862 100%
2008-09 4230 -1953%

INTERPRETATION:

From the above graph and table we can observe huge volatility in
the contracts traded on wheat. In the year 2006-07 we can find huge
decline of -27362% and after next year the contract traded on wheat
registered 100% growth. In the year 2008-09 it followed the history
of declining of -1953%.

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SPICES

TURMERIC

Year Traded Contracts(in lots) Percentage change

2003-04 127
2004-05 3215 96%
2005-06 89202 96%
2006-07 138162 35%

INTERPRETATION:

From the above table and graph we can observe the increase of
growth rate year by year but the data available up to 2006-07. The
contracts traded in every year registered the positive growth.

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CARDAMOM

Traded Percentage change

Year Contracts(in
lots)
2004-05 572157
2005-06 506934 -13%
2006-07 87908 -477%
2007-08 66314 -33%
2008-09 90219 26%

INTERPRETATION:
From the above graph and table the contracts traded on cardamom
in the declining way. In the year 2006-07 this took a sudden decline
of
-477% in the contract traded. After that in the year 2008-09 the
growth rate has shown the positive 26%.

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 FINDINGS

From the above analysis it can be concluded that:

 Derivative market is growing very fast in the Indian Economy.

The turnover of Derivative Market is increasing year by year in
the India’s largest stock exchange NSE. In the case of index
future there is a phenomenal increase in the number of
contracts and the value traded. In the case of stock future
there was a slower increase observed in the number of
contracts in the last couple of years whereas a decline was
observed in its turnover. In the case of index option there was
a huge increase observed both in the number of contracts and
turnover.

 The main factors driving the growth of derivatives India are

hedging against risk, the improvements in the communication
technology, more and more awareness of the uses and
benefits of derivative products.

 It encourages entrepreneurship in India. It encourages the

investor to take more risk & earn more return. So in this way it
helps the Indian Economy by developing entrepreneurship.
Derivative Market is more regulated & standardized so in this
way it provides a more controlled environment. In nutshell, we
can say that the rule of High risk & High return apply in
Derivatives. If we are able to take more risk then we can earn
more profit under Derivatives.

 Instability of the financial system: It has been argued that

derivatives have increased the risk factor not only for the
trading parties but also the entire financial system. The rapid
growth in the trading volumes of derivative instruments has
given rise to the fear of micro and macro financial crisis.

 Speculative and gambling motives: One of the strongest

arguments against derivatives is that they promote speculative

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 activities in the market. The world over, the volume of
derivative trading has increased in multiples of the value of the
underlying assets while a mere one or two percent of the
transactions are settled by actual delivery. The rest of the
trading is done with speculative and gambling motives.

Commodity derivatives have a crucial role to play in the price risk

management process for the commodities in which it deals. And it
can be extremely beneficial in agriculture-dominated economy, like
India, as the commodity market also involves agricultural produce.
Derivatives like forwards, futures, options, swaps etc are extensively
used in the country. However, the commodity derivatives have been
utilized in a very limited scale. Only forwards and futures trading are
permitted in certain commodity items.
.

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 RECOMMENDATIONS & SUGGESTIONS

 SEBI, RBI and other Government bodies should play a greater

role in supporting derivatives. At the same time they should
ensure that there is no misuse of derivatives.

 Derivatives market In India should be developed in order to

keep it at par with other derivative markets in the world.

 Speculation should be discouraged as far as possible.

 There must be more derivative instruments aimed at individual

investors. This would give a better choice to the individuals
and would lead to better participation from individuals

 SEBI should conduct seminars regarding the use of derivatives

to educate individual investors. This too would mean that more
people would be aware of the derivatives and their uses and
benefits. It should be ensured that at such investor education
programmes both the risks as well as the benefits should be
clearly spelt out. Investors should not get carried away only by
the benefits of the derivatives but should also be aware of the
potential risks involved.

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 CONCLUSION

 After study it is clear that Derivatives influence our Indian

Economy up to much extent. So, SEBI should take
necessary steps for improvement in Derivative Market so
that more investors can invest in Derivative market.

 There is a need of more innovation in Derivative Market

because in today scenario even educated people also fear
for investing in Derivative Market Because of high risk
involved in Derivatives.

 Derivatives are risk management tool that help in effective

management of risk by various stakeholders. Derivatives
provide an opportunity to transfer risk, from the one who
wish to avoid it; to one, who wish to accept it.

 India’s experience with the launch of equity derivatives

market has been extremely encouraging and successful

Alan Greenspan: “Although the benefits and costs of

derivatives remain the subject of spirited debate, the
performance of the economy and the financial system in
recent years suggests that those benefits have materially
exceeded the costs."

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 BIBLIOGRAPHY

Books Referred

 Gupta.S.L, Financial Derivatives, Eastern Economy Edition, Fourth

Edition 2007
 Jhon C.Hull, Options, futures and other Derivatives, Pearson Edition,
Sixth Edition

Websites visited:
 www.nse-india.com
 www.bseindia.com
 www.ncdex.com
 www.google.com
 www.derivativesindia.com
 www.mcxindia.com
 www.ncdexindia.com

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