DERIVATIVE 201 1 CHAPTER 1 INTRODUCTION ON DERIVATIVES.

1) MEANING
A Derivative is a financial instrument with a value dependent upon underlying variables. The term can refer to a contract, or its value, derived from the underlying assets. The most common derivatives are futures, options, and swaps but may also include other tradeable assets such as a stock or commodity or non-tradeable items such as the temperature (in the case of weather derivatives), the unemployment rate, or any kind of (economic) index. A derivative is essentially a contract whose payoff depends on the behavior of a benchmark. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile. Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-themoney naked calls on a stock, expecting the stock price to plummet, but
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exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies

Derivatives are used by investors to:

provide leverage (or gearing), such that a small

movement in the underlying value can cause a large difference in the value of the derivative;

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speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);

hedge or mitigate risk in the underlying, by entering

into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;

obtain exposure to the underlying where it is not

possible to trade in the underlying (e.g., weather derivatives);

create option ability where the value of the derivative

is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

1) DEFINITION:
Derivatives are securities whose value is derived from the some other time-varying quantity. Usually that other quantity is the price of some other asset such as bonds, stocks, currencies, or commodities. It could also be an index, or the temperature. Derivatives were created to support an insurance market against fluctuations. A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 define derivatives to include1.

A security derived from a debt instrument,

share, loan whether secured or unsecured, risk instrument or contract for differences or any other from of security.

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

3)_HISTORY
Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchangetraded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi4

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level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991. The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

4) ROLE OF DERIVATIVES:Derivatives play an important role in the investment world. Derivatives are commonly used on the stock index to define the asset value it is also used to help define the currency exchange rate and interest amounts.

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For investing, derivatives normally are contracts that pertain to index options and many of them are contracted outside the security exchanges. The contract that the derivative pertains to is provided from your investment. The value of the derivative is calculated by the underlying value of this investment by using the length of the contract and dividing it by its value. Obviously derivatives are extremely complicated and it is hard for most people to understand them. Moving on with derivatives, you have probably heard the term `options and derivatives' at least once. Options will help to protect your investment portfolio from risk. An options market normally pertains to highly traded stocks. Depending upon the stocks, you could be getting stocks that have obscure or light trade volumes. Options are used to generate income and to protect your portfolio. Think of options like owning life insurance for your investment portfolio. Like a bond, options will protect you when things aren't going your way. Options should be part of every good investment portfolio, especially if you are trying to diversify your portfolio. The benefit of options is that you have the choice of whether or not to buy or sell securities at a certain time and for a certain price. Once you purchase an option, you don't need to do much to it. You can let it expire if you don't know what to do with it or if you don't want to touch it. If you want to use your option, you can exercise it by selling it as mentioned previously. Depending upon the option you choose, you can exercise it at any time. Both American and European style options provide you with the right to exercise them at any time without repercussion. There will be an expiration date attached to the option, so you have the right to exercise your option until this time.

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Since options and derivatives are complicated, it is better to leave them up to the brokers and financial advisors that actually understand them. If you are new to the investment world, it is always a wise decision to hire someone else to handle things for you until you start to get the hang of how the investment world actually works. If you start investing in options and you don't know what to do with them, you could actually be losing money. If you want to build a diverse portfolio, let the broker know this so they can help you build a good portfolio. A diverse portfolio will have bonds, options, and some good stocks. The bonds and options will help to balance out the risk you may be taking on with your high-risk stocks and other investments. When it comes to selecting a broker, you need to find one that you trust. This can be hard because some brokers are known for scamming their clients out of money. They will charge money for the research they do (even though some of it is completely free, like stock tickers) and then they will charge for other things like transaction fees and account fees.

4) FEATURES OF DERIVATIVE MARKETS

Derivative can be defined as a contract or an agreement for exchange of payments, whose value is derived from the value of an underlying asset. In simple words the price of derivative depends on the price of other assets. Here are some of the features of derivative markets
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1. Derivative are of three kinds future or forward contract, options and swaps and underlying assets can be foreign exchange, equity, commodities markets or financial bearing assets. 2. As all transactions in derivatives takes place in future

specific dates it is easier to short sell then doing the same in cash markets because an individual can take of markets and take the position accordingly because one has more time in derivatives. 3. Since derivatives have standardized terms due to which it

has low counterparty risk, also transactions costs are low in derivative market and hence they tend to be more liquid and one can take large positions in derivative markets quite easily. 4. When value of underlying assets change then value of

derivatives also changes and hence one can construct portfolio which is needed by one and that too without having the underlying asset. So for example if one want to buy some stock and short the market then he can buy the future of a stock and at the same time short sell the market without having to buy or sell the underlying assets. Hence from the above one can see that derivatives have some important features which make them quite attractive to all category institutions, investors and traders.

CHAPTER - 2 ADVANTAGES AND DISADVANTAGES OF DERIVATIVES

Derivatives have come under general scrutiny in recent times, owing to the use of hedging instruments by companies for financial mismanagement. The misuse of derivatives has put many companies in the legal line of fire. The popular notion that derivatives caused the downfall of companies like Enron, is however, not true. The derivatives
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by themselves are not damaging, their misuse can cause trouble for businesses. If used properly, derivatives can shore up your company's defense against many economic problems.

1) ADVANTAGES OF DERIVATIVES: 1) FLEXIBILITY:

Derivatives can be used with respect to commodity price, interest and exchange rates and equity price. They can be used in many ways.

2) RISK REDUCTION:
Derivatives can protect your business from huge losses. In fact, derivatives allow you to cut down on non-essential risks.

3) STABLE ECONOMY:
Derivatives have a stabilizing effect on the economy by reducing the number of businesses that go under due to volatile market forces.

2) DISADVANTAGES OF DERIVATIVES:
If derivatives are misused, they can boomerang on the company.

1) CREDIT RISK:

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While derivatives cut down on the risks caused by a fluctuating market, they increase credit risk. Even after minimizing the credit risk through collateral, you still face some risk from credit protection agencies.

2) CRIMES:

Derivatives have a high potential for misuse. They have

been the caused the downfall of many companies that used trade malpractices and fraud.
3)

INTEREST RATES:
Wrong forecasts can result in losses amounting to millions of dollars for large companies; it can wipe out small businesses. You need to accurately forecast the long term and short term interest rates, something that many businesses cannot do.

MINIMIZING RISKS WITH DERIVATIVES: 1) FUTURE EXCHANGES:

Arrange the derivatives through future exchanges. You may need to put in a lot of work here; you must keep track of all adjustments in the market worth of the underlying asset.

2) ASSET AND LIABILITY DRIVEN TRANSACTIONS:

The transactions should be driven by asset and liability management. You should not speculate based on future forecasts.

3) DERIVATIVE POLICY:
A good derivative policy focuses more on cost management and less on forecasting. It should aim for cutting down expenses and costs. While dabbling in derivatives is risky if you choose to speculate, derivatives can be an important tool for financial structuring and cost

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management if you use them correctly. If you do not know how to start investing in derivatives, you can consult a small business advisor or financial consultant. Remember, if you do go for derivatives, always play by the book and never try anything illegal.

CHAPTER 3 TYPES OF DERIVATIVES

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A. FORWARD CONTRACT

In finance, a forward contract or simply a forward is a nonstandardized contract between two parties to buy or sell an asset at a
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specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into .The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party .Forwards, like other derivative securities, can be used to hedge risk, as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

Three different types of forward contract 1) Time option forward contract

This is a forward contract that allows access to the funds between two pre-determined dates eg. 01/04/00 - 31/08/00. This is of particular benefit when, for example a car delivery is not precisely known, and therefore funds may be needed earlier. It is important to remember that the last date is not flexible and physical delivery of the currency can take place before but no later than that date.
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2)

Drawdown forward contract

This is similar to a time option forward contract, however, if a portion of the funds are required during the life of the contract then they may be drawn down against the said contract at the original buy rate, thereby reducing the final balance. This would particularly suit either a boat or house purchase where large sums maybe needed to settle stage payments.

3)

Fixed term forward contract

A Fixed-Term Forward Contract gives you the ability to fix a currency rate with a view to take physical delivery of the said currency in the future. The rate is guaranteed irrespective of market fluctuations for the duration of the Contract. A deposit is required on each Forward Contract and must be

received within two (2) working days of the contract date. The balance of the contract must be settled no later than the maturity date. We recommend that our clients settle the outstanding balance on their contracts five (5) working days prior to the contract matures. Should the delivery of the currency not be required upon maturity, the said currency can usually be held on account at no additional charge or penalty.

WHAT ARE THE USES OF FORWARD CONTRACTS?

Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or
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ensure supply of a scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset. Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices. For instance, coffee growers may enter into a forward contract with Starbucks (SBUX) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to make. Starbucks benefits from contract because it is able to lock in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of coffee ahead of time helps Starbucks avoid price fluctuations and assists in planning.

HOW DO FORWARD CONTRACTS WORK?

Forward contracts have a buyer and a seller, who agree upon a price, quantity, and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the agreed upon price and receives the agreed upon quantity of the asset. \If the contract is cash settled, the buyer would have a cash gain (and the seller a cash loss) if the spot price, or price of the asset at expiry, is higher than the agreed upon Forward price. If the spot price is lower than the Forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset. A quick example would help illustrate the mechanics of a cash settled forward contract. On January 1, 2009 Company X agrees to buy

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from Company Y 100 pounds of coffee on April 1, 2009 at a price of $5.00 per pound. If on April 1, 2009 the spot price (also known as the market price) of coffee is greater than $5.00, at say $6.00 a pound, the buyer has gained. Rather than having to pay $6.00 a pound for coffee, it only needs to pay $5.00. However, the buyer's gain is the seller's loss. The seller must now sell 100 pounds of coffee at only $5.00 per pound when it could sell it in the open market for $6.00 per pound. Rather than the buyer giving the seller $500 for 100 pounds of coffee as he would for physical delivery, the seller simply pays the buyer $100. The $100 is the cash difference between the agreed upon price and the current spot price, or ($6.00-$5.00)*100.

A.FUTURE CONTRACT
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties -- the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each party is taking. In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the
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underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.

TYPES OF FUTURES TRADING CONTRACTS

There are mainly two types of futures trading contracts. They are futures contracts which are traded for physical delivery, known as commodities and futures contract which are end with a cash settlement, known as financial instruments. Both types of futures contracts are traded electronically and directly. Futures contracts which are traded for physical delivery includes agricultural commodities like wheat, oats, sugar etc, energy products like crude oil, heating oil, natural gas etc, or animals. Note that very commodity futures contracts actually end in delivery. Often these contracts are traded just like shares of a stock market, according to the changes in price trends. Online futures traders include both speculators and hedgers.

Futures contracts which are traded for cash settlement involve treasury notes, bonds, etc. These futures are also known as currency futures and are often traded just like commodity futures though electronic platforms. This information is provided by NobleTrading.com, a worldwide brokerage firm, offering direct access services for online stocks trading, options trading, futures trading, commodities trading and forex trading on a variety of trading software platform.
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ADVANTAGES OF FUTURES TRADING: There are several advantages of trading in futures. Here are some.
1.

Futures trading allows you to trade in 'large amounts' with low cash. For e.g. if you want to buy a futures contract of 500 shares of Tata steel Actually buying them would cost much more than the margin you have to pay for trading futures. Note however, leveraged position of futures can also be dangerous.

2.

Trading in stock market Futures is usually less expensive than actually buying stocks. For e.g. if you realize that you have 500 stocks and want to sell them and again buy them when the price is low, it is much cheaper (brokerage charges etc.) to sell futures than actually selling stocks.

3.

You can sell futures contract even if you dont have shares or the commodity. Thus if you have reasons to believe that the stock market is going down you can sell a particular stock future or index future and benefit from the price fall. This is possible only if you trade futures and not with physical stocks or commodity.

4.

Trading futures can be used in several hedging strategies which will be discussed in a later post.

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A.OPTIONS:
In finance, an option is a derivativefinancial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.
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In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other overthe-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.

TYPES: The Options can be classified into following types:

1)

Exchange-traded options:- Exchange-traded options

(also called "listed options") are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include: stock options,

commodity options, bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract

2] Over-the-counter
Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any
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business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: 1. interest rate options 2. currency cross rate options, and
3.

options on swaps or swaptions.

3]

Other option types

Another important class of options, particularly in the U.S., are

employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

FEATURES OF OPTION CONTRACTS:

Some important features of Options Contract are:

1. HIGHLY FLEXIBLE:
On one hand, option contract are highly standardized and so they can be traded only in organized exchanges. Such option instruments cannot be made flexible according to the requirements of the writer as well as the user. On the other hand, there are also privately arranged options which can be traded over the counter. These instruments can be made according to the requirements of the writer and user. Thus, it combines the features of futures as well as forward contracts.

2. DOWN PAYMENT:
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The option holder must pay a certain amount called premium for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise his option, he has to forego this premium. Otherwise, this premium will be deducted from the total payoff in calculating the net payoff due to the option holder.

3. SETTEMENT:
No money or commodity or share is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option by the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.

4. NON LINEARITY:
Unlike futures and forward, an option contract does not posses the property of linearity. It means that the option holders profit, when the value of the underlying asset moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profits and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration: Mr.X purchase a two month call option on rupee at Rs. 100=3.35 $. Suppose, the rupee appreciates within two months by 0.05 $per one hundred rupees, then the market price would be Rs. 100=3.40 $. If the option holder Mr.X exercises his option, he can purchase at the rate mentioned in the option ie., Rs. 100=3.53 $. He gets a payoff at the rate of 0.05 $ per every one hundred rupees. On the other hand, if the exchange rate moves in the opposite direction by the same amount and reaches a level of Rs. 100=3.30 $. The option holder will not exercise his
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option. Then, his loss will be zero. Thus, in an option contract, the gain is not equal to the loss.

5. NO OBLIGATION TO BUY OR SELL:

In all option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.

OPTION STYLES
Naming conventions are used to help identify properties common to many different types of options. These include:

European option an option that may only be exercised on

expiration.

American option an option that may be exercised on any

trading day on or before expiry.

Bermudan option an option that may be exercised only on

specified dates on or before expiration.

Barrier option any option with the general characteristic

that the underlying security's price must pass a certain level or "barrier" before it can be exercised.

Exotic option any of a broad category of options that may

include complex financial structures.[7]

Vanilla option any option that is not exotic.

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OPTION VALUATION
The theoretical value of an option is evaluated according to any of several mathematical models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. For example how the price changes with respect to changes in time to expiration or how an increase in volatility would have an impact on the value. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-thecounter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

Futures Trading: Example of a Futures Contract:

Suppose the current price of Tata Steel is Rs. 200 per stock. You are interested in buying 500 shares of Tata Steel. You find someone, say John, who has 500 shares you tell John that you will buy 500 shares at Rs. 200, but not now, at a later point of time, say on the last thursday of
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this month. This agreed date will be called the expiry date of your agreement or contract. John more or less agrees but the following points come up in your agreement. 1. John will have to go through the hassle of keeping the shares with him until the end of this month. Moreover, the economy is doing well, so it is likely that the price of the stock at the end of the month will be not Rs. 200, but something more. So he says lets strike a deal not at the current price of Rs 200 but Rs. 202/-. The agreed price of the deal will be called the Strike price of the futures contract. He says you can think of the Rs. 2 per share as his charge for keeping the shares for you until the expiry date. This difference between the strike price and the current price is also called as Cost of Carry. 2. The total contract size is now Rs. 202 for 500 shares, which means Rs 101000. However both you and John realize that each of you is taking a risk. For e.g. if tomorrow the price of the stock falls from Rs. 200 to Rs. 190, in that case it is much more profitable for you buy shares from the market than from John. What if you decide not to honour the contract or agreement? it will be a loss for John. Similarly if the price rises you are at a risk if John doesn't honour the futures contract. So both of you decide that you will find a common friend and keep Rs. 25000 each with this friend in order to take care of price fluctuations. This money paid by both of you is called Margin paid for the futures contract. Finally you decide that the futures contract will cash settled. Which means at the expiry date of the contract, instead of actually handing over 500 shares - John will pay you the money if the price rises, or if the price falls you will pay John the balance amount. For example at the end of the expiry date if you find out that the price of the share is Rs. 230, then the difference Rs. 230 - Rs. 202 = Rs. 28 will be paid to you by John. You can then purchase the shares from the Stock Market at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract. Similarly John can directly sell his 500 shares in the market at Rs. 230 and give you Rs 28 (per share) which means he effectively sold each share at Rs. 202, the agreed price.

EXAMPLE OF CALL OPTION ON A STOCK

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An investor typically 'buys a call' when he expects the price of the underlying instrument will go above the call's 'strike price,' hopefully significantly so, before the call expires. The investor pays a nonrefundable premium for the legal right to exercise the call at the strike price, meaning he can purchase the underlying instrument at the strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the profit. Of course, the investor can also hold onto the underlying instrument, if he feels it will continue to climb even higher. An investor typically 'writes a call' when he expects the price of the underlying instrument to stay below the call's strike price. The writer (seller) receives the premium up front as his or her profit. However, if the call buyer decides to exercise his option to buy, then the writer has the obligation to sell the underlying instrument at the strike price. Oftentimes the writer of the call does not actually own the underlying instrument, and must purchase it on the open market in order to be able to sell it to the buyer of the call. The seller of the call will lose the difference between his or her purchase price of the underlying instrument and the strike price. This risk can be huge if the underlying instrument skyrockets unexpectedly in price. The current price of ABC Corp stock is $45 per share, and investor 'Chris' expects it will go up significantly. Chris buys a call contract for 100 shares of ABC Corp from 'Steve,' who is the call writer/seller. The strike price for the contract is $50 per share, and Chris pays a premium up front of $5 per share, or $500 total. If ABC Corp does not go up, and Chris does not exercise the contract, then Chris has lost $500. ABC Corp stock subsequently goes up to $60 per share before the contract is expired. Chris exercises the call option by buying 100 shares of ABC from Steve for a total of $5,000. Chris then sells the stock on the market at market price for a total of $6,000. Chris has paid a $500 contract premium plus a stock cost of $5,000, for a total of $5,500. He has earned back $6,000, yielding a net profit of $500. Steve, however, did not do so well. Steve did not already own ABC Corp stock, so when Chris exercised the contract, Steve had to buy the stock on the open market for $6,000. Steve had already earned the $500 premium for the contract and $5,000 from Chris on selling the stock, so the total loss for Steve was $500. If, however, the ABC stock price drops to $40 per share by the time the contract expires, Chris will not exercise the option (i.e., Chris will not buy a stock at $50 per share from Steve when he can

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buy it on the open market at $40 per share). Chris loses his premium, a total of $500. Steve, however, keeps the premium with no other out-of-pocket expenses, making a profit of $500. The break-even stock price for Chris is $55 per share, i.e., the $50 per share for the call option price plus the $5 per share premium he paid for the option. If the stock reaches $55 per share when the option expires, Chris can recover his investment by exercising the option and buying 100 shares of ABC Corp stock from Steve at $50 per share, and then immediately selling those shares at the market price of $55. His total costs are then the $5 per share premium for the call option, plus $50 per share to buy the shares from Steve, for a total of $5,500. His total earnings are $55 per share sold, or $5,500 for 100 shares, yielding him a net $0.

D) SWAPS:
In finance, a swap is a derivative in which counter parties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or

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uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more thn $426.7 trillion in 2009, according to International Swaps and Derivatives Association (ISDA).

TYPES OF SWAPS
The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types

INTEREST RATE SWAPS

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A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments. The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%.
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The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

CURRENCY SWAPS
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

COMMODITY SWAPS
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

EQUITY SWAP
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do.

CREDIT DEFAULT SWAPS

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange,

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receives a payoff if a instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance , because the buyer pays a premium and , in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

E) WARRANT:
In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to "endow with the right", which is only slightly different to the meaning of an option. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable, and can be sold independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant

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before they can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so the investor can earn dividends. Warrants are actively traded in some financial markets such as Deutsche Borse and Hong Kong. In Hong Kong Stock Exchange, warrants accounted for 11.7% of the turnover in the first quarter of 2009, just second to the callable bull/bear contract.

STRUCTURE AND FEATURES:

Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:

Exercising: A warrant is exercised when the holder informs the

issuer their intention to purchase the shares underlying the warrant.

The warrant parameters, such as exercise price, are fixed shortly after the issue of the bond. With warrants, it is important to consider the following main characteristics:

Premium: A warrant's "premium" represents how much extra you

have to pay for your shares when buying them through the warrant as compared to buying them in the regular way.

Gearing (leverage): A warrant's "gearing" is the way to ascertain

how much more exposure you have to the underlying shares using the warrant as compared to the exposure you would have if you buy shares through the market.

Expiration Date: This is the date the warrant expires. If you plan on
exercising the warrant you must do so before the expiration date. The more time remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will increase the price of the

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warrant (unless it depreciates). Therefore, the expiry date is the date on which the right to exercise no longer exists.

Restrictions on exercise: Like options, there are different exercise

types associated with warrants such as American style (holder can exercise anytime before expiration) or European style (holder can only exercise on expiration date).

Warrants are longer-dated options and are generally traded over-thecounter.

TYPES OF WARRANTS:
A wide range of warrants and warrant types are available. The reasons you might invest in one type of warrant may be different from the reasons you might invest in another type of warrant.

Equity warrants: Equity warrants can be call and put warrants.

Callable warrants: Callable warrants give the Company the right to force the warrant holder to exercise the warrants into their predetermined number of shares at a predetermined price (or using a predetermined price formula) after certain contractual conditions are met

Putable warrants: Putable warrants give the warrant holder the right to force the Company to issue the underlying securities at a predetermined price after certain contractual conditions are met

Covered warrants: A covered warrants is a warrant that has some underlying backing, for example the issuer will purchase the stock beforehand or will use other instruments to cover the option.

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Basket warrants: As with a regular equity index, warrants can be classified at, for example, an industry level. Thus, it mirrors the performance of the industry.

Index warrants: Index warrants use an index as the underlying asset. Your risk is dispersedusing index call and index put warrantsjust like with regular equity indexes.

Wedding warrants: are attached to the host debentures and can be exercised only if the host debentures are surrendered

Detachable warrants: the warrant portion of the security can be detached from the debenture and traded separately.

Naked warrants: are issued without an accompanying bond, and like traditional warrants, are traded on the stock exchange.

F) LEAPS :
Long Term Equity Anticipation Securities (LEAPS) are an excellent way for a longer term trader to gain exposure to a prolonged trend in a given security without having to security short term contracts together. The ability to buy a call/put option that expires one or two years in the future is very alluring because it gives the holder exposure to the long term price movement without the need to invest the larger amount of capital that would be required to own the underlying asset outright. G) BASKETS: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. H) SWAPTIONS:

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

OTHER TYPES OF DERIVATIVES

1) Eurodollar Futures
Eurodollar futures work the same as T-bill contracts except the rate is based on LIBOR. Price quotes and actual price is determined the in the same Settles in cash One of most active contracts in the markets Instead of add-on interest, (for example a 100 @ 10% for a

way as for T-bills.

year and the bank would owe $110 dollars), the rate is subtracted from 100, just as it is with T-bills

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With T-bills the investor would receive $1 million per

contract, while in the Eurodollar futures market the firm would pay 1 million euros

2) Treasury Bond Contracts

A contract based on the delivery of a U.S. Treasury bond with any coupon and at least 15 years to maturity. There are many different bonds that fit the above description. To give some type of standardization, the markets use a

conversion factor to achieve a hypothetical bond with a 6% coupon. Because bond prices do not move in a linear fashion, there is a chance to use arbitrage to capitalize on the deviance of a bond when compared to the 6% standardized bond. To do this, traders look for the cheapest to deliver bond (CTD). This is the least expensive underlying product that can be delivered upon expiry to satisfy the requirements of a derivative contract. This helps minimize the slippage between the conversation factor and the actual price. The CTD bond is always changing because prices and yields A contract covers $100,000 par value of U.S. Treasuries. Contract expires March, June, September and December are always changing.

3) Stock Index Contracts

Investors trading index options are essentially betting on the overall

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movement of the stock market as represented by a basket of stocks. Options on the S&P 500 are some of the most actively traded options in the world.

Quoted in terms equal to the index itself. For example if the Each contract has a multiplier. For the S&P 500, it is 250.

S&P 500 is trading at 1050 the one-month contract may be at 1060. The actual price in the above point would equal 1060*250 = $265,000. S&P 500 contracts expire in March, June, September and Settlement is in cash. The FTSE 100 and Japan's Nikkei 225 are other types of December and can have maturity dates as far away as two years.

indexes upon which stock index contracts are based.

4) Currency Contracts
Currency contracts function in the same way as forward contracts for currency.

They are typically much smaller than forward contracts. Each contract has a stated size and quotation unit. Future price for euros = 0.92, which leads to a contract price Calls for actual delivery through book entry of the

of 125,000(this is the contract size)(.92) = 115,000 underlying currency.

CHAPTER 4 DERIVATIVES INSTRUMENTS TRADED IN INDIA

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In the exchange-traded market, the biggest success story has been derivatives on equity products. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. As of 2005, the NSE trades futures and options on 118 individual stocks and3 stock indices. All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product may be Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become hugely popular, accounting for about half of NSEs traded value in October 2005. NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has been little trading in them. One problem with these instruments was faulty contract specifications, resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. Institutional investors have preferred to trade in the OTC markets, where instruments such as interest rate swaps and forward rate agreements are thriving. As interest rates in India have fallen, companies have swapped their fixed rate borrowings into floating rates to reduce funding costs.10 Activity in OTC markets dwarfs that of the entire exchange-traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004. Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and8 Settlement. Swaps are the most popular. Importers, exporters and banks use the rupee forward to hedge their foreign currency exposure.
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Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less In a currency swap, banks and corporations may swap its rupee denominated debt into another currency, or vice versa. Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost four times in the same period. However, many contracts barely trade and, of those that are active, trading is fragmented over multiple market venues, including central and regional exchanges, brokerages, and unregulated forwards markets. Total volume of commodity derivatives is still small, less than half the size of equity derivatives.

DERIVATIVES USERS IN INDIA

The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Nonfinancial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies. In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share
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of index derivatives. In contrast to the exchange-traded markets, domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence. Corporations are active in the currency forwards and swaps markets, buying these instruments from banks. Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives.11 Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. Alternatively, they can incorporate locally as abroker-dealer.12 FIIs have a small but increasing presence in the equity derivatives markets. They have no incentive to trade interest rate derivatives since they have little investments in the domestic bond markets. It is possible that unregistered foreign investors and hedge funds trade indirectly, using a local proprietary trader as a front.

CHAPTER - 5 FACTORS CONTRIBUTING TO GROWTH OF DERIVATIVES

Factors contributing to the explosive growth of derivatives are price volatility, globalization of the markets, technological developments and advances in the financial theories.

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1. 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 ones own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have demand and producers or suppliers have supply, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as price volatility. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes .The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the
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markets. Nations that were poor suddenly became a major source of supply of goods. This price volatility risk 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.

2. GLOBALIZATION OF THE MARKETS

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red.

3. TECHNOLOGICAL ADVANCES
A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications

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allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmed 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.

4. ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970s, work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. The above factors in combination of lot many factors led to growth of derivatives instruments.

CHAPTER 6

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UNDERLYING ASSET FOR DERIVATIVES :

Derivatives are written on various tangible (commodity), nominal (currency , stock) and intangible (interest rate) assets.

(1)COMMODITY :
These are simple in concept. Commodity is to be sold bought. Demand supply pressures give room for speculation. Hence derivatives are written on these assets.

(2) STOCK

Purchasing common stock on the stock market is speculatives fancy and investors leveraged idea. As share itself can be purchased, future prices of specific scrip may also be speculated. So, instead of buying a share, a derivative written on share is traded for a specified future date. These are stock market derivatives. Futures/ Options on select scrip are available and also index futures are also available.
(3) CURRENCY

Foreign currency rates fluctuate. Many corporate require to buy or to sell foreign currency for a transaction proposed at a future date. Though currency itself can be purchased now, a futuristic

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derivative also is a favourite of many. This helps in hedging currencys exchange rate fluctuation risk. These are currency forwards/futures or currency options.
(4)

INTEREST RATE :
Interest rates fluctuate in response to government policies,

budget, international movements, recession and boom, inflation, etc. so, if the institution needs a confirmed interest rate at a future date, it can trade in interest rate based derivatives. These are also called as FRAs or forward rate agreements. If interest rate in the market moves downwards, the institution will get the difference between market driven interest rate and FRA specified rate. If market rates are higher, it will have to pay the difference. These are typically short term agreements up to 6 or 12 months.

CHAPTER 7 PARTICIPANTS OF DERIVATIVES MARKETS

Derivatives are those financial instruments which derive their value from the value of other assets. In other words they have no value on their own rather their value depends on the value of the underlying asset. For example the value of call or put option of Microsoft stock will depend on the price movement of Microsoft stock. There are 3 important participants in the derivatives market which include the following

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1. HEDGERS
They are those who buy or sell in derivatives market in order to reduce their risk of their portfolio. For example if the portfolio of hedger is long then he will protect or hedge this position by buying put options in derivatives market. Those who are involved in genuine trade of underlying asset, hedge their position through derivatives. In fact the whole concept of derivatives is evolved because of this basic motive.

2. SPECULATORS
Speculators are those who enter into the market purely for making profit by buying or selling the derivatives, they do not have any intention of hedging their portfolio or such thing their only aim is to make profit based on their judgment about the stock or market. Those who foresee gain because of price variation, trade in derivatives. Great level of liquidity observed in derivatives is because of speculators. In absence of speculators, trade level would have reduced to 5% or less, may be.

3. ARBITRAGEURS
Arbitrage refers to obtaining risk free profits by simultaneously buying and selling similar instruments in different markets. Arbitrageurs enter into derivative market in order to take advantage of any such opportunity and profit from it. It is risk free speculation. Arbitrageurs see difference in price of different markets and trade for gains. Thus profit is sure. But because of market efficiencies. Such gains are only marginal and be capitalized only by playing in big volumes.

CHAPTER - 8 DERIVATIVE TRADING

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If you are looking for a trading option outside of traditional stocks and bonds, derivatives trading may be a good option. Derivatives pay off over a period of time based on the performance of assets, interest rates, exchange rates, or indices. The payoff can be in cash or assets and vary, of course, by performance and timing. In addition to stocks and bonds, derivatives can also be traded through in the money market, foreign exchange (forex), and credit. Indicators affecting a derivative's performance are varied, and depending on the type of derivative. These can range from the stock market index to the consumer price index to weather conditions and fluctuations in currency exchange rates. The following reasons provide information on why it may be a good idea to begin derivatives trading.

1. LESS RISK THAN OTHER TRADES

When you trade in derivatives, you are not purchasing the underlying product or buying into the company, although in some cases you are agreeing to purchase assets in the future, also known as futures trading. Instead, your risk is on the performance. There are two main types of derivatives: futures and options, which allow someone the option to buy or sell at a prearranged price. There are three main types of firms that use derivatives. These are investment banks, commercial banks, and end users, such as floor traders, corporations, and hedge and mutual funds. While you can still lose money in derivatives trading, the risk is much less of an investment. Further, you can get involved in derivatives trading for a much lower initial investment, something that may appeal to those who cannot or do not want to invest as much as is required to purchase

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stock. Derivatives can also be a good way to add balance to your total portfolio, thereby spreading risk throughout a variety of investments rather than in only a few.

2. THEY CAN BE A GOOD SHORT TERM INVESTMENT

If you are looking for an investment opportunity that can pay off in a shorter time frame, derivatives may be a good option. While some stocks and bonds are long-term investments over the course of many years, derivatives can be days, weeks, or a few months. Because of the shorter turnaround time, they can be a good way to break into the market as well as a good way to mix short and long-term investments. If you have a portfolio consisting of long-term investments, such as some stocks, and want an option to put your money to work now, derivatives may be an option. Making derivatives work for you requires careful research and consideration just like any other investment opportunity. However, in a fast-paced world, investors have the option to see results much sooner in options or futures trading that are not available through other means.

3. VARIETY AND FLEXIBILITY

The nature of derivatives essentially means that the opportunities for trading this type of investment are limited only by the imagination. The other side of this is that someone interested in entering the derivatives trading market needs to either have a trusted financial representative, or learn as much about the business as possible. Doing both is the best option, as you can then work with a financial representative in a much more involved way and have a better handle on

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what your money is doing and where. Numerous resources are available on the Internet for learning more about derivatives trading and the many options available. Those interested in derivatives training may want to begin by focusing on a particular area, such as currency trading. Some types of trading options are available around the clock, on a global scale. This is another reason some investors are drawn to derivatives trading. Getting involved in the global economy can be exciting, and it opens international options that may not be available through the traditional stock market (particularly given the regulations placed on foreign companies to comply with U.S. laws such as Sarbanes-Oxley). In short, derivatives trading can be an excellent way to either break into the trading market or to round out an existing portfolio. It offers a wide range of options, including international opportunities. Finally, with some skill, research, and a bit of luck, it can be a good way to make your money work for you.

CHAPTER - 9 DERIVATIVE MARKET WORLDWIDE:

EUREX:

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Eurex is one of the worlds leading derivatives exchanges providing European benchmark derivatives featuring open and low-cost electronic access globally. Its electronic trading and clearing platform offers a broad range of products, and amongst others operates the most liquid fixed income markets. Eurex was established in 1998 with the merger of Deutsche Termin Borse (DTB, the German derivatives exchange) and SOFFEX ( Swiss Options and Financial Futures). EUREX is considered one of the big three derivative exchanges along with NYSE Euronext life and the Chicago Mercantile. It is owned by Qeutsche Borse and SIX Swiss Exchange. The trading participants are connected to the EUREX system via a communications network; at present, some 700 locations worldwide are connected to eurex.

EURONEXT:
Euronext was formed on 22 September 2000 following a merger of the Amsterdam Stock Exchange, Brussels Stock Exchange and Paris Bourse, in order to take advantage of the harmonization of the European Union Financial Market. In December 2001, Euronext acquired the shares of the London International Financial Futures and Options Exchanges (LIEFE), which continues to operate under its own governance. Beginning in early 2003, all derivatives product traded on its affiliated exchanges trade on LIEFE CONNECT, LIEFEs electronic trading platform. They provide a wide range of futures and option product on short-term interest rates, bonds, swaps, equities and commodities.

LME :
The London Metal Exchange is the worlds premier non-ferrous metals , market with highly liquid contracts and worldwide reputation. Its turnover in 2005 is in excess of us$4,500 billion. It also contributes to

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the UKs invisible earnings to the sum of more than 250 million in overseas earnings each year.

CBOT:
The Chicago Board Of Trade (CBOT) established in 1848, is leading futures and options exchanges. More than 3,600 CBOT members trade 50 different futures and options products at the exchange through open auction and/or electronically.

CHE :
Chicago Mercantile Exchange is the largest futures exchange in the United States and also owns and operates the largest futures Clearing House in the world. CHE products fall into five major areas : interest rates, equities, foreign exchange, agricultural commodities and alternatives instrument.

NASDAQ :
NASDAQ is the largest U.S. electronic stock market. With appropriately 3,200 companies, it lists more companies and, on average, trades more shares per day than any other U.S. market. It is home to companies that are leader across all areas of business, including technology, retail, communications, financial services, transportation, media and biotechnology.

CHAPTER - 10

TRADING PROCESS :

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Trading is done through computerized system of the exchange/brokers. A party buying or selling futures contracts makes an initial deposit of margin amount. If at the time of settlement, the rates moves in its favour, it makes a gain. This amount of gain can be immediately withdrawn or left as a credit in the account. In case the closing rate moves against the party, margin call is made and the amount of loss is debited to its account. As soon as the margin account falls below the maintenance margin, the party has to credit some amount in the account so as to bring it to the original level.

CLEARNING & SETTLEMENT

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Clearing refers to the administrative process initiated when an agreement to buy or sell a derivatives instrument is made through the exchange.

MATCHING CENTRAL COUNTERPARTY CASH SETTLEMENT DELIVERY: Matching means that the parties agree on the condition of the transaction i.e. what has been bought or sold, price, quantity,

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etc. central counterparty clearing is when the clearing organization becomes the legal counterparty in a transaction. Cash settlement refers to settlement of premiums, fees, mark-tomarket & other cash settlement. Delivery of the underlying stock or cash settlement occurs after expiration or premature exercise. CASH SETTLEMENT IN SEK:Riskbank the Swedish central bank, runs electronic cash clearing system for banks known as K-RIX which is used to settle cash transaction in SEK on the settlement day. These cash settlement relates premium, fees, mark-to-market and other cash settlement not relating to delivery. The Swedish Central Securities Depository (CSD) handles settlement involving all payment relating to deliveries on the Swedish market. Settlement is carried out per clearing member & payment bank. Members that are not participants in the payment or the CSD system must use an institution that is such a participant to be able to fulfill their obligations with respect to settlement & delivery.

REGULATORY FRAMEWORK

REGULATORY FRAMEWORK OF DERIVATIVE MARKET IN INDIA

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With the amendment in the definition of securities under SCA ( to include derivatives contract in the definition of Securities), derivatives trading takes place under the provisions of the Securities Contracts Act, 1956 & the Securities & Exchange board of India Act, 1992. Dr.L.C.Gupta committee constituted by SEBI had laid down the regulatory framework for derivatives trading in India. SEBI has also framed suggestive bye-law for derivatives Exchanges/Segment and their clearing Corporation/House which lays down the provisions for trading & settlement of derivatives contracts. The Rules, Bye-laws & Regulation
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of the derivative segment of the exchanges & their clearing corporation Bye-laws. SEBI has also laid the eligibility condition for derivative. It provide a transparent trading environment, safety & integrity & provide facilities for redressal of investor grievances.

RULES GOVERNING INTERMEDIARIES:Mr.Shipe specialize in the regulation of intermediaries in the securities & derivative markets. His practice includes:Counselling brokers , dealers regarding their obligations under federal & state securities laws and the rules of self - regulatory organization. Advising banks as to the permissible ranges of securities activities under regulation legislative & regulatory advocacy on behalf of investment industry associations. At the SEC, he advised on matter relating to broker dealer registration, dealer compensation, investment marketing & supervision requirement. He has extensive experience with the rules of NASO, the New York Stock Exchange, the Municipal Securities Rulemaking Board the national futures association & other self regulatory organizations. Mr.Shipe also advised SEC staff regarding inspection, investigation & litigation in matter involving revenue, sharing; the marketing of mutual funds & market timing.

CLEARING BANKS:NSCCL has empanelled 13 clearing banks Namely Axis Bank Ltd, Bank Of India, Canara Banks, Citibank N.A, HDFC Bank, Hong kong& Shanghai Banking Corporation Ltd, ICICI Bank, IDBI Bank. Industrial
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Bank, Kotak Mahindra Bank, Standard Chartered Bank, State Bank Of India & Union Bank Of India. Every clearing member is required to maintain & operate clearing accounts with any of the empanelled clearing banks at the designated clearing bank branches.

CASE STUDY 1: FAST TO MARKET

A major player in the U.S. futures industry, Rosenthal Collins Group (RCG) of Chicago realized that to compete in the emerging world of electronic futures trading they needed a way
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to services a new breed of Internet savvy traders. They decided as a first step they should create a way to accept applications for mew accounts online. Together with Connamara System, RCG created an online version of their account forms. It only took this team four weeks to create, deploy account for 90% of the total new account submissions at RCG.

SITUATION:
Since it was founded in 1922, RCG had become a leader in servicing customers who traded open-outcry futures markets. By the end of 2001 the futures trading world was demanding more and more electronic trading services. RCG recognized that to remain competitive and grow it would need to address the needs of these internet savvy customers. To help support their venture into this new area of futures trading, RCG decided that they needed to create and deploy an online account forms applications. Time to market was critical if RCG wanted to be recognized as a leader in e-trading.

SOLUTION:
RCG contacted Connamara System to recommend a solution. RCG was surprised at the recommended approach. RCG needed online representations of their account forms that covered all account types : individual, joint, corporate and
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partnership. To create and release a site with this complexity would not allow RCG to meet their time to market objectives. Working with the RCG compliance and customer service staff, Connamara discovered that a majority of the new accounts being opened were for individuals. Armed with this knowledge, Connamara devised a Quick to market implementation and release plan. This plan began with creating account forms for individuals only and placing these account forms into production. This allowed RCG to capture a majority of the new account submissions and validate their assumption about the feasibility and cost of rolling out an online account forms application.

CONCLUSION
For carrying out this project in best was possible I accumulated a lot of information on derivative and studied the

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market scenario by all the ways I could after having done all this I conclude by saying that Derivatives Securities Markets plays an important role by allowing investors who do not want the risks associated with holding an asset to transfer it to those who do. However, because they are market for risks as opposed to physical assets, derivatives markets can be every dangerous place for unsophisticated investors. People who reduce their risk by entering a derivatives market are called hedgers & those who increase their risk are called speculators. The Derivatives Securities Markets play a vital role in the modern financial system and without them many common business transaction would be rendered mush riskier or practically impossible.

BIBLOGRAPHY Books & websites searched

Books :

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When & How to invest Your Money Ratan K Sharma & Ajay Garg.

Derivatives Markets in India Dr . Susan Thomas

Derivatives TV Somanathan

Website :
www. Ncdex.com

www.fmc.gov.in www.nseindia.com

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