Introduction to the Project

Derivatives have vital role to play in enhancing shareholder value by ensuring access to the cheapest source of funds. Active use of derivatives instruments allows the overall business risk profile to be modified, thereby providing the potential to improve earning quality by offsetting undesired risk. Under my project report I have studied various trends that comes in the way of Derivatives Market because impression is usually given that losses arose from derivatives are extremely complex and difficult to understand financial strategies. So after interviewing with different brokers, investors and dealers I have tried to give a solution to these complexities. I also find out that what would be the future of derivative market in India on the basis of interviews and observations of brokers, dealers and investors regarding future. I have find out that derivatives can be indeed used safely and successfully provided a sensible control and management strategy is established and executed in spite of that more awareness should be done and technical expertise knowledge should be more expanded.

Objectives of the Project

The main Objectives of my final project report are as follows: To study the various trends that comes in the way of derivatives market. To find out that what would be the future and market potential of derivatives market in India. To know the awareness & familiarity of investors, dealers and brokers hold regarding derivative markets. To know the experience of dealers, investors and brokers with derivatives till date To get knowledge about shortcomings in Indian derivative market.

INTRODUCTION TO THE STOCK EXCHANGE

A Stock exchange is a corporation or mutual organization which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends. The securities traded on a stock exchange include: shares issued by companies, unit trusts and other pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it has to be listed there. Usually there is a central location at least for record keeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives those advantages of speed and cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors which, as in all free markets, affect the price of stocks. There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that bonds are traded. Increasingly, stock exchanges are part of a global market for securities. The Securities Contract (Regulation) Act 1956 defines Stock Exchange as: A body of individuals whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling & dealing in securities.

A Stock Exchange is the essential pillar of the private sector and corporate economy. It is the open auction market where buyers and sellers meet and involve a competitive price for the securities. It reflects hopes aspiration and fears of people regarding the performance of the economy. It exerts a powerful and significant influence as a depressant or stimulant of business activity. So, stock exchange mobilizes savings, canalizes them as securities into those enterprises which are favored by the investors on the basis of such criteria as - Future growth prospects. - Good Returns. - Appreciation of capital.

The stock exchange serves the role of barometer, not only of the state of wealth of individual companies, but also of the nations economy as a whole (it measures of all the pull and pressure of securities in the market). The trade in market is through the authorized members who have duly registered with concerned stock exchange and SEBI. Stock markets refer to a market place where investors can buy and sell stocks. The price at which each buying and selling transaction takes is determined by the market forces (i.e. demand and supply for a particular stock). Let us take an example for a better understanding of how market forces determine stock prices. ABC Co. Ltd. enjoys high investor confidence and there is an anticipation of an upward movement in its stock price. More and more people would want to buy this stock (i.e. high demand) and very few people will want to sell this stock at current market price (i.e. less supply). Therefore, buyers will have to bid a higher price for this stock to match the ask price from the seller which will increase the stock price of ABC Co. Ltd. On the contrary,

if there are more sellers than buyers (i.e. high supply and low demand) for the stock of ABC Co. Ltd. in the market, its price will fall down. In earlier times, buyers and sellers used to assemble at stock exchanges to make a transaction but now with the dawn of IT, most of the operations are done electronically and the stock markets have become almost paperless. Now investors dont have to gather at the Exchanges, and can trade freely from their home or office over the phone or through Internet.

FEATURES OF THE STOCK EXCHANGE:

It provides the trading platform where buyers and sellers meet to transact in securities. The stock exchange in India is under the supervision of the regulatory authority, the Securities and Exchange Board of India It is the place where sale and purchase of existing securities is done. It enables an investor to adjust his holdings of securities in response to changes in assessment about risk and return. It enables to meet the liquidity needs by providing market for sale of securities. Stock exchange is an association of individual members called member brokers. Stock exchanges are formed for the purpose of regulating and facilitating the buying and selling of securities. Stock exchange operate with due recognition from the govt. under securities and contract regulation act 1956. Stock exchange facilitates trading in securities of the public sector companies as well as govt. securities. It acts as a host of intermediaries which assist in trading of securities and clearing and settlement of trade.

History of the Indian Stock Market

One of the oldest stock markets in Asia, the Indian Stock Markets has a 200 years old history.

18th Centur y 1830's

1840's 1850's

1860's 186061

186263 1865

East India Company was the dominant institution and by end of the century, business in its loan securities gained full momentum Business on corporate stocks and shares in Bank and Cotton presses started in Bombay. Trading list by the end of 1839 got broader Recognition from banks and merchants to about half a dozen brokers Rapid development of commercial enterprise saw brokerage business attracting more people into the business The number of brokers increased to 60 The American Civil War broke out which caused a stoppage of cotton supply from United States of America; marking the beginning of the "Share Mania" in India The number of brokers increased to about 200 to 250 A disastrous slump began at the end of the American Civil War (as an example, Bank of Bombay Share which had touched Rs. 2850 could only be sold at Rs. 87)

Pre-Independence Scenario - Establishment of Different Stock Exchanges

1874

1875

1880' s 1897 1880 90's 1908 1920

1923

1934 1936 1937

With the rapidly developing share trading business, brokers used to gather at a street (now well known as "Dalal Street") for the purpose of transacting business. "The Native Share and Stock Brokers' Association" (also known as "The Bombay Stock Exchange") was established in Bombay Development of cotton mills industry and set up of many others Establishment of "The Ahmedabad Share and Stock Brokers' Association" Sharp increase in share prices of jute industries in 1870's was followed by a boom in tea stocks and coal "The Calcutta Stock Exchange Association" was formed Madras witnessed boom and business at "The Madras Stock Exchange" was transacted with 100 brokers. When recession followed, number of brokers came down to 3 and the Exchange was closed down Establishment of the Lahore Stock Exchange Merger of the Lahore Stock Exchange with the Punjab Stock Exchange Re-organisation and set up of the Madras Stock Exchange Limited (Pvt.) Limited led by improvement in stock market activities in South India with establishment of new textile mills and

1940 1944 1947

plantation companies Uttar Pradesh Stock Exchange Limited and Nagpur Stock Exchange Limited was established Establishment of "The Hyderabad Stock Exchange Limited" "Delhi Stock and Share Brokers' Association Limited" and "The Delhi Stocks and Shares Exchange Limited" were established and later on merged into "The Delhi Stock Exchange Association Limited"

Post Independence Scenario

The depression witnessed after the Independence led to closure of a lot of exchanges in the country. Lahore stock Exchange was closed down after the partition of India, and later on merged with the Delhi Stock Exchange. Bangalore Stock Exchange Limited was registered in 1957 and got recognition only by 1963. Most of the other Exchanges were in a miserable state till 1957 when they applied for recognition under Securities Contracts (Regulations) Act, 1956. The Exchanges that were recognized under the Act were:

1. 2. 3. 4. 5. 6. 7.

Bombay Calcutta Madras Ahmedabad Delhi Hyderabad Bangalore

8. Indore

Many more stock exchanges were established during 1980's, namely:

Cochin Stock Exchange (1980) Uttar Pradesh Stock Exchange Association Limited (at Kanpur, 1982) Pune Stock Exchange Limited (1982) Ludhiana Stock Exchange Association Limited (1983) Gauhati Stock Exchange Limited (1984) Kanara Stock Exchange Limited (at Mangalore, 1985) Magadh Stock Exchange Association (at Patna, 1986) Jaipur Stock Exchange Limited (1989) Bhubaneswar Stock Exchange Association Limited (1989) Saurashtra Kutch Stock Exchange Limited (at Rajkot, 1989) Vadodara Stock Exchange Limited (at Baroda, 1990) National stock Exchange of India Limited (1994) Coimbatore Stock Exchange (1996) OTC Stock Exchange of India Interconnected Stock Exchange (ICSE)

At Present there are 23 recognized stock exchanges in India. From these BSE & NSE are the two major stock exchanges and rest 21 are the regional stock exchanges. Daily turnover of all the stock exchange is appropriately 20,000 cr. BSE is 133 years old. NSE is 14 years old and it brought the screen based trading system in India.

The Function of Stock Exchanges

Stock exchanges have multiple roles in the economy, this may include the following: Raising capital for businesses The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public. Mobilizing savings for investment When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilized and redirected to promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in a stronger economic growth and higher productivity levels and firms. Facilitating company growth Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a merger agreement through the stock market is one of the simplest and most common ways for a company to grow by acquisition or fusion. Redistribution of wealth

Stocks exchanges do not exist to redistribute wealth. However, both casual and professional stock investors, through dividends and stock price increases that may result in capital gains, will share in the wealth of profitable businesses. Corporate governance By having a wide and varied scope of owners, companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations imposed by public stock exchanges and the government. Consequently, it is alleged that public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than privately-held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs, or otherwise by a small group of investors). Creating investment opportunities for small investors As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares of the same companies as large investors. Government capital-raising for development projects Governments at various levels may decide to borrow money in order to finance infrastructure projects such as sewage and water treatment works or housing estates by selling another category of securities known as bonds. These bonds can be raised through the Stock

Exchange whereby members of the public buy them, thus loaning money to the government. The issuance of such bonds can obviate the need to directly tax the citizens in order to finance development, although by securing such bonds with the full faith and credit of the government instead of with collateral, the result is that the government must tax the citizens or otherwise raise additional funds to make any regular coupon payments and refund the principal when the bonds mature. Barometer of the economy At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.

Who Benefits from Stock Exchange

Investors: It provides them liquidity, marketability, safety etc. of investments. Companies: It provides them access to market funds, higher rating and public interest. Brokers: They receive commission in lieu of services to investors. Economy and Country: There is large flow of saving, better growth, more industries and higher income.

Trading Pattern of the Indian Stock Market

Indian Stock Exchanges allow trading of securities of only those public limited companies that are listed on the Exchange(s). They are divided into two categories:

Types of Transactions
The flowchart below describes the types of transactions that can be carried out on the Indian stock exchanges:

Indian stock exchange allows a member broker to perform following activities:

Act as an agent, Buy and sell securities for his clients and charge commission for the same, Act as a trader or dealer as a principal, Buy and sell securities on his own account and risk.

About Ludhiana stock Exchange

Ludhiana Stock Exchange Association Limited (LSE) was established in the year 1983 by Sh. S.P. Oswal and Sh. B.M. Munjal, leading industrial luminaries, to fulfill a vital need of having a Stock Exchange in this region. Since its inception, the Stock Exchange has grown phenomenally. By 19992000, the exchange had a total of 284 brokers, out of which 79 were corporate brokers. Among 284 brokers, it was further classified as 212 proprietor brokers, 2 partnership brokers and 70 corporate brokers. Then, there were only 23 sub-brokers registered. Ludhiana Stock Exchange became the second bourse in India to introduce modified carry forward system after BSE on April 6, 1998. On the same date, LSE also introduced a settlement guarantee fund (SGF). The SGF guarantees settlement of transactions and the carry forward facility provides liquidity to the market. LSE became the first in India to start LSE Securities Ltd., a 100% owned subsidiary of the exchange. The LSE Securities got the ticket as sub-broker of the NSE. In 1998, the exchange also got permission to start derivative trading.

OPERATIONS OF LUDHIANA STOCK EXCHANGE:

Turnover: LSE is one of the leading Stock Exchanges among the Regional Stock Exchanges of the country, and has been providing a trading platform for the investors situated in Punjab, J&K, Himachal Pradesh and Chandigarh. At present it has 344 listed companies and among them, 220 are listed as regional companies. It had been generating significant amount of business in the secondary market. It recorded a peak turnover of Rs.9154crores during the year 2000-2001. The structural changes that took place in the recent past in

the Capital Market of the country had a negative impact on the trading volume of the Regional Stock Exchanges. There has been a significant reduction of turnover during the financial year 2001-2002, but the reduction in turnover of the Exchange has been more than adequately compensated by substantial rise in the turnover of LSE Securities Limited, a subsidiary of Ludhiana Stock Exchange. Listing: Listing is one of the major functions of a Stock Exchange wherein the securities of the Companies are enlisted for trading purpose. It is mandatory for the company coming out with an IPO to get its shares listed on the Stock Exchange. The Listing Dept. of the LSE deals with listing of securities, further listing of issues like bonus and rights issues, postlisting compliance of the companies, which are already listed with LSE. The companies desirous of listing its securities on the Exchange have to sign a Listing Agreement with the Stock Exchange. After getting the listing approval, the company has to ensure and report compliance of the post listing requirements. The listing section of the LSE monitors the post-listing compliance of all the listed companies and follows up with the companies, which are found deficient in compliance. Settlement Guarantee Fund (SGF): The Stock Exchange established a Settlement Guarantee Fund (SGF) on April 6, 1998. It provides guarantee of all the genuine trades made through the Screen Based Trading System of the Stock Exchange. Investors related services: The stock exchange offers the various services investors related services such as it has formed the Investor Grievance Cell which receives complaints from investors and follows up the complaints with companies and member-brokers to ensure their satisfactorily redressal. It has also set up an Investors Protection Fund, Investors Service Center; more over for the education of investors it has been organizing investors awareness

workshops in the parts of Punjab, Himanchal Pradesh, Chandigarh and adjoining areas of Rajasthan and Haryana since March, 2003. DEPARTMENTS OF LSE: The main aim of LUDHIANA STOCK EXCHANGE is to ensure the safety and security to the investors and to provide the proper services under the prescribed guidelines of SE 131. So to maintain the proper system of working of exchange, there are so many different interconnected departments, which perform the specific functions. There is an organized network of activities performed in various departments.

LIST OF THE VARIOUS DEPARTMENTS

A) Operational Departments: Margin Section Clearing House Market Surveillance Computer Section and Information System Department

B) Service Departments: Legal Department Secretarial Dept. I.G.C. (Investor Grievance Cell) Listing Section Accounting Section Membership Department/Personnel Department

Introduction To Derivatives
Primary market is used for raising money and secondary market is used for trading in the securities, which have been used in primary market. But derivative market is quite different from other markets as the market is used for minimizing risk arising from underlying assets. The word "derivative" originates from mathematics. It refers to a variable, which has been derived from another variable. That is, X = f (Y) WHERE, X (dependent variable) = DERIVATIVE PRODUCT Y (independent variable) = UNDERLYING ASSET A financial derivative is a product that derives value from the market of another product. Hence derivative market has no independent existence without an underlying asset. The price of the derivative instrument is contingent on the value of underlying assets. Derivative means a Forward, Future, Option or any other hybrid contract of Pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. As a tool of risk management we can define it as, "a financial contract whose value is derived from the value of an underlying asset/derivative security ". All derivatives are based on some cash product. The underlying assets can be:

 Any type of agriculture product of grain (not prevailing in India). Price of precious and metals gold. Foreign exchange rates. Short term as well as long-term bond of securities of different type issued by Govt. and Companies etc. O.T.C. money instruments for example loan & deposits. Example: Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. The price of these derivatives is driven from spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the derivative and wheat on the spot market is the underlying. The terms derivative contract, derivative product, or derivative are used interchangeably. In Indian context, the Securities Contract (regulation) act, 1956 [SC(R) A] defines Derivative to include: A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for difference or any other from of security. A contract which drives its value from prices, or index of prices, or underlying security.

HISTORICAL ASPECT OF DERIVATIVES:

The need for Derivatives as hedging tool was first felt in the commodities market. Agriculture F&O helped farmers and PROCESSORS hedge against commodity price risk. After the fallout of BRITAIN WOOD AGREEMENT, the financial markets in the world started undergoing radical changes, which gave rise to the fear factor. This situation led to development of derivatives as Risk Management tools. Derivative trading in financial market started in 1972 when "Chicago Mercantile Exchange opened its International Monetary Market Division (IIM). The IMM provided an outlet for currency speculators and for those looking to reduce their currency risks. Trading took place on currency. Futures, which were contracts for specified quantities of given currencies, the exchange rate was fixed at time of contract later on commodity future contracts was introduced then followed by interest rate futures. Looking at the liquidity market, derivatives allow corporate and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund e.g. can reduce its exposure to the stock market and at a relatively low cost without selling of part of its equity assets by using stock index futures or index options. Therefore the stock index futures first emerged in U.S.A. in 1982.

ORIGIN OF DERIVATIVE TRADING IN INDIA:

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof. J. R. Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000,

the threedecade old notification, which prohibited forward trading in securities.

Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.

Some milestones:
Nov.1996 - Formation of Dr. L C Gupta Committee Dec.1999 - Formation of Prof. J R Varma Committee May 2000 - Granting approval by SEBI June 2000 Commencement of Derivatives Trading (Index Futures) June 2001 Commencement of trading in Index Options July 2001 Commencement of trading in Options on Individual Securities November 2001 Commencement of trading in Futures on Individual Securities August 2003 Launch of Futures & options in CNXIT Index June 2005 Launch of Futures & options in BANK Nifty Index December 2006 'Derivative Exchange of the Year', by Asia Risk magazine

Products, Participants And Functions:

Derivatives contract have several variants. The most common are FORWARDS, FUTURES, OPTIONS AND SWAPS. The following three categories of Participants are - Hedgers, speculators and Arbitrageurs.
(1) Hedger: Hedgers face risk associated with the price

of an asset. They use futures or options markets to reduce the risk. Thus, they are operators who want to eliminate the risk composing of their portfolio.
(2) Speculators: They wish to be on future movement in

the price of an asset. A speculator may buy securities in anticipation of rise in price. If this expectation comes true he sells the securities at a higher price and makes a profit. Usually the speculator does not take direct delivery of securities sold by him. He only receives and pay the difference between the purchase and sale prices.
(3) Arbitrageurs:

They are in business to take advantage of discrepancy between prices in two different markets. For example, they see the future price of an asset getting out of line with the cash price, they will take off setting positions in two markets to lock in profit.

Operators in Derivative Market

Hedgers

Speculator

Arbitrageur

TYPES OF DERIVATIVE CONTRACTS: The following types of derivative contracts are there. But, the most commonly used derivative contracts are forwards, futures and options. FORWARDS: a forward contract is a customized contract between two entities, where settlement takes place on a specific date in the futures at today's preagreed price. FUTURES: a future contract is an agreement between two parties to buy or sell an asset at a certain time the future at the certain price. Futures contracts are the special types of forward contracts in the sense that are standardized exchange traded contracts. OPTIONS: options are of two types: call option and put options. a. Call Option gives the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a give price on or before a given future date. b. Put Option gives the buyer the right but not the obligation to sell a give quantity of the underlying asset at a given price on or before a given date.

Cash Vs Derivative Market

The basis differences between these two may be noted as follows: In cash market tangible asset are traded whereas in derivatives market contract based on tangible assets or intangible like index or rates are traded.

 The value of derivative contract is always based on and linked to the underlying asset. Though, this linkage may not be on point-to point basis. Cash market contracts are settled by delivery and payment or through an offsetting contract. The derivative contracts on tangible may be settled through payment and delivery, offsetting contract or cash settlement, whereas derivative contracts on intangibles are necessarily settled in cash or through offsetting contracts. The cash markets always have a net long position, whereas the net position in derivative market is always zero. Cash asset may be meant for consumption or investment. Derivatives are used for hedging, arbitration or speculation. Derivative markets are highly leveraged and therefore could be much more risky.

THE DERIVATIVE MARKETS PERFORM A NUMBER OF ECONOMIC FUNCTIONS:

Prices in organized derivative markets reflect the perception of market participants about the future and lead the prices of underlying to perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well current prices. The derivative market helps to transfer the risks from those who have them but may like them to those who have an appetite for them. Derivatives due to their inherent nature are linked to the underlying cash markets. With the introduction of derivative, the underlying market, witness higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

 Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new business, new products and new employment opportunities, the benefits of which are immense. Derivatives market helps increase savings and investments in the long run Transfer of risk enables market participants to expand their volume of activities.

Participants in Derivative Market:

Exchange, trading members, clearing members. Hedgers, arbitrageurs, speculators. Clearing, clearing bank. Financial institutions. Stock lenders and borrowers.

Objectives of Derivative Trading:

(1) Hedging: You own a stock and you are confident

about the prospects of the company. However at the same time you feel overall market may not perform as well and therefore price of your stock may also fall in line with overall market trend. You expect that some adverse economic or political event might affect the market sentiments, though fundaments of the company will remain good, therefore, it is good to retain the stock. In both these situations you would like to insure your portfolio against any such market fall. Such insurance is known as Hedging. Hedging is a tool to reduce the inherent risk in an investment. Various strategies designed to reduce

investment risk using call options, put options, short selling, and futures are used for hedging. The basic purpose of a hedge is to reduce the risk of loss.
(2) Speculation: You may have very strong opinion about

the future market price of a particular asset based on past trends, current information and future expectation. Likewise you may also have an opinion about the overall market trend. To take advantage of such opinion, individual asset or the entire market (index) could be sold or purchased. Position taken either in cash market of derivative market on the basis of personal opinion is known as speculation.
(3) Arbitrage: The future price of an underlying asset is

function of spot price and cost of carry adjusted for any return on investment. However, due to uncertainty about interest rates, distortions in spot prices, or uncertainty about future income stream, prices in futures market may not truly reflect the expected spot price in future. This imbalance in future and spot price in the market are known as arbitrage transactions.

REASON FOR STARTING DERIVATIVES:

a. Counter party risk on the part of broker, in case it asks money from us but before giving delivery of shares goes bankrupt. b. Liquidity risk in the form that the particular scrip might not be traded on exchange. c. Unsystematic risk in the form that the price of scrip may go up or down due to "Company Specific Reasons". d. Mutual funds may find it difficult to invest the funds raised by them properly as the scrip in which they want to invert might not be available at the right price. e. Systematic risk in the form that the price of scrip may go up or down due to reason affecting the sentiment of whole market.

STRENGTH OF INDIAN CAPITAL MARKET FOR INTRODUCTION OF DERIVATIVES:

Large Market Capitalization: India is one of the

largest market capitalized country in Asia with a market capitalization of more than 7,65,000 corers. High Liquidity: In the underlying securities the daily average traded volume in Indian capital market today is around 7,500 crores, which means on an average every

month 14% of the country market capitalization gets traded, shows high liquidity. Trader Guarantee: The first "clearing corporation" (CCL) guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL) for which it does the clearing. Strong depository: A strong depository National Securities Depositories Ltd. (NSDL), which started functioning in the year 1997, has strengthen the securities settlement in our country. A Good Legal Guardian: SEBI is acting as a good legal guardian for Indian Capital market.

IMPORTANCE OF DERIVATIVE TRADING:

a. Reduction of borrowing cost. b. Enhancing the yield on assets. c. Modifying the payment structure of assets to correspond to investor market view. d. No physical delivery of share certificate so reduction in cost by stamp duty. e. Increase in hedger, speculator and arbitrageurs. f. It does not totally eliminate speculation, which is basic need of Indian investors.

INSTRUMENTS OF DERIVATIVE TRADING:

FORWARD Derivative FUTURE OPTIONS

FORWARD CONTRACT:
"It is an agreement to buy/sell an asset on a certain future date at an agreed price". The two parties are: Who takes a long position agreeing to buy Who takes a short positionagreeing to sell The mutually agreed price is known as "delivery price" or "forward price". The delivery price is chosen in such a way that the value of contract for both parties is zero at the time of entering the contract, but the contract takes a positive or negative value for parties as the price of

underlying asset moves. It removes the future price risk. It a speculator has information or analysis, which forecast an upturn in price, and then he can go long on the forward market instead of cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculator may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of assets underlying the forward contract.

Effect of change in price:

As mentioned above the value of such a contract in zero for both the parties. But later as the price & the underlying asset changes, it gives positive or negative value for contract. PRICE UNDERLYING ASSETS INCREASE DECREASE POSITIVE VALUE NEGATIVE VALUE NEGATIVE VALUE POSITIVE VALUE & HOLDER POSITION & LONG HOLDER & SHORT POSITION

E.g: Suppose that A wants to buy a house in one year's time. At the same time, suppose that B currently owns a house worth Rs.1 lac that he wishes to sell in one year's time. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of Rs.104,000 (more below on why the sale price should be this amount).A and B have entered into a forward contract. A, because he is buying the underlying, is said to have entered a long forward contract. Conversely, B will have the short forward contract.

At the end of one year, suppose that the current market valuation of Bs house is Rs.110,000. Then, because B is obliged to sell to A for only Rs.104,000. A will make a profit of Rs.6,000. To see why this is so, one needs only to recognize that A can buy from B for Rs.104,000 and immediately sell to the market for Rs.110,000. A has made the difference in profit. In contrast, B has made a potential loss of Rs.6,000, and an actual profit of Rs.4000. Profit/Loss = ST-E Where, ST= Spot price on maturity date E = Delivery price

Limitations of forward contract:

No standardization. One party can breach its obligation. Lack of centralization of trading. Lack of liquidity

A forward contract is specified with four variables:

the underlier, the notional amount n, the delivery price k, and the

settlement date on which the underlier and

payment will be exchanged.

Futures
A futures contract is a legally binding agreement to buy or sell a specific commodity, such as soybeans, or financial

instrument, such as silver or the Euro, on a particular date in the future at an agreed upon price. Futures belong to a category of financial instruments known as derivatives, because their prices are derived from the value of other, underlying instruments, items, or products. In the case of futures, commodities of various kinds are the products underlying the contracts.

From Forward to Future

Futures developed from forward contracts, originally used by commodity producers corn farmers for example who wanted to lock in the price they were to be paid for corn when it was harvested some months later. The object was to reduce risk. With the contract in hand, the farmer could be protected if corn prices dropped.

Futures contracts formalized the forward contract process, imposing standard contract terms for grade or quality quantity, time, and location. With the imposition of standard delivery specifications, it became possible to trade contracts on an organized exchange, creating a futures marketplace. Buying and selling a futures contract does not transfer ownership, as buying or selling a stock does. Rather, it spells out the terms under which the underlying commodity is to be purchased or sold at a later date.

Categories of futures
Two distinct categories of commodities underlie futures contracts consumable and financial. Historically, futures contracts were for consumable commodities commodities that are the raw materials literally consumed in production processes that create food, fuel, clothes, cars, houses, and thousands of other products that consumers buy. Futures contracts were, and still are in many cases, a way to help protect the producers and users of the consumable commodities the gold miner and the jeweler, the oat grower and the cereal maker from the risk of price fluctuations. Though you may not think of currencies or Treasury bonds as commodities, they are. Money is as much the raw material of domestic and international trade, as wheat is the raw material of bread. The value of a currency concerns people whose businesses depend on the money supply, or on what imported materials will cost. There are four basic categories of financial commodities that are the subject of futures contracts: Currencies Stock indexes Interest rates Individual stocks

Futures contracts

A futures transaction always has two parties, a buyer and a seller, and you can enter the market either way. If you buy a contract, you take a long position and are called the long. If you sell a contract, you take a short position and are called the short. Further, in the futures market, every contract has an equal number of long and short positions. To liquidate and leave the futures market, you need to cancel your existing futures position either by offsetting your contract with a matching futures contract on the opposite side of the market, or by delivering or taking delivery of the commodity or its cash value. Long positions are offset by short positions, and short positions by long ones. For example, if you have a long position on 5,000 bushels of soybeans deliverable in January, you need to short or enter a contract to sell 5,000 bushels of soybeans deliverable in January or expect to have the 5,000 bushels delivered to your doorstep. This obligation differs from the terms of an options contract you buy, which you may allow to expire unexercised. But it resembles what happens when you sell an options contract and must offset or fulfill your part of the bargain. To overcome the problems in forward contract, other type of derivative instrument known as "Future Contract came into existence. It is an agreement between buyer and seller for the purchase and sale of a particular assets at a specific future date; specific size, date of delivery, place and alternative asset. It takes obligation on both parties to fulfill

the contract

Futures Fundamentals:
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities - remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators. The consensus in the investment world is that the futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions.

Features of Future Contract:

Standardized contracts e.g. contract size. Between two parties who do not necessarily know each other. Guarantee for performance by a clearing corporation or clearing house. Clearinghouse is associated with matching, processing, registering, confirming setting, reconciling and guaranteeing the trades on the future

exchanges. Clearinghouse tries to eliminate risk of default by either party.

Standardized Items in Futures:

Quantity of the underlying Quality of the underlying The date and month of delivery The units of price quotation and minimum price change Location of settlement

Future terminology:
Spot price: the price at which an asset trades in the spot market. Futures price: the price at which the futures contract trades in the futures market. Contract cycle: the period over which the contract trades. The index futures contracts on the NSE have one month, two month, and three-month expiry cycles, which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of the January. On the Friday following the last Thursday, a new contract having three-month expiry is introduced of trading. Expiry date: it is date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: the amount of asset that has to be delivered less than one contract. For instance, the contract size on NSE's futures market is Nifties.

Basis: in the contract of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. in a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Initial margin: the amount that must be deposited in the margin account at a time a future contract is first entered into is known as initial margin. Cost of carry: the relation between futures price and spot price can be summarized in terms of what is known as cost of carry. This measures the storage cost plus the interest that is paid to finance the assets less the incomes earned on the asset. Marking-to-market: in the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's margin gain or loss depending upon the future's closing price. Maintenance margin: this is somewhat lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance amount falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

Forwards Vs Futures:
Features Operational Mechanism Contract specification Forward Traded between two parties Customized contract Future Traded thro exchange Standardized contract

Counter party risk Exists such risk liquidity Price discovery example settlement low Not efficient current market At end of period

No such risk High Highly efficient current market Daily

Futures Payoffs:
Futures contracts have linear pay-offs unlimited profits or losses Payoff for buyer of futures: long futures An obligation to take delivery at a future date Similar to that of a person who holds an asset Example - A speculator buys a two-month nifty index futures contract when the nifty stands at 3250. When the index starts moving up, the long futures position makes profits and when the index moves down the future starts making losses. Payoff for seller of futures: short futures An obligation to give delivery at a future date Similar to that of a person who sells/shorts an asset Example - A speculator sells a two-month nifty index futures contract when the nifty stands at 3250. when the index starts moving down, the short futures position makes profits and when the index moves up the future starts making losses.

Futures Payoffs:

Gain Loss Sold Futures Current Price Purchase Price of contract Pr of it Pr of it Loss

Gain

Bought Futures

Current Price Purchase Price of Contract

Gain/Loss = Sale Price Purchase Price

Gain/Loss = Purchase Price - Sale Price

Applications of Futures:
Hedging a risk management tool long security, short futures Example an investor holds a security but gets uncomfortable with the movements in the short run. Sees prices falling from 450 to 390. in the absence of stock futures, he either live with it or sells the security. With security futures he can minimize the price risk. He can enter into an off-setting short futures position.

 Assuming spot price is 390. Two-months future costs him Rs. 402, for which he pays an initial margin. If prices fall, so does the price of futures. As a result, his short futures position starts making profits. The loss incurred on the security will be made up by the profit on his short futures position. N.B. Hedging does not always make money! It removes unwanted exposure i.e. unnecessary risk. Speculation bullish security, buy futures Case 1 a speculator believes a security at 1000 is undervalued; in the absence of a deferred product, he has to buy it and hold on to it till his hunch proves correct. assume he buys 100 shares which cost him one lakh rupees. Two-months later, say the security closes at 1010. he makes a profit of 1000 on an investment of 100,000 for a period of two-months. This works out to be an annual return of 6% . Case 2 the security trades at 1000 and the two-month future at 1006. for the sake of comparison, assume the minimum contract value is 100,000. he buys 100 security futures for which he pays a margin of Rs. 20,000. two months later, the security closes at 1010. on the date of expiration, the future price converges to the spot price and he makes a profit of Rs. 400 on an investment of Rs. 20,000. this works out to an annual return of 12 percent. There lies the power of leverage. Arbitrage Overpriced futures: buy spot, sell futures Cash-and-carry arbitrage opportunity The cost-of-carry ensures that futures price stay in tune with the spot price. Whenever futures price deviates from its fair value, arbitrage opportunities arise. Say X trades at 1000. one month future trades at 1025 and seems overpriced. As an arbitrageur, you can enter into the following trade to make risk-less profit:

 Borrow funds to buy the security in cash/spot

market for 1000. Simultaneously, sell the security future for 1025.

Take delivery of the security and hold for a

month. On futures expiration date, spot and future prices converge. Unwind the position. Say the security closes at 1015. sell the security. Futures position expires with a profit of Rs. 10 The result is a risk-less profit of Rs.15 on the spot position and Rs. 10 on the futures position. Return the borrowed funds.

Economic Market :

Importance

of

the

Futures

Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators. Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.

Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market. TYPE OF FUTURE CONTRACTS: In India, three types of future derivatives are available for trading at NSE & two at BSE. Future derivatives that are trading in BSE are: Equity index future on SENSEX. Stock futures on 41individual securities. Future derivatives that are trading in NSE are: Equity index future on S & P CNX NIFTY. Stock futures on 41 individual securities. Interest rate future on 91/365 T-bills, ten year notional bond (with coupon rate) & ten year notional bond ( zero coupon rate) But now there is more than 125 individual securities.

INDEX FUTURES:
Index futures are futures contracts where the underlying asset is the index. The index futures provide a hedge against price fluctuations of the securities and hedgers are using it as an insurance tool. A stock index future contract is an obligation to deliver at settlement an amount of cash equal to the difference between the stock index value at the clause of the last trading day of the contract & the price at which the futures contracts was originally struck. For instance ,if the SENSEX index is at 3000 & a lot size of contract is equal to 50,a contract struck at this level could be worth

Rs150000(3000* 50).If ,at the expiration of the contracts ,the SENSEX stock index is at 3100,a cash settlement of Rs5000 is required [(3100-3000)*50]. In stock index futures, no physical delivery of stock is made. In India, the BSE was the first stock exchange to introduce Index futures on June 9, 2000 on SENSEX. In NSE the trading of index futures commenced on June 12, 2000 on the S&P CNX NIFTY. The stock index futures are traded on the F&O segment of the both exchanges. Both buyers & sellers are required to deposit margin at the time of contract. The margin amount is based volatility if market indices. In India the initial margin is expected to be around 8-10%.The margin is kept in a way that it covers price movement more than 99% of the time. Usually key sigma (standard deviation) is used or this measurement. This technique is also called value at risk (VAR). In futures market, at the end of each trading day the margin account is adjusted to reflect the investors gains or loss depending up on the futures closing price & variation may be required or released. This is known as MTM (mark to market). In India, three types of future derivatives are available for trading at NSE & two at BSE. Future derivatives that are trading in BSE are: Equity index future on SENSEX. Stock futures on 41individual securities. Future derivatives that are trading in NSE are: Equity index future on S&P CNX NIFTY. Stock futures on 41 individual securities. Interest rate future on 91/365 T-bills, ten year notional bond (with coupon rate) & ten year notional bond (zero coupon rate)

Buying futures
Futures contracts are highly leveraged instruments. Leverage is the ability to control large dollar amounts of a commodity with a comparatively small amount of capital. In most cases, you can buy or sell futures with a good faith deposit, or initial margin of 10% or less of the value of the contract on delivery. The margin acts as a performance bond that is available to the futures broker to meet your obligations for potential losses on a futures position.

Changing

contract

value

Both over the term of your futures contract and throughout a regular trading day, the price of liquidating your futures position changes constantly. So during the term of a contract, you must maintain the margin level of your account, adding money if required to cover the loss if the value of the contract you hold drops. Maintenance margin

requirements may differ from initial margin requirements, depending on the exchange. Maintaining an appropriate margin level affirms to the exchange that you will meet the terms of the contract, either by delivering or taking delivery of the underlying commodity, or, as happens in an estimated 98% of futures transactions, by buying or selling an offsetting contract.

The changes in contract value are caused by fluctuations in the price of an offsetting contract, which in turn is caused by changes in the cash price of the underlying commodity, among other factors. The difference between the price of your contract and the price of an offsetting contract represents the profit or loss of the position.

How futures trading works

Most producers and users of commodities buy and sell them in the cash market, also called the spot market, because the full cash price is paid on the spot. Cash prices are determined by supply and demand, which in many cases move in predictable seasonal cycles. Fresh fruits and vegetables are cheapest in the summer when they're plentiful (and most flavorful). So soup, juice, and jam manufacturers prices. But supply and demand is also affected by unpredictable events. Drought might wipe out a wheat crop, causing the plan their production season to take advantage of the highest-quality produce at the lowest

cash price of wheat to soar. Political turmoil in the Gulf region might threaten the oil supply and cause the cash price of energy commodities to rise. The futures market is designed to help protect producers and users from just such price risks. Farmers, loggers, manufacturers, and bakers can buy futures contracts in the products they produce or use to smooth out the unexpected price fluctuations.

Supply and demand, plus expectations

Futures prices tend to track cash prices closely, but not identically. The difference between the futures contract price and the cash price of the underlying commodity is the basis. Futures prices are determined not only by supply and demand, but also by traders' expectations of a host of other factors, bear. including weather changes, environmental conditions, political situations, and what the market will

Options
Options are fundamentally different from forward and futures. An option gives the holder/buyers of the option the right to do something. The holder does not have committed himself to doing something. In contrast, in a forward or futures contract, the two parties have committed them self to doing something. Whereas it nothing (expect margin requirement) to enter in to a futures he purchases of an option require an up front payment. An options is the right, but not the obligation to buy or sell a specified amount (and quality) of a commodity, currency, index or financial instruments to buy or sell a specified number of underlying futures contracts, at a specified price on a before a give date in the future.

OPTION

BUYER RIGHT

SELLER OBLIGATION

TO BUY (CALL)

TO SELL (PUT)

TO SELL (CALL)

TO BUY (PUT)

Thus, option like futures, also provide a mechanism by which one can acquire a certain commodity on other assets, or take position in order to make profits or cover risk for a price.

Participants in the Options Market:

There are four types of participants in options markets depending on the position they take: 1. 2. 3. 4. Buyers of calls Sellers of calls Buyers of puts Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. Here is the important distinction between buyers and sellers: -Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. -Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell While the buyer takes "long position" the seller take "short position"

History:
Options on stocks were first traded on an organized stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts.

Terminology of Options
Options are of two basic types: The Call and the Put Option A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this which is called "the call option premium or call option price". A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price".

The price at which the underlying asset would be bought in the future at a particular date is the "Strike Price" or the "Exercise Price". The date on the options contract is called

the "Exercise date", "Expiration Date" or the "Date of Maturity". There are two kind of options based on the date. The first is the European Option which can be exercised only on the maturity date. The second is the American Option which can be exercised before or on the maturity date.

In most exchanges the options trading starts with European Options as they are easy to execute and keep track of. This is the case in the BSE and the NSE

Cash settled options are those where, on exercise the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put). Delivery settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of the undertaking (puts).

Call Options
The following example would clarify the basics on Call Options. Illustration1: An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff

table (Table 1). It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer. Payoff from Call Buying/Long (Rs.) S Xt c Payoff Net Profit 57 60 2 0 -2 58 60 2 0 -2 59 60 2 0 -2 60 60 2 0 -2 61 60 2 1 -1 62 60 2 2 0 63 60 2 3 1 64 60 2 4 2 65 60 2 5 3 66 60 2 6 4 A European call option gives the following payoff to the investor: max (S - Xt, 0). The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0). Notes:

S - Stock Price Xt - Exercise Price at time 't' C - European Call Option Premium Payoff - Max (S - Xt, O )

Graph: Net Profit - Payoff minus 'c'

Exercising the Call Option and what are its implications for the Buyer and the Seller?
The Call option gives the buyer a right to buy the requisite shares on a specific date at a specific price. This puts the seller under the obligation to sell the shares on that specific date and specific price. The Call Buyer exercises his option only when he/ she feels it is profitable. This Process is called "Exercising the Option". This leads us to the fact that if the spot price is lower than the strike price then it might be profitable for the investor to buy the share in the open market and forgo the premium paid. The implications for a buyer are that it is his/her decision whether to exercise the option or not. In case the investor expects prices to rise far above the strike price in the future then he/she would surely be interested in buying call

options. On the other hand, if the seller feels that his shares are not giving the desired returns and they are not going to perform any better in the future, a premium can be charged and returns from selling the call option can be used to make up for the desired returns. At the end of the options contract there is an exchange of the underlying asset. In the real world, most of the deals are closed with another counter or reverse deal. There is no requirement to exchange the underlying assets then as the investor gets out of the contract just before its expiry.

Put Options
The European Put Option is the reverse of the call option deal. Here, there is a contract to sell a particular number of underlying assets on a particular date at a specific price. An example would help understand the situation a little better: Illustration 2: An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoff table shows the fluctuations of net profit with a change in the spot price. Payoff from Put Buying/Long (Rs.) S Xt p Payoff Net Profit 55 60 2 5 3 56 60 2 4 2 57 60 2 3 1 58 60 2 2 0 59 60 2 1 -1 60 60 2 0 -2 61 60 2 0 -2 62 60 2 0 -2 63 60 2 0 -2

64 60 2

-2

The payoff for the put buyer = Max (Xt - S, 0) The payoff for a put writer = Max(Xt - S, 0) or Min(S - Xt, 0)

Graph

These are the two basic options that form the whole gamut of transactions in the options trading. These in combination with other derivatives create a whole world of instruments to choose form depending on the kind of requirement and the kind of market expectations.

Exotic Options are often mistaken to be another kind of option. They are nothing but non-standard derivatives and are not a third type of option.

AMERICAN Vs EUROPEAN OPTION:

Its owner can exercise an American option at any time on or before the expiration date.

A European style option gives the owner the right to use the option only on expiration date and not before.

OPTION PREMIUM:
A glance at the rights and obligation of buyer and seller reveals that option contracts are skewed. One way naturally wonders as to why the seller (writer) of an option would always be obliged to sell/buy an asset whereas the other party gets the right? The answer is that writer of an option receives, a consideration for Undertaking the obligation. This is known as the price or premium to the seller for the option. The buyer pays the premium for the option to the seller whether he exercise the option is not exercised, it becomes worthless and the premium becomes the profit of the seller. Premium/Price of an option = Intrinsic Value + Time Value

Do Nothing Option to option holder matching Close out the position by write a call option or it in case of writer. Exercise the option.

In-The-Money and Out-The-Money Options Condition Call So>E In the money So<E Out of the money So=E At the money

Put Out of the money In the money At the money

So =spot price E = exercise price

Options Basics: How to Read an Options Table

Column 1: Strike Price - This is the stated price per share for which an underlying stock may be purchased (for a call) or sold (for a put) upon the exercise of the option contract. Option strike prices typically move by increments of $2.50 or $5 (even though in the above example it moves in $2 increments).

Column 2: Expiry Date - This shows the termination date of an option contract. Remember that U.S.-listed options expire on the third Friday of the expiry month. Column 3: Call or Put - This column refers to whether the option is a call (C) or put (P). Column 4: Volume - This indicates the total number of options contracts traded for the day. The total volume of all contracts is listed at the bottom of each table. Column 5: Bid - This indicates the price someone is willing to pay for the options contract. Column 6: Ask - This indicates the price at which someone is willing to sell an options contract. Column 7: Open Interest - Open interest is the number of options contracts that are open; these are contracts that have neither expired nor been exercised.

INDEX OPTION:
Index options are the contracts between two parties that give the right, but not the obligation, to buy or sell underlying at a stated date & a stated price to the buyer of the contract. In index option, the underlying is share price index & all contracts are based up on it. In index option the buyer requires to pay a sum for the buying the contract that is called premium. The premium is decided by the market forces & not by the stock exchange. All index option is cash settled & physical delivery is not applicable. Beside the premium the seller of the contract is required to pay 3% margin on contract value to the exchange to eliminate the risk That is called exposure margin.

In India the options on index started by the BSE & NSE on their index SENSEX and S&P CNX NIFTY respectively. Trading on S&P CNX NIFTY commenced at NSE on June 2, 2001.

Market players
Hedgers: The objective of these kind of traders is to reduce the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiraling oil prices have to be tamed using the security in derivative instruments. Speculators: They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down. Arbitrageurs: Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one market and selling in another, buying two products in the same market are common. They could be making money even without putting there own money in and such opportunities often come up in the market but last for very short timeframes. This is because as soon as the situation arises arbitrageurs take advantage and demand-supply forces drive the markets back to normal.

OPTIONS PRICING
Prices of options are commonly depend upon six factors. Unlike futures which derives there prices primarily from prices of the undertaking. Option's prices are far more complex.

SPOT PRICES: In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favorable for the buyer. It is the other way round for the seller, more the Spot Price higher are the chances of his going into a loss.

In case of a put Option, the payoff for the buyer is max(Xt - S, 0) therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing. STRIKE PRICE: In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the call option.

TIME TO EXPIRATION: More the time to Expiration more favorable is the option. This can only exist in case of

American option as in case of European Options the Options Contract matures only on the Date of Maturity. VOLATILITY: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer. The table show all effects on the buyer side of the contract. RISK FREE RATE OF INTEREST: In reality the r and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices Discounting factor increases making the price fall

In case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the buyer to the position of loss in the payoff chart. The discounting factor increases and the future value becomes lesser.

In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in

the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favorable on the call option. DIVIDENDS: When dividends are announced then the stock prices on ex-dividend are reduced. This is favorable for the put option and unfavorable for the call option.

What are the various membership categories in the derivatives market?

The various types of membership in the derivatives market are as follows: Trading Member (TM) A TM is a member of the derivatives exchange and can trade on his own behalf and on behalf of his clients. Clearing Member (CM) These members are permitted to settle their own trades as well as the trades of the other non-clearing members known as Trading Members who have agreed to settle the trades through them. Self-clearing Member (SCM) A SCM are those clearing members who can clear and settle their own trades only.

What are the requirements to be a member of the derivatives exchange/ clearing corporation?

Balance Sheet Networth Requirements: SEBI has prescribed a networth requirement of Rs. 3 crores for clearing members. The clearing members are required to furnish an auditor's certificate for the networth every 6 months to the exchange. The networth requirement is Rs. 1 crore for a self-clearing member. SEBI has not specified any networth requirement for a trading member. Liquid Networth Requirements: Every clearing member (both clearing members and self-clearing members) has to maintain atleast Rs. 50 lakhs as Liquid Networth with the exchange / clearing corporation. Certification requirements: The Members are required to pass the certification programme approved by SEBI. Further, every trading member is required to appoint atleast two approved users who have passed the certification programme. Only the approved users are permitted to operate the derivatives trading terminal.

What are requirements for a Member with regard to the conduct of his business?
The derivatives member is required to adhere to the code of conduct specified under the SEBI Broker Sub-Broker regulations. The following conditions stipulations have been laid by SEBI on the regulation of sales practices: Sales Personnel: The derivatives exchange recognizes the persons recommended by the Trading Member and only such persons are authorized to act as sales personnel of the TM. These persons who represent the TM are known as Authorised Persons. Know-your-client: The member is required to get the Know-your-client form filled by every one of client.

 Risk disclosure document: The derivatives member must educate his client on the risks of derivatives by providing a copy of the Risk disclosure document to the client. Member-client agreement: The Member is also required to enter into the Member-client agreement with all his clients.

What derivative contracts are permitted by SEBI?

Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced in June 2003 and exchange traded interest rate futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004.

What is the eligibility criteria for stocks on which derivatives trading may be permitted?
A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria: The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis. The stocks median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stocks quarter-sigma order size is the mean order size (in value

terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The market wide position limit in the stock shall not be less than Rs.50 crores. A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued.

What is minimum contract size?

The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending amendment to Securities Contract (Regulation) Act, 1956 had recommended that the minimum contract size of derivative contracts traded in the Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the time of introducing the contract in the market. In February 2004, the Exchanges were advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges were authorized to align the contracts sizes as and when required in line with the methodology prescribed by SEBI.

What is the lot size of a contract?

Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

What is corporate adjustment?

The basis for any adjustment for corporate action is such that the value of the position of the market participant on cum and ex-date for corporate action continues to remain the same as far as possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-themoney and out-of-the-money. Any adjustment for corporate actions is carried out on the last day on which a security is traded on a cum basis in the underlying cash market. Adjustments mean modifications to positions and/or contract specifications as listed below: Strike price Position Market/Lot/ Multiplier The adjustments are carried out on any or all of the above based on the nature of the corporate action. The adjustments for corporate action are carried out on all open, exercised as well as assigned positions. The corporate actions are broadly classified under stock benefits and cash benefits. The various stock benefits declared by the issuer of capital are: Bonus Rights Merger/ Demerger Amalgamation Splits Consolidations Hive-off Warrants, and Secured Premium Notes (SPNs) among others The cash benefit declared by the issuer of capital is cash dividend.

What is the margining system in the derivative markets?

Two type of margins have been specified -

Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected. Mark to Market Margin (MTM) - collected in cash for all Futures contracts and adjusted against the available Liquid Networth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement. Dr. L.C Gupta Committee had recommended that the level of initial margin required on a position should be related to the risk of loss on the position. The concept of value-at-risk should be used in calculating required level of initial margins. The initial margins should be large enough to cover the one day loss that can be encountered on the position on 99% of the days. The recommendations of the Dr. L.C Gupta Committee have been a guiding principle for SEBI in prescribing the margin computation & collection methodology to the Exchanges. With the introduction of various derivative products in the Indian securities Markets, the margin computation methodology, especially for initial margin, has been modified to address the specific risk characteristics of the product. The margining methodology specified is consistent with the margining system used in developed financial & commodity derivative markets worldwide. The exchanges were given the freedom to either develop their own margin computation system or adapt the systems available internationally to the requirements of SEBI. A portfolio based margining approach which takes an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and Single Stock Futures, has been prescribed. The initial margin requirements are required to be based on the worst case loss of a portfolio of an individual client to cover 99% VaR over a specified time horizon.

What measures have been specified by SEBI to protect the rights of investor in Derivatives Market?
The measures specified by SEBI include: Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member. In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.

Research Methodology & Analysis

Research Methodology
Research is a procedure of logical and systematic application of the fundamentals of science to the general and overall questions of a study and scientific technique by which provide precise tools, specific procedures and technical, rather than philosophical means for getting and ordering the data prior to their logical analysis and manipulation. Different type of research designs is available depending upon the nature of research project, availability of able manpower and circumstances. The study about Trends and future of derivatives in India is descriptive in nature. So survey method is used for the study.

Sampling Procedure
The small representative selected out of large population is selected at random is called sample. Well-selected sample may reflect fairly, accurately the characteristic of population. The chief aim of sampling is to make an inference about unknown parameters from a measurable sample statistics. The Statistical hypothesis relating t population. The sample size was 60 which include brokers, dealers and investors.

Sources of Data:
The source of data includes Primary and Secondary data sources. Primary Data: Primary data is collected by structured questionnaire administered by sitting with guide and discussing problems. Secondary Sources: The secondary data is data, which is collected and compiled for the different purpose, which are used in research for this study. The secondary data include material collected from:

Newspaper

Magazine Internet

Data collection Instruments:

The various method of data gathering involves the use of appropriate recording forms. These are called tools or instruments of data collection. Collection Instruments: 1. Observation 2. Interview guide 3. Interview schedule

Each tool is used for specific method of data gathering. The tool for data collection translates the research objectives in to specific term/questions to the response, which will provide research objective. He instrument data collection in our study was interview conducted

schedule

mainly.

Every

respondent

personally with an interview schedule containing questions. Interview method was used because it can be explained more easily and clearly and takes less time to answer.

Methodology Assumptions:
The research was based on the following assumption: 1. The methodology used for this purpose is survey and questionable method. It is assumed that this method is more suitable for collection of data. 2. It is assumed that the respondent have sufficient knowledge to ensure questionable. 3. It is assumed that the respondent have filled right and correct option according to their view.

Brokers Perception about Derivatives(Analysis) Trading Period in Derivatives

25 20 15 10 5 0 Less 1 2 3 More than year year year than 1 3 year year Series 1

From my sample of 60, 13 (22%) brokers and investors investing in derivatives from last 1 year and less than this, 21(35%) are investing from last 2 years, 7(11%) are investing from last 3 years and only 6(10%) have experience of more than 3 years of investment in derivatives.

Reasons Behind its Adoption

25 20 15 10 5 0
Hedging Speculation Risk Management Liquidity

Series 1

Reason behind adoption of derivatives are different by brokers, investors and dealers e.g. liquidity, risk management, hedging, investor demand (speculation) etc. Out of 60 brokers, investors dealing in derivatives 14(23%) adopt it due to characteristics of risk management, 15(25%) due to hedging, 24(40%) for investor (clients) demand (speculation) and remaining 7(12%) due to liquidity.

Experience With Derivatives

Out of my sample size 60, only 23(38%) find derivatives as quite profitable investment, 14 (23%) find that derivatives cant give big profits in future, 17(29%) feels that equities are better option for investment than derivatives, remaining 6(10%) have other opinion that only those investors, brokers, can derive good return from derivatives those have surplus funds and patience for long period because derivatives requires huge investment and risk also.

Investment Amount In Derivatives

30 25 20 15 10 5 0 2 lacs 2 lacs - 5 lacs 5 lacs - 10 Any Other lacs Series 1

Out of my size 60, 27(45%) investors and brokers have invested 2 lacs normally, 9(15%) invested between 2 lacs to 5 lacs and 15(25%) invested between 5 lacs to 10 lacs and remaining have invested in other amounts. Reason behind this those are investing from many years are taking the risk of investing the huge amount.

Traded period in Derivatives

25 20 15 10 5 0 Series 1

Weekly

Monthly

More than 1 month

More than 2 months

Out of 60 Samples 13(22%) investors and brokers are investing weekly in derivatives, 23 (38%) investing monthly, 19(32%) investing after more than 1 month and only 5(8%) investing too late after 2 months.

Impact on Customer Base

45 40 35 30 25 20 15 10 5 0

Series 1

Increase

Remain same

Out of 60 brokers and investors, 3(5%) brokers said that it doesnt increase their customer base because introducing small savings as investment, but derivatives increases customer base of 42(70%) which is more than half, it is basically beneficial for those who are investing from last 2 or more years. In investment sector need minimum of Rs.2 lac as investment so it is basically for corporate and investment sector only not for small investors, 15(25%) said their customer base remain same because they have started just now for investing in derivatives, in future it will increase their customer base.

Results/Findings
1. Brokers not dealing in derivatives at present are also not going to adopt it in near futures.

2. Hedging & Risk Management is the most important feature of derivatives. 3. It is not for small Investors. 4. It has increased brokers turnovers as well as helpful in aggregate investment. 5. Brokers dont have adequate knowledge about options, so most by them are dealing in futures only. 6. There is a risk factor in derivative also. 7. Most of investors are not investing in derivatives. 8. people are not aware of derivatives, even people who are invested in it, havent adequate knowledge about it. These are interested to take it in their future portfolio also. They consider it as a tool of risk management. 9. They normally invest in future contracts. 10. They are investing in future contract, because futures have up to home extent similar quality as Badla.

SUGGESTIONS:
1. Lot size: Lot size should be reduced so that the major

segment of an India society i.e. small saving class can come under F & O trading. There is strong need for

revision of lot sizes as the lot sizes of some of the individual scrips that were worth of Rs. 200000 in starting, now same lot size amount to a much larger value.
2.

Sub broker: Sub-broker concept should be added and the actual brokers should give all rights of brokers in F & O segment also. Scrips: More scrips of reputed companies etc. should be introduced in "F & O segment".

3.

4. Trading period: Trading period should be increased. 5. Training

classes or Seminars: There should be proper classes on derivatives for investors, traders, brokers, students and employees of stock exchanges. Because lack of knowledge is the main reason of its less development. The first step towards it should be seminars provide to brokers & LSE employees and secondly seminar to students.

Limitation of the Study

No study is complete in itself, however good it may and every study has some limitations: Time is the main constraint of the study Availability of information was not sufficient because of less awareness among investors/brokers Study is based only on NSE because information and trading in BSE is not available here. Sample size is not enough to have a clear opinion.

CONCLUSION:

The Indian accounting guidelines in this area need to be carefully reviewed. The international trend is moving the underlying securities as well as associated derivative

instrument to market. Such a practice would bring into the account a Clear picture of the impact of derivative related operations. On the basis of overall study on derivatives it was found that derivative products initially emerged as hedging devices against fluctuation and commodity prices and commodity linked derivatives remained the soul form of such products. The financial derivatives came in spotlight in 1972 due to growing in stability in financial market. I was really surprised to see during my study that a layman or a simple investor does not even know how to hedge and how to reduce risk on his portfolios. All these activities are generally performed by big individual investors, institutional investors, mutual funds etc. No doubt that derivative growth towards the progress of economy is positive. But the problems confronting the derivative market segment are giving it a low customer base. The main problems that it confronts are unawareness and bit lot sizes etc. these problems could be overcome easily by revising lot sizes and also there should be seminar and general discussions on derivatives at varied places.

BIBLOGRAPHY

BOOKS :

NCFM on risk management modules by NSEIL Indian Capital Market by H.S.Sidhu Indian Securities Exchange Capital Market Dealer Module-NSE The Indian Commodity Derivatives Market in Operations.

MAGAZINES & NEWSPAPER:

LSE Bulletin NSE news Economic Times Business Standard

INTERNET SITES:
www.nseindia.com www.bseindia.com www.sebi.gov.in www.derivativeindia.com

SAMPLE QUESTIONNAIRE
Dear Respondent,

I am a student of MBA 2nd year. I am working on the project Trends And Future of Derivatives In India: A Detailed . You are requested to fill in the questionnaire to enable, to undertake the study on the said project. Your cooperation will be highly appreciated. Name: Occupation: Address: Phone-no: 1) For how long you have been trading in derivatives?
1 3

Less than 1 year 2 Year

2 4

1 Year 3 Year or more

2) What is your purpose for trading in derivatives?

1 3

Hedging Risk Management

2 4

Speculation Liquidity

3) How often do you trade?

1 3

Weekly More than 1 month

2 4

Monthly Daily

4) How will you describe your experience with derivative till date?

Quite Profitable

Profitable

Average

No profit No loss

Losses

5) In which market segment your majority of investors insist for dealing? F&O segment 1 Capital market segment 2 Cant say 3 Equal customers 4

6) What shortcomings do you feel in Indian derivative market?

1 2 3

Lack of awareness among the investors about derivatives. Shortage of domestic technical expertise. If any other___________________________

7) In which market segment derivative customer trade more? 1 Index futures 2 Stock futures Stock options 3 Index options 4 8) What will be the affect of derivative trading on countrys economy? 1 Accelerates globalization of Indian markets 2 Makes Indian markets more safe Inflate the gains of investors 3 Increased investment by FIIs 4 9) What is your customer base with introduction of derivatives? 1 Increase 3 22 Decrease Remain Same 10) Do you think adoption of derivatives trading in India is a right step towards survival & growth of capital market in India? 1 Yes 2 No No 11) What suggestions do you want to make with regard to investors education in derivative markets in India? _________________________________________________________________________ ___________________________________________________________

Signature: