Chapter 1 Introduction to Stock Exchange

A stock market is an institution, organization, or association where stocks, bonds, options and futures, and commodities are traded. Buyers and sellers come together to trade during specific hours on business days. The Indian Securities Contracts (Regulation) Act of 1956, defines Stock Exchange as, "An association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities." Stock exchanges are indispensable for the smooth and orderly functioning of corporate sector in a free market economy. A stock exchange need not be treated as a place for speculation or a gambling den. It should act as a place for safe and profitable investment, for this, effective control on the working of stock exchange is necessary. This will avoid misuse of this platform for excessive speculation, scams and other undesirable and anti-social activities.

History of Stock Exchange

The Bombay Stock Exchange (BSE) is known as the oldest exchange in Asia. It traces its history to the 1850s, when stockbrokers would gather under banyan trees in front of Mumbais Town Hall. The location of these meetings changed many times, as the number of brokers constantly increased. The group eventually moved to Dalal Street in 1874 and in 1875 became an official organization known as The Native Share & Stock Brokers Association. In 1956, the BSE became the first stock exchange to be recognized by the Indian Government under the Securities Contracts Regulation Act.

The Bombay Stock Exchange developed the BSE Sensex in 1986, giving the BSE a means to measure overall performance of the exchange. In 2000 the BSE used this index to open its derivatives market, trading Sensex futures contracts. The development of Sensex options along with equity derivatives followed in 2001 and 2002, expanding the BSEs trading platform. Historically an open-cry floor trading exchange, the Bombay Stock Exchange switched to an electronic trading system in 1995. It took the exchange only fifty days to make this transition. Capital market reforms in India and the launch of the Securities and Exchange Board of India (SEBI) accelerated the integration of the second Indian stock exchange called the National Stock Exchange (NSE) in 1992. After a few years of operations, the NSE has become the largest stock exchange in India.

Types of Stock Exchange

1. Bombay Stock Exchange (BSE) BSE is the leading and the oldest stock exchange in India as well as in Asia. It was established in 1887 with the formation of "The Native Share andStockBrokers' Association". BSE is a very active stock exchange with highest number of listed

securities in India. Nearly 70% to 80% of all transactions in the India are done alone in BSE. BSE is now a national stock exchange as the BSE has started allowing its members to set-up computer terminals outside the city of Mumbai.

BSE Index or SENSEX. The BSE Index or the Sensex as it is popularly known, is the index of the performance of the 30 largest & most profitable, popular companies listed in the index. 2. National Stock Exchange (NSE) Formation of National Stock Exchange of India Limited (NSE) in 1992 is one important development in the Indian capital market

The NSE is slowly becoming the leading stock exchange in terms of technology, systems and practices in due course of time. NSE is the largest and most modern stock exchange in India. In addition, it is the third largest exchange in the world next to two exchanges operating in the USA.

NSE Index or NIFTY. The NSE Index or the Nifty Index as it is popularly known, is the index of the performance of the 50 largest & most profitable, popular companies listed in the index.

Functions of Stock Exchange

1. Continuous and ready market for securities: Stock exchange provides a ready and continuous market for purchase and sale of securities. It provides ready outlet for buying and selling of securities. Stock Exchange also acts as an outlet/counter for the sale of listed securities.

2. Facilitates evaluation of securities: Stock exchange is useful for the evaluation of industrial securities. This enables investors to know the true worth of their holdings at any time. Comparison of companies in the same industry is possible through stock exchange quotations (i.e price list).

3. Encourages capital formation: Stock exchange accelerates the process of capital formation. It creates the habit of saving, investing and risk taking among the investing class and converts their savings into profitable investment. It acts as an instrument of capital formation. In

addition, it also acts as a channel for right (safe and profitable) investment.

4. Provides safety and security in dealings: Stock exchange provides safety, security and equity (justice) in dealings as transactions are conducted as per well define rules and regulations. The managing body of the exchange keeps control on the members. Fraudulent practices are also checked effectively. Due to various rules and regulations, stock exchange functions as the custodian of funds of genuine investors.

5. Regulates company management: Listed companies have to comply with rules and regulations of concerned stock exchange and work under the vigilance (i.e supervision) of stock exchange authorities.

DERIVATIVES

AND

RISK

MANAGEMENT

The emergence of the market for derivatives products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest, etc. Banks, Securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future. DEFINITION OF DERIVATIVES Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
Securities Contracts (Regulation) Act, 1956 (SCR Act) defines debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities.

The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by

the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets The Derivatives can be classified as Types of derivatives Forward Futures Options Swaps

The Types of Derivative Market The Derivative Market can be classified as Exchange Traded Derivatives Market and over the Counter Derivative Market. Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges whereas Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market. The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest. In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and by trading of derivatives actually risks is traded between two parties. One party who purchases future contract is said to go

long and the person who sells the future contract is said to go short. The holder of the long position owns the future contract and earns profit from it if the price of the underlying security goes up in the future. On the contrary, holder of the short position is in a profitable position if the price of the underlying security goes down, as he has already sold the future contract. So, when a new future contract is introduced, the total position in the contract is zero as no one is holding that for short or long. The trading of foreign exchange traded derivatives or the future contracts has emerged as very important financial activity all over the world just like trading of equity-linked contracts or commodity contracts. The derivatives whose underlying assets are credit, energy or metal, have shown a steady growth rate over the years around the world. Interest rate is the parameter which influences the global trading of derivatives, the most. DERIVATIVE MARKET AND FINANCIAL MARKET Derivatives play a vital role in risk management of both financial and nonfinancial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In todays world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns. It is true that growth of derivatives market reveal the increasing market demand for risk managing instruments in the economy. But, the major concern is that, the main components of Over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy will suffer surely if the derivative instruments are misused and if a major fault takes place in derivatives market.

THE OVER- THE- COUNTER DERIVATIVES The derivatives traded over the counter are known as the over the counter derivative market. The Over the counter derivative market consists of the investment banks and include clients like hedge funds, commercial banks, government sponsored enterprises etc. The products that are traded over the counter are swaps, forward rate agreements, forward contracts, credit derivatives etc. Derivatives are basically the financial instruments whose value is a function of the value of the underlying asset. The participants who enter into the contract do so when they agree on the exchange rate or the value of some asset to be delivered on a future date. DERIVATIVE MARKET EQUITY The derivative market equity includes the financial instruments such as futures, options and swaps. The equity derivatives are stocks or stock indices whose prices depend on the prices of the underlying equity instrument. The equity derivatives are traded in the futures and options exchanges or in the over the counter markets. The most common forms of the derivative market equity are the futures and the options market. The options and futures market Options are contracts that give the buyer or seller the right and not the obligation to buy or sell the underlying asset at a fixed price at a future date. The call option gives the right to buy while the put option gives the right to sell. The buyer of the call option can gain by an increase in the price of the underlying asset without buying the underlying asset. Conversely the put option holder benefits from the fall in the price level of the underlying asset. Contrast to the option market the person who goes long or short in the futures market is bound to buy or sell the contract at the specified price and date. Hence the futures contracts

are much more standardized in comparison to the options and hence they are traded in accredited exchanges.

WARRANTS Unlike the options and the futures which are exchange traded financial instruments, the warrants are equity derivatives that are traded over the counter. Warrants are used sometimes to increase the yield of bonds. Warrants are similar to the equity options but are an exception since they are traded by private parties. CONVERTIBLE BONDS Convertible bonds are a combination of bonds and equity. The convertible bonds provide asset protection, high equity returns and they are of less volatile nature. The investors in the equity derivative can hedge their risk. The equity derivatives are also used as a speculative instrument. The derivative market equity traders use the data on stock and their derivatives. They also need, in addition, the factors that may affect the equity prices. To analyze the data the equity market traders need appropriate statistical tools. For further information on derivative market equity, the following websites need to be looked at equityderivatives.com, reuters.com, asx.com, amazon.com etc.

FORWARD AND FUTURES CONTRACTS Fundamentally, Forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price futures contracts are traded on the exchange, forwards contracts are traded over- the-counter market. In case of futures

contracts the exchange specifies the standardized features of the Contract, while no pre determined standards are there in the forward contracts. Exchange provides the mechanism that gives the two parties a guarantee that the Contract will be honored whereas there is no surety/guarantee of the trade settlement in case of forward Contract.

A forward Contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil). One party agrees to buy, the other to sell, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise no asset of any kind actually changes hands, until the maturity of the Contract. The forward price of such a Contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually next business day). The difference between the spot and the forward price is the forward premium or forward discount. A standardized forward Contract that is traded on an exchange is called a futures Contract. In finance, a futures Contract is a standardized Contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The futures price, naturally, converges towards the settlement price on the delivery date. A futures Contract gives the holder the right and the obligation to buy or sell, which differs from an options Contract, which gives the buyer the right, but not the obligation, and the

option writer (seller) the obligation, but not the right. In other words, the owner of an options Contract can exercise (to buy or sell) on or prior to the predetermined settlement/expiration date. Both parties of a "futures Contract must exercise the Contract (buy or sell) on the settlement date. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its Contract obligations. Futures contracts, or simply futures, are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc. While futures and forward contracts are both a Contract to trade on a future date, key differences include:

Futures are always traded on an exchange, whereas forwards always trade over-the-counter Futures are highly standardized, whereas each forward is unique The price at which the Contract is finally settled is different:

Futures are settled at the settlement price fixed on the last trading date of the Contract (i.e. at the end) Forwards are settled at the forward price agreed on the trade date (i.e. at the start) The credit risk of futures is much lower than that of forwards: Traders are not subject to credit risk due to the role played by the clearing house. The profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero. The profit or loss on a forward Contract is only realised at the time of settlement, so the credit exposure can keep increasing In case of physical delivery, the forward Contract specifies to whom to make the delivery. The counterparty on a futures Contract is chosen randomly by the exchange. In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls. OPTION/ OPTIONS CONTRACT Futures Option are an excellent way to trade the futures markets. Many new traders start by trading futures Option instead of straight futures contracts. There

is generally less risk and volatility when using Option instead of futures. Actually, many professional traders only trade Option. FUTURES OPTION An Option is the right, not the obligation, to buy or sell a futures contract at a designated strike price. For trading purposes, you buy Option to bet on the price of a futures contract to go higher or lower. There are two main types of Option calls and puts. Calls You would buy a call Option if you believe the underlying futures price will move higher. For example, if you expect corn futures to move higher, you will want to buy a corn call Option. Puts You would buy a put Option if you believe the underlying futures price will move lower. For example, if you expect soybean futures to move lower, you will want to buy a soybean put Option. Premium You are obviously going to have to pay some kind of price when you buy an Option. The term used for the price of an Option is premium. You can think of the pricing of Option as a bet. The bigger the long shot, the less expensive they will be. Oppositely, the more sure the bet is, the more expensive it will be. Contract Months (Time) Option have an expiration date, which means they only last for a certain period of time. When you buy an Option, you cannot hold it forever. For example, a December corn call expires in late November. You will need to close the position before expiration. Generally, the more time you have on an Option, the more expensive it will be. Strike Price This is the price at which you could buy or sell the underlying futures contract. For example, a December $3.50 corn call allows you to buy a December futures contract at $3.50 anytime before the Option expires. Most traders do not convert Option; they just close the Option position and take the profits Example of Buying an Option:

Lets say you expect the price of gold futures to move higher over the next 3 -6 months. It is currently January, so you would probably buy an August gold call to give yourself enough time. Gold is currently trading at $590 per ounce. You expect the price to climb to $640 within 6 months. You purchase: 1 August $600 gold call at $15 1 = number of Option you are buying August = Month of Option contract $600 = strike price Gold = underlying futures contract Call = type of Option (bet on price moving higher) $15 = premium ($1,500 is the price to buy - 100 ounces of gold x $15 = $1,500)

SWAPS: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used Swaps are: Interest rate Swaps: These entail swapping only the related cash flows between the parties in the same currency. Currency Swaps:

These entail swapping both principal and interest between the parties, with the cash flows in on direction being in a different currency than those in the opposite direction. SWAPTION: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has received swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and received floating.

PARTICIPANTS IN THE DERIVATIVE MARKETS The following three broad categories of participants: HEDGERS: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. SPECULATORS: Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.

ARBITRAGERS: Arbitrageurs are in business to take of a discrepancy between prices in two different markets, if, for, example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting position in the two markets to lock in a profit objectives
To analyze the derivatives market in India

To analyze the operations of futures and options To find the profit/loss position of futures buyer and also the option writer and option holder. To study about risk management with the help of derivatives.