PROJECT REPORT ON

SUBMITTED TO PUNJAB TECHNICAL UNIVERSITY, JALANDHAR IN THE PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE DEGREE OF

SUBMITTED TO:-

SUBMITTED BY :VINAY KUMAR M.B.A 4th !"# ROLL NO - $%&%$'()%*$

STUDENT DECLARATION
I V+," -./"# hereby declare that In Final Project Report on Trends And Future Of Derivatives In India: A Detailed Study which is submitted in partial fulfillment of the requirements of degree of Masters Of Business Administration to Punjab Technical University, alandhar is my original wor and not submitted for the award of any other degree! diploma! fellowship or other similar titles"

#inay $umar

ACKNO0LEDGEMENT
This formal piece of acknowledgement may be sufficient to express the feelings of gratitude people who have helped me in successfully completing my Final Project Report. I am grateful to !ect" #uchi for giving me a chance to do my Final Project Report on Trends And Future Of Derivatives In India: A Detailed Study which re uired extensive study of various !rokers and Investors that are engaged in "erivatives investment. I feel#I shall always remain indebted to $rs" Sarabjeet %au r&'ead Of De(art)ent, $ana*e)ent+ without whom it is being impossible to complete my project report.$e gave his kind supervision#guidance#timely support and all other kind of help re uired in each and every moment of need. I am deeply indebted to my dear parents#friends whose blessings and inspirations have brought me up to this stage of my carreer. %&I'() *+,(R-

CONTENTS OF THE TABLE

," P#O -.T ASSI/0-D"
Introduction of the project" Objecti%es of the project"

1" .O0.-PT OF STO.2 $A#2-T"

Introduction to stoc mar et & a global approach" 'istory of stoc mar et" Features and characterstics of stoc mar et" Future Plans for de%eloping stoc mar et" #arious Functions performed in stoc mar et" Performance of stoc mar et in Indian mar et"

3"FI0A0.IA! D-#I4ATI4-S $A#2-T"

Introduction" 'istorical aspect" Products! participants and functions" (eri%ati%e terminology" Reasons behind its e%olution" Requirements for Future and Options" )trength of Indian capital mar et" Importance of deri%ati%e in%estment" Instruments in%ol%ed in deri%ati%e"

 Performance in India" Regulatory framewor "

5"A0A!6SIS OF T'- P#O -.T"

Research Methodology" *raphical analysis"

7"#-SU!TS A0D FI0DI0/S"

Reasons behind less de%elopment of F +O at AMRI,)AR stoc e-change"

8"SU//-STIO0S" 9"!I$ITATIO0S OF STUD6" :".O0.!USIO0S" ;"<I<!O/#AP'6" ,="SA$P!- OF >U-STIO00AI#-"

INTRODUCTION OF THE PROJECT

(eri%ati%es ha%e %ital role to play in enhancing shareholder %alue by ensuring access to the cheapest source of funds" Acti%e use of deri%ati%es instruments allows the o%erall business ris profile to be modified! thereby pro%iding the potential to impro%e earning quality by offsetting undesired ris " .nder my project report! I ha%e studied %arious trends that comes in the way of (eri%ati%es mar et" Because impression is usually gi%en that losses arose from deri%ati%es are e-tremely comple- and difficult to understand financial strategies" )o after inter%iewing with different bro ers !in%estors and dealers! I ha%e tried to gi%e a solution to these comple-ities" i also find out that what would be the future of deri%ati%e mar et in india on the basis of inter%iews and obser%ations of bro ers! dealers and in%estors" regarding future! I ha%e find out that deri%ati%es can indeed be used safely and successfully pro%ided a sensible control and management strategy is established and e-ecuted" inspite of that more awareness should be done and technical e-pertise nowledge should be more e-panded"

OBJECTIVES OF THE PROJECT

,he main objecti%es of my final project report are as follows/0 ,o study the %arious trends that comes in the way of (eri%ati%es mar et ,o find out that what would be the future and mar et potential of deri%ati%e mar et in india" ,o now the awareness + familiarity in%estors! dealers and bro ers hold regarding deri%ati%es mar et" ,o now the e-perience of dealers! in%estors and bro ers with deri%ati%es till date" ,o get nowledge about shortcomings in indian deri%ati%e mar et"

INTRODUCTION TO THE STOCK E1CHANGE

A stoc e-change is the place where securities! shares! debentures and bonds of joint stoc companies! central + state go%t"! semi go%t" organi1ations! local bodies and foreign go%t" are bought and sold" A stoc e-change is the ner%e center of capital mar et" 2hanges in the capital mar et are brought about by a comple- set of factors! all operating on the mar et simultaneously" )uch changes are subject to secular trends set by the economic progress of the nation! and go%erned by the factors li e general economic situation! financial and monetary policies! ta- changes! political en%ironment! international economic and financial de%elopment etc" A stoc e-change pro%ides necessary mobility to capital and directs the flow of capital into profitable and successful enterprises" Th! S!2.#+t+!3 C4,t#"2t 5R!6.7"t+4,8 A2t (9*& :!;+,!3 3t42- !<2h",6! "3: .( body of individuals whether incorporated or not# constituted for the purpose of assisting# regulating or controlling the business of buying# selling# / dealing in securities.0

A stoc e-change is a platform for the trade of already issued securities through primary mar et" It is the essential pillar of the pri%ate sector and corporate economy" It is the open auction mar et where buyers and sellers meet and in%ol%e a competiti%e price for the securities"

It reflects hopes aspiration and fears of people regarding the performance of the economy" It e-erts a powerful and significant influence as a depressant or stimulant of business acti%ity" )o! stoc in%estors on the basis of such criteria as & 0 Future growth prospects" 0 *ood returns" 0 Appreciation of capital" ,he stoc e-change ser%es the role of barometer! not only of the state of health of indi%idual companies! but also of the nation3s economy as a whole 4it measures of all the pull and pressure of securities in the mar et5" ,he trade in mar et is through the authori1ed members who ha%e duly registered with concerned stoc e-change and )6BI" e-change mobili1es sa%ings! canali1es them as securities into those enterprises which are fa%ored by the

HISTORY OF STOCK E1CHANGE

,he trading of securities in India was started in early 789:" ,he only stoc e-change operating in the 78th century were those of Bombay set up in 7;9< and in Ahemdabad set up in 7;8=" ,hese were organi1ed as %oluntary non0 profit ma ing associations of bro ers to regulate and protect their interests" Before the control on securities trading became a central subject under the constitution in 78<>" It was a state subject and Bombay securities contract 4control5 act of 78?< used to regulate trading in securities" .nder this act! Bombay stoc e-change was recogni1ed in 78?9 and Ahemdabad stoc e-change were organi1ed at Bombay! Ahemdabad and other centers but they were not recogni1ed soon after it became a central subject! central legislation was proposed and a committee headed by sh" A"("*OR@AAA went into bill for security regulation" On the basis securities contract act became law in 78<B" At =#!3!,t th!#! >!#! ?' #!246,+@!: 3t42- !<2h",6!3 +, I,:+". F#4/ th!3! BSE A NSE "#! th! t>4 /"B4# 3t42- !<2h",6!3 ",: #!3t ?( "#! th! #!6+4,"7 3t42- !<2h",6!3. (aily turno%er of all the stoc e-change is app" ?>!>>>cr" B)6 is 7?8 years old" C)6 is 77 years old and it brought the screen based trading system in India

FEATURES OF THE STOCK E1CHANGE

It is a place where listed securities are bought and sold" It is an association of persons nown as members" ,rading in securities is allowed under rules and regulations of stoc e-change" Membership is must for transacting business" In%estors and speculators! who want to buy and sell securities! can do so through members of stoc e-change i"e" bro ers" ,here are mainly three participants in stoc e-change i"e" Issuer of security 4company5" In%estor of security 4Indi%idual! '.F5" Intermediaries and products 4bro er! merchant ban ers and shares! bonds! warrants! deri%ati%es products etc"5" It is the mar et as well as source for the capital" 2orporate and go%t" raise resource from the mar et"

FUTURE PLANS OF STOCK E1CHANGE

,he current mar et scenario in the capital mar et is not %ery encouraging! howe%er! in the futureD the business model of I)6 would be the most preferred method of accessing multiple mar ets with low cost and high credibility of an 6-change" I)6 is considering se%eral %alue added ser%ices or new products which may help I)6 and I)) in fulfilling the demands of low cost users" @e are considering deri%ati%e segment through C)6 and (P ser%ices initially for the participants and later for clients through 2()A and C)(A" ,his futuristic concept of consolidation being pursued by I)6 is now being also e-plored by the (e%eloped 2ountries" @e thin such consolidation enables optimal utili1ation of e-isting resources! enhanced due to economies of scale and permit product inno%ation! a sign o any dynamic mar et" On account of this philosophy we are proposing to implement most of the new products centrally on I)6! li e! Internet trading! IPO segment! (istribution of mutual funds units! Information dissemination! etc" @e are also planning to pro%ide trading support to the commodities 6-changes and also consider pro%iding hem entry into the securities industries" ,he creation of a national mar et has pro%ided the bro ers of the R)6s and indi%idual in%estors in the regions and opportunity approach the liquid national le%el

mar et" ,his mar et is e-pected to pro%ide liquidity in small capital companies as the other Cational Ae%el mar ets ha%e a higher entry norm and may not cater to this mar et"

FUNCTIONS OF STOCK E1CHANGE

)toc 6-change Performs ,he Following Functions/ ,he stoc =#+2!3. People ha%ing surplus funds in%est in the securities and these funds used for industriali1ation and economic de%elopment of country that 7!":3 t4 2"=+t"7 ;4#/"t+4,. ,he stoc e-change pro%ides " #!": /"#-!t for the con%ersion of e-isting securities into cash and %ice0%ersa" ,he stoc e-change acts as th! 2!,t!# 4; =#4D+:+,6 C.3+,!33 +,;4#/"t+4, relating to enterprise whose securities are traded as the listed companies are to present their financial and other statements to it" )toc e-change =#4t!2t3 th! +,t!#!3t 4; th! +,D!3t4#3 through strict enforcement of rules and regulations with respect to dealings" Punishments 4including fine! suspension or e%en e-pulsion of e-change pro%ides appropriate conditions where by =.#2h"3! ",: 3"7! 4; 3!2.#+t+!3 t"-!3 =7"2! "t #!"34,"C7! ",: ;"+#

membership5 may be there if bro er ma e any malpractice in dealing with in%estors li e charging high commissions etc" )toc e-change acts as th! C"#4/!t!# 4; th! 24.,t# as it measures all the pulls and pressures of the securities in the mar et" ,he stoc e-change pro%ides th! 7+,-"6! C!t>!!, th! 3"D+,63 +, th! h4.3!h47: 3!2t4# ",: th! +,D!3t/!,t +, 24#=4#"t! !24,4/ .

STOCK E1CHANGES OF INDIA

N"/! 4; St42- E<2h",6! Y!"# 4; E3t"C7+3h/! 7" ,he )toc 6-change Mumbai ?" Ahmedabad )toc 6-change :" 2alcutta )toc 6-change =" Madhya Pradesh )toc 6-change <" Madras )toc 6-change Atd" ,t 7;9< 7;89 78>; 78:> 78:9 #oluntary Con profit org" #oluntary Con profit org" Public ltd" 2ompany #oluntary Con profit org" 2ompany guarantee 2ompany ltd" ltd" By By T =! 4; O#6",+@"t+4,

B" 'yderabad )toc 6-change Atd" 78=: 9" (elhi )toc 6-change 78=9 78<9 789; 78;?

guarantee Public ltd" 2ompany P%t" 2on%erted into

Association Atd" ;" Bangalore )toc 6-change 8" 2ochin )toc 6-change 7>"."P" )toc 6-change Atd"

public ltd" company Public ltd" 2ompany Public ltd" 2ompany

77"Pune )toc 6-change Atd"

78;?

2ompany

ltd"

By

(?.L.:h+"," St42- E<2h",6! (9$' 7:"*uwahati )toc 6-change 78;= 7="Magadh )toc 6-change Ass" 78;B 4Patna5 7<"Eaipur )toc 6-change Atd" 7B"Bhubaneshwar )toc 6-change 79")aurashtra$utch )toc 78;: 78;8 78;8

guarantee P.C7+2 7t:. C4/=", Public ltd" 2ompany 2ompany ltd" By guarantee Public ltd" 2ompany 2ompany ltd" By guarantee 2ompany guarantee C"( C"( C"( C"( C"( C"( ltd" By

6-change Atd" 7;"#adodara )toc 6-change Atd" 788> (9.N"t+4,"7 St42- E<2h",6! 4; (994 I,:+" Lt:. ?>"2oimbatore )toc 6-change 788B

Atd" ?7"O,2 )toc 6-change of India ??"Mangalore )toc 6-change Atd" ?:"Interconnected )toc 6-change 4I2)65

0HO BENEFITS FROM STOCK E1CHANGE

7" ?" :" =" I,D!3t4#3: ? It pro%ides them liquidity! mar etability! safety etc" of in%estments" C4/=", : - It pro%ides them access to mar et funds! higher rating and public interest" B#4-!#3: - ,hey recei%e commission in lieu of ser%ices to in%estors" E24,4/ ",: C4.,t# : ? ,here is large flow of sa%ing! better growth more industries and higher income"

INTRODUCTION TO DERIVATIVES
Primary mar et is used for raising money and secondary mar et is used for trading in the securities! which ha%e been used in primary mar et" But deri%ati%e mar et is quite different from other mar ets as the mar et is used for minimi1ing ris arising from underlying assets" ,he wor Fderi%ati%eF originates from mathematics" It refers to a %ariable! which has been deri%ed from another %ariable" i"e" G H f 4I5 @'6R6 G 4dependent %ariable5 H (6RI#A,I#6 PRO(.2, I 4independent %ariable5 H .C(6RAIIC* A))6, A financial deri%ati%e is a product that deri%es %alue from the mar et of another product" 'ence deri%ati%e mar et has no independent e-istence without an underlying asset" ,he price of the deri%ati%e instrument is contingent on the %alue of underlying assets" As a tool of ris management we can define it as! Fa financial contract whose %alue is deri%ed from the %alue of an underlying assetJderi%ati%e securityF" All deri%ati%es are based on some cash product" ,he underlying assets can be/ a" b" c" d" e" Any type of agriculture product of grain 4not pre%ailing in India5 Price of precious and metals gold Foreign e-change rates )hort term as well as long0term bond of securities of different type issued by go%t" and companies etc" O","2" money instruments for e-ample loan + deposits"

6-ample/ @heat farmers may wish to sell their har%est at a future date to eliminate the ris of change in price by that date" ,he price of these deri%ati%es is dri%en from spot price of wheat" DEFINITION OF DERIVATIVE In the Indian conte-t the )ecurities contracts 4Regulation5! Act 78<B defines F(eri%ati%eF to include/ 475 A security deri%ed from a debt instrument! )hare! Aoan whether secured or unsecured! Ris instrument or contract for difference or any other form of security" A contract! which deri%es its %alue from the prices of underlying securities"

HISTORICAL ASPECT OF DERIVATIVES:

,he need for deri%ati%es as hedging tool was first felt in the commodities mar et" Agricultural F+O helped farmers and PRO26))OR) hedge against commodity price ris " After the fallout of BRI,AIC @OO( A*R66M6C,! the financial mar ets in the world started undergoing radical changes! which gi%e rise to the ris factor" ,his situation led to de%elopment of deri%ati%es as effecti%e FRis Management toolsF" (eri%ati%e trading in financial mar et started in 789? when F2hicago Mercantile 6-change opened its International Monetary Mar et (i%ision 4IIM5" ,he IMM pro%ided an outlet for currency speculators and for those loo ing to reduce their currency ris s" ,rading too place on currency" Futures! which were contracts for specified quantities of gi%en currencies! the e-change rate was fi-ed at time of contract later on commodity future contracts was introduced then followed by interest rate futures" Aoo ing at the liquidity mar et! deri%ati%es allow corporate and institutional in%estors to effecti%ely manage their portfolios of assets and liabilities through instruments li e stoc inde- futures and options" An mar et and at a inde- futures first equity fund e"g" can reduce its e-posure to the stoc inde- futures or inde- options" ,herefore the stoc emerged in .")"A" in 78;?"

relati%ely low cost without selling of part of its equity assets by using stoc

PRODUCTS, PARTICIPANTS AND FUNCTIONS

(eri%ati%e contracts ha%e se%eral %ariants" ,he most common are FOR@A()! F.,.R6)! OP,IOC) AC( )@AP)" ,he following three categories of Participants0'edgers! )peculators! and Arbitrageurs"

475

HEDGER:
'edgers face ris associated with the price of an asset"

,hey use futures or options mar ets to reduce the ris " ,hus! they are operation who want to eliminate the ris composing of their portfolio"
4?5

SPECULATORS:
,hey wish to be on future mo%ements in the price of

an asset" A speculator may buy securities in anticipation of rise in price" If this e-pectation comes true he sells the securities at a higher price and ma es a profit" .sually the speculator does not ta e deli%ery of securities sold by him" 'e only recei%es and pays the difference between the purchase and sale prices"
4:5

ARBITRAGEURS:
,hey are in business to ta e ad%antage of discrepancy

between price in two different mar ets" If for e-ample! they see the future price of an asset getting out of line with the cash price! they will ta e off setting positions in two mar ets to loc in profit"

TYPES OF DERIVATIVES
,he most commonly used deri%ati%e contract is forwards! futures and options/
475

FOR0ARDS/
a forward contract is a customi1ed contract

between two entities! where settlement ta es place on a specific date in the futures at todayKs pre0agreed price"
4?5

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 standardi1ed e-change traded contracts"
5'8

OPTIONS:
it is of two types/ call and put options" .nderlying asset! at a gi%en price on or before a gi%en future date" P.,) gi%e the buyer the right but not the obligation to sell a gi%en quantity of the underlying asset at a gi%en price on or before a gi%en date"

548 LEAPS:
Cormally option contracts are for a period of 7 to 7? months" 'owe%er! e-change may introduce option contracts with a maturity period of ?0: years" ,hese long0term option contracts are popularly )ecurities" nown as Aeaps or Aong term 6quity Anticipation

4<5

BASKETS:
Bas ets options are option on portfolio of

underlying asset" 6quity Inde- Options are most popular form of bas ets"

5&8 S0APS:
these are pri%ate agreements between two parties to e-change cash flows in the future according to a prearrange formula" ,hey can be regarded as portfolios of forwardKs contracts" ,he two commonly used swaps are/

"8 INTEREST RATE S0APS/

these entail swapping both Principal and interest between the parties! with the cash flow in one direction being in a different currency than those in the opposite direction"
C8

CURRENCY S0APS/
these entail swapping both Principal

and interest between the parties! with the cash flow in one direction being in a different currency than those in the opposite direction"

C"3h V3 D!#+D"t+D! M"#-!t

,he basis differences between these two may be noted as follows" a5 In cash mar et tangible asset are traded whereas in deri%ati%es mar et contract based on tangible assets or intangible li e inde- or rates are traded" b5 ,he %alue of deri%ati%e contract is always based on and lin ed to the underlying asset" ,hough! this lin age may not be on point0to point basis" c5 2ash mar et contracts are settled by deli%ery and payment or through an offsetting contract" the deri%ati%e contracts on tangible may be settled through payment and deli%ery! offsetting contract or cash settlement! whereas deri%ati%e contracts on intangibles are necessarily settled in cash or through offsetting contracts" d5 ,he cash mar ets always has a net long position! whereas the net position in deri%ati%e mar et is always 1ero" e5 2ash asset may be meant for consumption or in%estment" (eri%ati%es are used for hedging! arbitration or speculation" f5 (eri%ati%e mar ets are highly le%eraged and therefore could be much more ris ier"

THE DERIVATIVE MARKETS PERFORM A NUMBER OF ECONOMIC FUNCTIONS:

475 Prices in organi1ed deri%ati%e mar ets reflect the perception of mar et participants about the future and lead the prices of underlying to percei%ed future le%el" ,he prices of deri%ati%es con%erge with the prices of the underlying at the e-piration of the deri%ati%e contract" ,hus deri%ati%es help in disco%ery of future as well current prices" 4?5 ,he deri%ati%e mar et helps to transfer the ris s from those who ha%e them but may li e them those who ha%e an appetite for them" 4:5 (eri%ati%es due to their inherent nature are lin ed to the underlying cash mar ets" @ith the introduction of deri%ati%e! the underlying mar et! witness higher trading %olumes because of participation by more players who would not otherwise participate for lac of an arrangement to transfer ris " 4=5 (eri%ati%es ha%e a history of attracting many bright! creati%e! well0 educated people with an entrepreneurial attitude" ,hey often energi1e others to create new business! new products and new employment opportunities! the benefits of which are immense" 4<5 (eri%ati%es mar et helps increase sa%ings and in%estments in the long run ,ransfer of ris enables mar et participants to e-pand their %olume of acti%ities"

PARTICIPANTS IN DERIVATIVE MARKET

6-change! trading members! clearing members" 'edgers! arbitrageurs! speculators" 2learing! clearing ban " Financial institutions" )toc lenders and borrowers"

OBJECTIVES OF DERIVATE TRADING

5(8 HEDGING:
you own a stoc and you are confident about the prospects of the company" 'owe%er at the same time you feel that o%erall mar et may not perform as good and therefore price of your stoc may also fall in line with o%erall mar ed trend" Iou e-pect that some ad%erse economic or political e%ent might affect the mar et sentiments! though fundamentals of the company will remain good! therefore! it is good to retain the stoc " In both these situations you would li e to insure your portfolio against any such mar et fall" )uch insurance is nown as hedging" 'edging is a tool to reduce the inherent ris in an in%estment" #arious strategies designed to reduce in%estment ris using call option! put options! short selling! and futures are used for hedging" ,he basic purpose of a hedge is to reduce the ris of loss"

5?8 ARBITRAGE/
,he future price of an underlying asset is function of spot price and cost of carry adjusted for any return on in%estment" 'owe%er! due to uncertainty about interest rates! distortions in spot prices! or uncertainty about future income stream! prices in futures mar et may not truly reflect the e-pected spot price in future" ,his imbalance in future and spot price gi%es rise to arbitrage opportunities" ,ransaction made to ta e ad%antage of temporary distortions in the mar et are nown as arbitrage transactions"

5'8 SPECULATION:
you may ha%e %ery strong opinion about the future mar et price of a particular asset based on past trends! current information and future e-pectation" Ai ewise you may also ha%e an opinion about the o%erall mar et trend" ,o ta e ad%antage of such opinion! indi%idual asset or the entire mar et 4inde-5 could be sold or purchased" Position ta en either in cash mar et of deri%ati%e mar et on the basis of personal opinion is nown as speculation"

DERIVATIVE TERMINOLOGY
ASSIGNMENT:
It means allocation of an option contract! which is e-ercised! to a short position in the same opinion contract! at the same stri e price! for fulfillment of the obligation! in accordance with the procedure specified in by the rele%ant authority from time to time"

BADLA:
It is an indigenous mechanism of postponing the settlement of trade" ,his product is peculiar to India mar ets" ,his in%ol%es Badla financiers! stoc lenders and stoc traders" ,he long buyers and short sellers may postpone settlement of their trade by ma ing payments and gi%ing deli%ery by using the ser%ices of Badla financiers and stoc lenders who assume their positions for Badla charges" 2ounterparty ris ! unpredictable charges and high ris inherent limitations of Badla" due to inadequate margining are

BASIS:
It is difference between spot price and future price of the same asset" In normal mar ets this basis is always negati%e! i"e" spot price is always less than future price" A positi%e basis pro%ides for arbitrage opportunity"

BETA/
It is a measure of the sensiti%ity of returns on scrip to return on the mar et inde-" It shows how the price of scrip would mo%e with e%ery percentage point change in the mar et inde-"

CONTRACT VALUE
It is the %alue arri%ed at by multiplying the stri e price of the option contract with the regularJmar et lot si1e"

E1ERCISE:
It is defined as the number of future or option contracts required be buying or selling per unit of the spot underlying position to completely hedge against the mar et ris of the underlying"

MARGIN:
It is the money collected from parties to trade to insure against the default ris " )ome amount of margins is collected upfront and some are collected shortly after the trade" Failure to pay margins may result in mandatory closure of position"

OFFSETTING CONTRACT/
new matching contract! which offsets an e-isting contract! is nown as offsetting contract"

OPTION PREMIUM:
It is consideration paid by the option buyer to option writer" ,he premium has two components intrinsic %alue and time %alue" Intrinsic %alue is the difference between the spot price of the underlying and e-ercise price of the contract" ,ime %alue represents the cost of carrying the underlying for the option period! adjusted for any di%idend and option premium"

RISK TRANSFER/
It refers to hedging against the price ris through futures" ,he holder of an asset! which he intender to sell in near future! may transfer the inherent ris by selling futures today" ,he counterparty assumes the ris in anticipation of ma ing gain

REASON FOR STARTING DERIVATIVES

7"2ounter party ris on the part of bro er! in case it as money from us but before gi%ing deli%ery of shares goes ban rupt" ?"Aiquidity ris in the form that the particular scrip might not be traded on e-change" :".nsystematic ris in the form that the price of scrip may go up or down due to L2ompany )pecific ReasonsM" ="Mutual funds may find it difficult to in%est the funds raised by them properly as the scrip in which they want to in%ert might not be a%ailable at the right price" B")ystematic ris in the form that the price of scrip may go up or to reason affecting the sentiment of whole mar et" down due

THE REQUIREMENTS FOR SETTING UP FUTURE AND OPTION TRADING ARE OUTLINED BELO0:
7" 2reation of an Options 2learing 2orporation 4O225 as the single guarantor of e%ery traded option" In case of default by a party to a contract! the clearing house has to bear the cost necessary to carry out the contract" ?" 2reation of a strong cash mar et 4secondary mar et5" ,his is because after the e-ercise of an option contract! the in%estors mo%e to the secondary mar et to boo profits" :" 2reation of paper0less trading and a boo 0entry transfer system" =" 2areful selection of the securities may be listed on a Cational securities e-change! ha%e a wider capital base! be acti%ely traded! and so on" <" .niformity of rules and regulation in all the stoc e-changes" B" )tandardi1ation of the terms go%erning the options contracts" ,his would decrease the transaction costs! For a gi%en underlying security! all contracts on the options e-change should ha%e an e-piry date! a stri e price! and a contract price! only the premium should be negotiated on the floor of the e-change" 9" Aarge! financially sound institutions! members and a number of mar et ma ers! who can write the options contracts" )trict capital adequacy norms to be laid out and followed"

STRENGTH OF INDIAN CAPITAL MARKET FOR INTRODUCTION OF DERIVATIVES

7"

LARGE MARKET CAPITALIEATION/

India is one of the largest mar et capitali1ed country

in Asia with a mar et capitali1ation of more than 9!B<!>>> corers"

?"

HIGH LIQUIDITY/
In the underlying securities the daily a%erage traded

%olume in Indian capital mar et today is around 9!<>> crores" @hich means on an a%erage e%ery month 7=N of the country mar et capitali1ation gets traded! shows high liquidity"
:"

TRADER GUARANTEE:
,he first Fclearing corporationF 422A5 guaranteeing

trades has become fully functional from Euly 788B in the form of Cational )ecurities 2learing 2orporation 4C)22A5 for which it does the clearing"
="

STRONG DEPOSITORY/
A strong depository Cational )ecurities (epositories

Atd"4C)(A5! which started functioning in the year 7889! has strengthen the securities settlement in our country"
<"

A GOOD LEGAL GUARDIAN/

)6BI is acting as a good legal guardian for Indian

2apital mar et"

IMPORTANCE OF DERIVATIVE TRADING

7" Reduction of borrowing cost" ?" 6nhancing the yield on assets" :" Modifying the payment structure of assets to correspond to in%estor mar et %iew" =" Co physical deli%ery of share certificate so reduction in cost by stamp duty" <" Increase in hedger! speculator and arbitrageurs" B" It does not totally eliminate speculation! which is basic need of Indian in%estors"

INSTRUMENTS OF DERIVATIVE TRADING

FOR@AR( (eri%ati%e F.,.R6 OP,IOC )@AP)

FOR0ARD CONTRACT
FIt is an agreement to buyJsell an asset on a certain future date at an agreed priceF" ,he two parties are/ @ho ta es a long position & agreeing to buy @ho ta es a short positionOagreeing to sell ,he mutually agreed price is nown as Fdeli%ery priceF or Fforward priceF" ,he deli%ery price is chosen in such a way that the %alue of contract for both parties is 1ero at the time of entering the contract! but the contract ta es a positi%e or negati%e %alue for parties as the price of underlying asset mo%es" It remo%es the future price ris " If a speculator has information or analysis! which forecast an upturn in price! and then be can go long on the forward mar et instead of cash mar et" ,he speculator would go long on the forward! wait for the price to rise! and then ta e a re%ersing transaction to boo profits" )peculator may well be required to deposit a margin upfront" 'owe%er! this is generally a relati%ely small proportion of the %alue of assets underlying the forward contract"

EFFECT OF CHANGE IN PRICE:

As mentioned abo%e the %alue of such a contract in 1ero for both the parties" But later as the price + the underlying asset changes! it gi%es positi%e or negati%e %alue for contract"

PRI26 .C(6RAIIC* A))6,) IC2R6A)6 (62R6A)6

+ 'OA(6R PO)I,IOC PO)I,I#6

AOC* 'OA(6R + )'OR, PO)I,IOC #AA.6 C6*A,I#6 #AA.6

C6*A,I#6 #AA.6

PO)I,I#6 #AA.6

E.6.
A agrees to deli%er 7>> equity shares of Reliance to B on )ept" :>! ?>>? at a Rate of Rs" 7?> per share" Cow if the price of share on that date is Rs" 7=> per share! than a who has short position would stand to loss of Rs" 4?>P?>>5 H =>>>! long position would gain the same amount or %ise %ersa if price quoted is less than deli%ery price" ProfitJAoss H ),06 ), H spot price on maturity date 6 H deli%ery price

LIMITATIONS OF FOR0ARD CONTRACT

7" Co standardi1ation" ?" One party can breach its obligation" :" Aac of centrali1ation of trading" =" Aac of liquidity" ,o o%ercome this other type of deri%ation instrument FFuture 2ontractsF were introduced" nown as

VALUATION OF FOR0ARD CONTRACT

,he forward contract can be put under three categories for the purpose + %aluation/

4A!UATIO0 OF T'OS- S-.U#ITI-S P#O4IDI0/ 0O I0.O$)hares! which neither e-pects to do not pay any! di%idend in future nor ha%ing arbitrage opportunities" e"g" 'ere Price 4F5 H )>e rt @here F H Future Price )> H spot price of asset R H ris free rate of interest p"a" with continuous compounding , H time of maturity" If FQ)>ert In this case the in%estor will buy asset and ta e a short position in the forward contract"

F)hort position is not position of in%estor is of seller means contract sold is greater then contract boughtF" In%estor may buy the assets! borrowing an amount equal to P P for FtF period at ris free rate" At the time of maturity! the assets will be deli%ered for price F and repayment will be equal to )>ert and there is net profit equal to F0 )>ert

If F@ S=ert
'e will long his position in forward contract" @hen contract matures/ the assets would be purchased for FFF 'ere profit is )>ert &F

E.6.
2onsider a forward contract were non0di%idend shares a%ailable at Rs! 9> matures in : months! Ris continuously" )>ert H 9> - ReS >"?<->">; H 9> - >?>? H Rs" 97"=7 If F H 9: ,hen an arbitrageur will short a contract! borrow an amount of Rs" 9> + buy share at Rs! Repay the loan of Rs" 9>" At maturity sell it as Rs" 9: 4forward contract price5 and 97"=>! thus profit is 49:0 97"=>5 7"B> ,hus he shorts his forward contract position" free rate ;N p"a" compounded

SECURITIES PROVIDING A CERTAIN CASH INCOME

If there is certain cash income to be generated on securities in future to the in%estor! we will determine present %alue of income e"g" in case of preference share" Present #alue of (i%idend H Rate + Interest 4continuously compounded5 TIf there is no arbitrage ,hen F H 4)o & I5 ert

AIf FB &SC DI+ert

Arbitrageur can short a forward contract! borrow money and buy the asset at present and at maturity asset is sold and earns profit" Profit H F &4)o & I5 ert If

F @&SC?I+ ert
Arbitrageur can long a forward contract! short the asset a present and in%est the proceeding Profit 4at maturity5 4)o0I5 ert &F

E.6.
Aet us consider a B0month forward contract on 7>> shares at Rs" :; each ris free of interest 4compounding continuously5 earn is 7>N p"a" di%idend is e-pected to a yield of Rs" 7"<> in = months"

SClutiCn: di%ided recei%able after = months

resent #alue + di%idend

7>>-7"<>HRs"7"<>

H 7<>-e 4=J7?54>"7>5<>

H Rs <>->"8B9?HR) 7=<";; H 4:;>>07=<";5 e4>"<54>"7>5 H :B<="8?-7"><7?9 F H :;=?":7

4A!UATIO0 E FO#FA#D .O0T#A.T P#O4IDI0/ A 20OF0 6I-!D

In case of share included in portfolio companies the inde-! as underlying assets! are e-pected to gi%e di%idend in course of time! which may be percentage > their prices" It is assumed to be paid continuously at a rate of FIF p"a" F H )oert

-"*"
)toc underlying an under pro%ide a! di%idend yield of ="7N p"a"! current %alue of inde- is <?> and ris free rate of interest is 7>N p"a" rH>"7>! y H >">=! P P H <?> , H:J7? H>"?< F H <?>-e4>"7>0>"=>5 4>"?<5 H <?>->7<7? H Rs" <?9";<

FUTURE CONTRACT
KIt is an agreement between buyer and seller for the purchase and sale of a particular assets at a specific future dateD specific si1e! date of deli%ery! place and alternati%e asset" It ta es obligation on both parties to fulfill the contract"

FEATURES OF FUTURE CONTRACT:

7" )tandardi1ed contracts e"g" contract si1e" ?" Between two parties who do not necessarily now each other" :" *uarantee for performance by a clearing corporation or clearing house" 2learinghouse is associated with matching! processing! registering! confirming setting! reconciling and guaranteeing the trades on the future e-changes" 2learinghouse tries to eliminate ris of default by either party" =" It has some features of Badla also"

FUTURE TERMINOLOGY
SPOT PRICE/
the price at which an asset trades in the spot mar et"

FUTURES PRICE:
the price at which the futures contract trades in the futures mar et"

CONTRACT CYCLE/
the period o%er which the contract trades" ,he indefutures contracts on the C)6 ha%e one month! and three0month e-piry

cycles! which e-pire on the last ,hursday of the month" ,hus a Eanuary e-piration contract e-pires on the last ,hursday of the Eanuary" On the Friday following the last ,hursday! a new contract ha%ing three0month e-piry is introduced of trading"

E1PIRY DATE/
it is date specified in the futures contract" ,his is the last day on which the contract will be traded! at the end of which it will cease to e-ist"

CONTRACT SIEE:
the amount of asset that has to be deli%ered less than one contract" For instance! the contract si1e on C)6Ks futures mar et is Cifties"

BASIS/
in the contract of financial futures! basis can be defined as the futures price minus the spot price" ,here will be a different basis for each deli%ery month for each contract" in a normal mar et! basis will be positi%e" ,his reflects that futures prices normally e-ceed spot prices"

COST OF CARRY:
the relation between futures price and spot price can be summari1ed in terms of what is nown as cost of carry" ,his measures the storage cost plus the interest that is paid to finance the assets less the incomes earned on the asset"

INITIAL MARGIN:
the amount that must be deposited in the margin account at a time a future contract is first entered into is nown as initial margin"

MARKING-TO-MARKET:
in the futures mar et! at the end of each trading day! the margin account is adjusted to reflect the in%estorKs margin gain or loss depending upon the futureKs closing price"

MAINTENANCE MARGIN/
this is somewhat lower than initial margin" ,his is set to ensure that the balance in the margin account ne%er becomes negati%e" If the balance amount falls below the maintenance margin! the in%estor recei%es a margin call and is e-pected to top up the margin account to the initial margin le%el before trading commences on the ne-t day"

INSTRUMENTS OF FUTURE CONTRACTS

.O$$ODIT6 FUTU#-S
7" ,rader in American 6-changes li e 2BO,! Cew Ior / 2ommodity 6-change! 2hicago Mercantile 6-change 42M65! Cew Ior Mercantile 6-change Includes/ @heat! Catural *as! Platinum! *old! and 2attle etc" ?" 2ontract Aife/ Mostly for 8> days or less" :" Maturity date is mostly non0standardi1ed" =" Uuality specified

FINANCIAL FUTURES
7" Introduced by IMM 4a di%ision of 2M65 It Includes/ 7> or < year treasury notes 4in 789B by I/M/M5! ) + P <>>>! Ci Inde-! Russell ?>>>! Russell :>>>! etc" ?" Mostly Aonger time e"g" .) ,reasury Bond Futures are of e%en more than ? years :" Maturity date is standardi1ed" =" ,here connot be any quality %ariations into these assets" ie ??<! 6uro (ollars! British Pound! 2anadian (ollars! Mini #alue line )toc

TYPE OF FUTURE CONTRACTS:

INDE1 FUTURES A STOCK FUTURES INDE1 FUTURES/

Of the financial futures! Inde- future contracts are ey contracts! introduced in .")" A! in 78;? by the F2ommodity Futures ,rading 2ommissionF 42F,25 by appro%ing the $ansas Board proposal" IndeFutures began trading in India in Eune ?>>> of ,rade 4$)B,5Ks Futures deri%e its %alue from the underlying inde-0e"g" C)6Ks futures" 2ontracts are based on F) + P 2CG CIF,IF At present it has become the most liquid contract in the country! the arbitrage between the futures equity mar et is further e-pected to reduce impact cost" ;>08>N of retail participation is e-pected in India because" 7" Bro erage cost is lower" ?" )a%ings in cost is possible thorough reduced bid0as spreads where stoc s are trade in pac age forms" :" Impact cost will be much lower than dealing in indi%idual scrip" =" Institutional and large equity holders need portfolios hedging facility" Inde- deri%ati%es are more suited to them and more cost effecti%e than in indi%idual stoc s" Pension funds in the .) are nown0to use stoc inde- futures for ris hedging purpose"

<" )toc Inde- is difficult to manipulate as compared to indi%idual stoc prices! more so in India! and the possibility of cornering is reduced" B" )toc inde-! being an a%erage is much less %olatile than indi%idual stoc prices" ,his implies lower capital adequacy and margin requirements" 9" Inde- deri%ati%es are cash settled! and hence donKt suffer from settlement delays and problems related to bad deli%ery + forged certificates"

INDIVIDUAL STOCK FUTURES

,he high le%el committee on capital mar et on ?>>7 decided to permit FIIKs to participate in FIndi%idual )toc FuturesF trading e"g" in Reliance )6BV Frame guidelines for its trading stoc futures can be effecti%ely used for hedging/ speculation and arbitrage At present there are :7 scrips in which stoc deri%ati%es are trading" 6"g" the Reliance stoc traders at Rs" 7>>> and the two month futures trades at 7>>B" Assume that the minimum contract %alue is Rs" 7!>>!>>>" 'e buys 7>> Indi%idual stoc futures for which he buys a margin of Rs" ?>!>>>" ? months later the stoc closes at Rs" >7>" OR e-piration date! he ma es a profit of Rs" =>> on an in%estment of Rs" ?>!>>> wor s out annual return of 7?N"

VALUATION OF FUTURES CONTRACTS

It can be made possible on following basis/ ," 4aluatiCn Cf financial futures 1" 4aluatiCn Cf cC))Cdity futures I" II" .arry ty(e cC))Cdities 0Cn?.arry ty(e cC))Cdities

VALUATION OF FINANCIAL FUTURES:

#aluation of financial futures is based on following assumptions 7" ,he mar ets are perfect" ?" ,here is no transaction cost" :" All the assets are infinitely di%isible" =" Bid0as s spreads do not e-it so that it is assumed that only one price pre%ails",here is no restriction on short selling" Also short selling gets to use the full proceeds of the sales %aluations" ,his includes stoc inde- futures" ,he %alue of futures contract on a stoc inde- may be obtained by using the Fcost of carry modelF" In this case Price of the contract is H spot priceW 2arry cost0carry returns i"e" 4s W 2 & R5

'ere/ SPOT P#I.-: 2urrent Price of One .nit of (eli%erable asset in the Mar et"

.A##6 .OST/ 'olding cost i"e" interest 2harges etc" W opportunity

cost of using funds"

.A##6 #-TU#0S: (i%idends etc"

#aluation of )toc Inde- futures is F H )>e4r0y5 t

COMMODITY FUTUREFS VALUATION (8 CARRY TYPE OR INVESTMENT PURPOSE

,hese types of commodities are held by significant number" Of in%estor for futures safety as in%estment alone" TIf storage cost is 1ero then F H )oert TIf any storage cost or opportunity cost then it is regarded as negati%e income" If ) is the present %alue" of all the storage costs that may be incurred during the life of a future contract then F H 4)o W s5ert TIf the storage cost were proportional to price of commodity then would be the same as in case of Pro%iding a negati%e yield" If ) represents the storage costs p"a" proportion of spot prices! we ha%e F H )oe4rWs5 t 6"g" Aet us consider a B months gold futures contract of 7>> gm"

COMMODITIES VALUATION

Assume that the spot price is Rs" =;> per gram and that it cost Rs" : per gram for the B monthly period to store gold and that the cost is incurred at the end of the period" If the ris free rate of Interest is 7?N p"a" compounded continuously then RH>"7?! sH=;> - 7>>H =;>>>! e H BJ7? H >"< )H: - 7>> e04>"7? - >"<5 H Rs" ?;?"<: ,hen F 4=;>>> ?;?"<:5e0>"7? H Rs" <=!=:;"=>

?5

NON CARRY TYPE COMMODITITES/

2onsumable goods li e agricultural

productKs futures price will not e-ceed the sum of spot price W 2aring 2ost0 2aring Returns! in these arbitrage arguments doesnKt wor in%estor stores these on because of its consumption %alue only not for in%estment" #aluation of non0carry commodity futures requires another concept" i"e" F2on%enience returnF or F2on%enience yieldF! which is the returns 4in terms of money5 that the in%estor reali1es for carrying commodity o%er his short term needs" ,he financial assets ha%e no con%enience return" ,his is different or different in%estor" FH 4)o Ws5 e 4r0c5 t )H P"#" 2Hcon%enience cost )oH)pot price

PAY OF FOR FUTURES:

&a+ PayCff fCr buyers Cf futures cCntract?lCn* futures
Its payoff is same as payoff of a person who holds assets" Result of holding an asset may be unlimited upside or unlimited downside" Profit 7??> Cifty 4underlying5 Assets Aoss

I0T-#P#-TATIO0
,he figure shows PJA for a long futures position" ,he in%estor bought futures when ,'6 IC(6G @A) A, 7??>" If IndeIf Inde'is futures position shows profits 'is futures position shows losses

&b+ PayCff fCr seller Cf futures cCntract?shCrt futures

It can be e-plained by ta ing an e-ample/ A speculator who sells a ? months Cifty Inde- futures contracts when the nifty stands at 7??> 4Cifty an underlying assets5 Profit XCifty 4underlying assets5

Aoss I0T-#P#-TATIO0: @hen Inde- mo%es @hen inde- mo%ers" )eller start ma ing Profits" )eller starts ma ing Aoss"

FOR0ARD VS. FUTURES F!"t.#!3

0Operational Mechanism 02ontract )pecifications 02ounter party Ris s 0Aiquidity 0Price (isco%ery 06-ample 0)ettlement

F4#>"#:
,raded between two parties (iffer from traded to trade 6-ists such ris Aow Cot 6fficient 2urrency Mar et At end of period

F.t.#!
,rade on 6-change )tandardised contracts Co such ris 'igh 'ighly 6fficient Future Mar et (aily

COBOT 0HEAT FUTURES CONTRACT SPECIFICATIONS ,rading .nit (eli%erable *rades <>>> Bushels Co" 7 Corthern )pring wheat at par and Co" ? )oft" Red! Co" ? 'ard Red @inter! Co" ? (ar Corthern )pring and Price Uuotation ,ic )i1e (aily Price Aimit 2ents substitution and at different bushel established by the e-change" quarter0cents 4Y7?"<> per contract"5 One0quarter cent per bushel 4Y7?"<> per contract5 ?> cent per bushel 4Y7>>> per contract5 pre%ious abo%e dayKs or below the price settlement

4e-pandable to :> cent per bushel5 Co limit in the spot month 4limit are lifted two business day before the spot month begins"5 2ontract Months 2ontract Iear Aast ,rading day March! May! Euly! )eptember and (ecember" )tarts in Euly and ends in May )e%enth business day preceding the last business day of the deli%ery month"

Aast (eli%ery (ay ,rading 'ours

Aast business day of the deli%ery month 8":> to 7"7< p"m 42hicago timeV! Monday through Friday! Only the last trading day of an e-piring contract! trading that contract closes in noon"

,ic er )ymbol

OPTIONS
Options are fundamentally different from forward and futures" An option gi%es the holderJbuyers of the option the right to do something" ,he holder does not ha%e committed himself to doing something" In contrast! in a forward or futures contract! the two parties ha%e committed them self to doing something" @hereas it nothing 4e-pect margin requirement5 to enter in to a futures he purchases of an option require an up front payment"

HISTORICAL BACKGROUND OF OPTION/

Although options ha%e e-ercised for a long time! they were traded O,(! without much nowledge of %aluation" ,oday e-change0traded options are acti%ely traded on stoc s! stoc contracts" indices! foreign currencies and futures

,he first trading is options began in 6urope and .")" as early as the century" It was only in early! 78>>s that a group of firms set up what is nown as the Fput and call bro ers and dealers associationF with the aim of pro%iding a mechanism for bringing buyers and sellers together" It someone wanted to buy an option! he or she would contract one of the member firms" ,he firm would then attempt to find a seller or writer of option either from its own client of those of other member firms" If no seller could be found! the firm would underta e to write the option itself in return of price" ,he two deficiencies in abo%e mar ets were 7" ?" Co secondary mar et Co mechanism to guarantee the writer of option would honor it In 789:! Blac ! Marton! )choles in%ented the Blac 0)choles formula" In April 789:! 2BO6 was set up specially for the purpose of trading options" ,he mar et for options de%elop so rapidly that by early ;>Ks number of share underlying the options contract sold each day e-ceed the daily %olume of share traded on the CI)6" )ince then! there has been no loo ing bac "

Fhat is C(tiCnG
An options is the right! but not the obligation to buy or sell a specified amount 4and quality5 of a commodity! currency! inde- or financial instruments a to buy or sell a specified number of underlying futures contracts! at a specified price on a before a gi%e date in the future" ,hus! option li e futures! also pro%ide a mechanism by which one can acquire a certain commodity on other assets! or ta e position in order to ma e profits or co%er ris for a price" In this type of contract as well! there are two parties/

4a5 ,he buyer 4or the holder! or owner of options5 4b5 ,he seller 4or writer of options5 @hile the buyer ta e Flong positionF the seller ta e Fshort positionF )o e%ery option contract can either be Fcall optionF or Fput optionF options are created by selling and buying and for e%ery option that is buyer and seller"

OPTION

B.I6R

)6AA6R

RI*',

OBAI*A,IOC

,O B.I 42AAA5

,O )6AA 4P.,5

,O )6AA 42AAA5

,O B.I 4P.,5

OPTION TERMINOLOGY
Buyer of an option/ the buyer of an option is the one who by paying the option premium buys the right but not the obligation e-ercise his option on the sellerJwriter" @riter of an option/ the writer of a callJput option is the one who recei%es the option premium and is thereby obliged to sellJbuy the asset if the buyer e-ercise on him" Option price/ option price is the price! which the option buyer pays to the option seller" It is also referred as option premium" 6-piration date/ the date specified in the options contract is nown as e-piration date! the e-ercise date! the stri e date or the maturity" )tri e price/ the price specified in the options contract is nows as stri e price or the e-ercise price" American options/ these are the options that can be e-ercised at any time upto the e-piration date" Most e-change0traded options are Americans" 6uropean options/ these are the options that can be e-ercised only on the e-piration date itself" ,hese are easier or analy1e than American option! and properties of American options are frequently deducted from those of its 6uropean counterpart" In the money option/ an in the money option is an option that would lead to a positi%e cash flow to the holder if it will e-ercise immediately" A call option in the inde- is set to be in0the0money when the current inde- stands at a le%el higher than the stri e price 4i"e" spot priceQstri e price5" If the inde- is much higher than the stri e price!

 the call is set to deep I,M" In the case of a put! the put is I,M if the inde- is below the stri e price" At0money option/ 4A,M5 option is an option that would lead to 1ero cash flow if it were e-ercised immediately" An option on the inde- is at0the0money when the current inde- equals the stri e price" Out0of0the money option/4O,M5 option is an option that would lead to a negati%e cash flow it was e-ercised immediately" A call option on the inde- is O,M when the current inde- stands at a le%el! which is less than the stri e price 4spot priceZstri e price5" If the inde- is much lower than the stri e price! the call is set to be deep O,M" In the case of a put! the put is O,M if the inde- is abo%e the stri e price" Intrinsic %alue of an option/ the option premium can be bro en into two components0intrinsic %alues and time %alue" ,he intrinsic %alue of a call is the amount the option is I,M! if it is I,M" If the call is O,M! its intrinsic %alue is 1ero" ,ime %alue of an option/ it is a difference between its premium and its intrinsic %alue" Both calls and puts ha%e time %alue" An option that is O,M or A,M has only time %alue" .sually the ma-imum time %alue e-ists when the options is A,M" ,he longer the time to e-piration! the greater is an optionKs time %alue! all else equal" At e-piration! an option should ha%e no time %alue"

TYPES OF OPTIONS
,hus the options are of two types/ 2AAA OP,IOC AC( P., OP,IOC"

CALL OPTION:
It gi%es an owner the write to buy a specified quantity of the underling assets at a predetermined price i"e" the e-ercise price! or the specific date i"e" is the date of maturity"

E1AMPLE
)uppose it is Eanuary now and the in%estor buys a March option contract on Reliance Industries 4RIA5 )hare with an e-ercise priceJstri e price Rs" ?7>" @ith this he get a right to buy share on a particular date in March! of course he is under no obligation" Ob%iously! if at the e-piry date the price in mar et 4spot price on e-piry date5 is abo%e the e-ercise price heKll e-ercise his option and re%erse is also true"

PUT OPTION:
It gi%es the holder the right to sell a specific quantity of underlying assets at an agreed price on date of maturity he gets the right to sell"

E1AMPLE
If an in%estor buys a March Put Option on RIA shares with an e-ercise price of Rs" ?7> per share the in%estor get the right to sell 7>> share [ ?7> per share" ,he in%estor would naturally e-ercise his right if on maturity date price were below ?7> and stand to gain and %ice0 %ersa" Buying out options is buying insurance" ,o buy a put option on Cifty is to buy insurance/ which reimburses the full e-tent to which0Cifty drops below the stri e price of the put option" ,his is attracti%e to many people"

AMERICAN V3 EUROPEAN OPTION

Its owner can e-ercise an American option at any time on or before the e-piration date" A 6uropean style option gi%es the owner the right to use the option only on e-piration date and not before"

OPTION PREMIUM
A glance at the rights and obligation of buyer and seller re%eals that option contracts are s ewed" One way naturally wonder as to why the seller 4writer5 of an option would always be obliged to sellJbuy an asset whereas the other party gets the right\ ,he answer is that writer of an option recei%es! a consideration for .nderta ing the obligation" ,his is nown as the price or premium to the seller for the option" ,he buyer pays the premium for the option to the seller whether he e-ercise the option is not e-ercised! it becomes worthless and the premium becomes the profit of the seller" PremiumJPrice of an option H Intrinsic #alue W ,ime #alue (o Cothing Option to option holder matching writer" 6-ercise the option" 2lose out the position by write a! call option or it in case of

IN-THE-MONEY AND OUT-THE-MONEY OPTIONS

2ondition )oQ6 )oZ6 )oH6 )o Hspot price 2all In the money Out of the money At the money 6 H e-ercise price Put Out of the money In the money At the money

C4,3+:!#"t+4, ;4# 3!77+,6 th! 4=t+4,GO=t+4, P#+2+,6GO=t+4, P#!/+./ A33./=t+4, Cot transaction cost li es bro erage or commission on buying or selling"

FACTORS AFFECTING PRICING

7" )upply and demand in secondary mar et ?" 6-ercise price :" Ris free interest rate! =" #olatility of underlying <" ,ime to e-piration B" (i%idend on underlying

O(tiCn?tC?C(tiCn hClder in case CfHhe C(t fCr eI(iry date"

+.! H4> O=t+4, 04#-

2AAA OP,IOC) )pot Cifty/ 77>> )tri e Price/ 77<> (uration /: months Co" of option boughtH?>> Premium per option/7> ,otal premium paidH?>>>

D" (

(a y 8>

)pot Cifty/7?>> Buyer e-ercise the option Profit/ Co" of option - price (ifferential0Premium paidHRs" 4?>>-47?>>077<>50 ?>>>HRs";>>>5

)pot Cifty/ 7>>> Buyer foregoes the option Aoss premium paid Rs" ?>>>

2AAA OP,IOC @OR$ )pot Cifty/7?>> Buyer e-ercise the option Profit/ Co" of option - price (ifferential0Premium paidHRs" 4?>>-47?>>077<>50 ?>>>HRs";>>>5

D" (

)pot Cifty/ 77>> )tri e Price/ 77<> (uration /: months Co" of option boughtH?>> Premium per option/7> ,otal premium paidH?>>>

(a y 8>

)pot Cifty/ 7>>> Buyer foregoes the option Aoss premium paid Rs" ?>>>

PRICING OF OPTION

A, 6GPIRA,IOC

B6FOR6 6GPIRA,IOC

2all option At e-piration

Put option Before e-piration

Put option At e-piration

2all option Before

e-piration

( AT E1PIRATION 5"8 .all C(tiCn (ricin* at eI(iratiCn/

If the price of the underlying asset were lower than the e-ercise price on the e-piration date! the call would e-pire une-ercised" ,his is because no one would li e to buy an asset! which is a%ailable in the mar et at a lower price" If an out of money call did actually sell for a certain price! the in%estor can ma e an arbitrage profit by selling it and earning premium" ,he buyer is unli ely to e-ercise option! the allowing seller to retain premium" In e%en of 4irrational5 e-ercise of such a call! writer can purchase asset as )7 and gi%e it at ma ing a profit of 46W)75W premium" On the other hand! if the call happens to be in the money! itKll! be worth its intrinsic %alue! equal to e-cess of asset price o%er the e-ercise price" If call price Zintrinsic %alue then he can buy call at c! e-ercise it immediately at )7 and ma e a profitF of )7O6O2

VALUE OF CALL OPTION

#alue

Price of share

Put C(tiCn at eI(iratiCn1

@hen at the e-piration date the price of the underlying asset is greater than e-ercised price! the put option will go une-ercised" ,his is because there is no use of using option to sell at 6 when If the option were e-ercised! it would ha%e resulted in a profit to seller of option of about 460)75 W premium" @hen )7Z6

#alue of put option

#alue

Price of share

?. BEFORE E1PIRATION:
Before e-piration! the options call and put are usually sold for at least intrinsic %alued 4difference of 6 + )75"

5"+ .all O(tiCn Pricin*:

A call option will usually sell for at least its intrinsic %alue! Minimum %alue of call is always is equal to its intrinsic %alue" Intrinsic %alue H )Q6 ,o this would be added the time %alue! if any longer the time e-piry! greater were time %alue" PHf 46!)!,5 I Price of 2all option Intrinsic #alue

=<>

)toc Price

In figure intrinsic %alue is shown! by! a =< > line starting at 6! equal to the e-cess of stoc price o%er the e-ercise price"

At )toc price ) ?! 2all Option pence is out0 of0the money i"e" 1ero intrinsic %alue then option priceH)?BH only time %alue

&c+Put O(tiCn Pricin*

It would sell for a price that is at least equal to intrinsic %alue! which is e-cess of e-ercise price o%er stoc price! when option is in &the money" For in the money Put Option i"e" )Z6 PHIntrinsic %alue W,ime #alue ,ime #alueHf 4,ime of Maturity5 'igher the time to maturity! higher is the time %alue"

FCr Cut?the?)CneyJat the )Cney Put O(tiCn i"e" SB-, -,S K = PHT+/! V"7.! CF24@ +,t#+,3+2 D"7.! H %
B Price of put option ,ime %alue

#alue Intrinsic B7 ,ime #alue )toc prices )7 6 )?

DERIVATIVES TRADING IN INDIA

,he first step towards introduction of deri%ati%es trading in India was the promulgation of the securities laws 4amendment5 ordinance! 788< which withdrew the prohibition on options in securities" ,he mar et for deri%ati%es! howe%er! did not ta e off! as there was no regulatory framewor to go%ern trading of deri%ati%es" )6BI set up a ?= members committee under the 2hairmanship of (r" A"2" *upta on 7;th Co%ember! 8B to de%elop appropriate regulatory framewor for deri%ati%es trading in India" ,he committee submitted its report on 79th March! 8; prescribing necessary pre0 conditions for introduction of deri%ati%es trading in India" the committee recommended that deri%ati%es should be declared as KsecuritiesK so that regulatory framewor applicable to trading of KsecuritiesK could also go%ern trading of securities" )6BI also set up a group in Eune 788; under the 2hairmanship of Prof" E"R" #arma! to recommend measures for ris containment in deri%ati%es mar et in India" ,he report! which was submitted in October! 788;! wor ed out the operational details of margining system! methodology for charging initial margins! bro er net worth! deposit requirement and real time monitoring requirements" ,he )2RA was amended in (ec" 7888 to include deri%ati%es within the ambit of KsecuritiesK and the regulatory framewor was de%eloped for go%erning deri%ati%es trading" ,he act also made it clear that deri%ati%e shall be legal and %alid only it such contract are traded on a recogni1ed stoc e-change! thus preluding O,2 deri%ati%e" ,he go%ernment also rescinded in March ?>>?! the three decade old notification! which prohibited forward trading in securities"

(eri%ati%es trading commenced in India in Eune ?>>> after )6BI granted the final appro%al to this effect in May ?>>>" )6BI permitted the deri%ati%e segments of two stoc e-changes" C)6 and B)6! and their clearing houseJcorporation to commence trading and settlement in appro%ed deri%ati%es contracts" ,o begin with! )6BI appro%ed trading in inde- futures contracts based on ) + P 2CG Cifty and B)60:> 4)ense-5 inde-" ,his was followed by appro%al! for trading in options based on these two inde-es and options on indi%idual securities" ,he trading in inde- options commenced in Eune ?>>7" Futures contracts on indi%idual stoc s were launched in Co%ember ?>>7" ,rading and )ettlement in deri%ati%es contracts is done in accordance with the rules! bye0laws! and regulations of the respecti%e e-changes and their clearing houseJcorporation duly appro%ed by )6BI and notified in the official ga1ette" ,hus! the following fi%e types of (eri%ati%es are now being traded in the India )toc Mar et" P )toc Inde- Futures P )toc Inde- Options P Futures on Indi%idual )toc s P Options on Indi%idual )toc s P Interest Rate (eri%ati%es

INDE1 FUTURES/
Inde- futures are financial contracts for which the underlying is the cash mar et inde- li e the )ense-! which is the brand inde- of India" inde- futures contract is an agreement to buy or sell a specified quantity of underlying inde- for a future date at a price agreed

upon between the buyer and seller" ,he contracts ha%e standardi1ed specifications li e mar et lot! e-piry day! tic si1e and method of settlement"

INDE1 OPTIONS:
Inde- Options are financial contracts whereby the right is gi%en by the option seller in consideration of a premium to the option buyer to buy or sell the underlying inde- at a specific price 4stri e price5 on or before a specific date 4e-piry date5"

STOCK FUTURES/
)toc Futures are financial contracts where the underlying asset is an indi%idual stoc " )toc futures contract is an agreement to buy or sell a specified quantity of underlying equity share for a

future date at a price agreed upon between the buyer and seller" Eust li e Inde- deri%ati%es! the specifications are pre0specified"

STOCK OPTIONS/
)toc Options are instruments whereby the right of purchase and sale is gi%en by the option seller in consideration of a premium to the option buyer to buy or sell the underlying stoc at a specific price 4stri e price5 on or before a specific date 4e-piry date5"

INTEREST RATE DERIVATIVES:

,he deri%ati%es are ta en on %arious rates of interests" OPERATIONAL MECHANISM FOR DERIVATIVES TRADIN

7"

REGISTRATION 0ITH BROKER:

,he first step towards trading in the deri%ati%es mar et is selection of a proper bro er with whom the in%estor would trade" In%estors should complete all the registration formalities with the bro er before commencement of trading in the deri%ati%es mar et" ,he in%estor should also ensure to deal with a bro er 4member of the e-change5 who is a )6BI registered bro er and possesses a )6BI registration certificate"

?" CLIENT AGREEMENT/ ,he in%estor should sign the 2lient Agreement with the bro er before the bro er can place any order on his behalf" ,he client agreement includes pro%isions specified by )6BI and the deri%ati%es segment" :" UNIQUE CLIENT IDENTIFICATION NUMBER/ After signing the client agreement! the in%estor gets a unique identification number 4I(5" ,he bro er would ey this identification number in the system at the time of placing the order on behalf of the in%estor" ,his I( is bro er specific i"e" if the in%estor chooses to deal with different bro ers! he needs to sign the client agreement with each one of them and resultantly! he would ha%e different Ids" =. RISK DISCLOSURE DOCUMENT/ As stipulated in the Bye0Aaws pro%ide his particulars to the in%estor" ,he particulars would include his )6BI registration number! the name of the employees who would be primarily responsible for the clientKs affairs! the precise nature of his liability towards

the client in respect of the business done on behalf of the in%estor" ,he bro er must also apprise the in%estor about the ris associated with the business in deri%ati%e trading and the e-tent of his liability" ,his information forms part of the Ris (isclosure document! which the bro er issues to the client" ,he in%estor should carefully read the ris disclosure document and understand the ris s in%ol%ed in the deri%ati%es trading before committing any position in the mar et" ,he ris disclosure document has to be signed by the client and a copy of the same is retained by the bro er for his records"

*. FREE COPY OF RELEVANT REGULATION/

,he client is also entitled to a free copy of the e-tracts of rele%ant pro%isions go%erning the rights and obligations of clients! rele%ant manuals! notifications! circulars and any additions or amendments etc" of the deri%ati%es segment or of any regulatory authority to the e-tent it go%erns the relationship between the bro er and the client"

B. PLACING ORDER 0ITH THE BROKER/

,he in%estor should place orders only after understanding the monetary implications in the e%ent of e-ecution of the trade" After the trade is e-ecuted! the in%estor can request for a copy of the trade confirmation slip generated on the systems on e-ecution of the trade" ,he in%estor should also obtain from the bro er! a contract note for the trade e-ecuted within ?= hours" ,he contract note should be time 4order receipt and order e-ecution5 and price stamped" 6-ecution prices! bro erage and other charges! if any! should be separately mentioned in the contract note" If desired! the in%estor may change an order anytime before the same is e-ecuted on the e-change"

). MARGINING SYSTEM IN DERIVATIVES/

,he aim of margin money is to minimi1e the ris of default by either counter0party" ,he payment of margin ensures that the ris is limited to the pre%ious dayKs price mo%ement on each outstanding position" ,he different types of margins are/

A5 INITIAL MARGIN/ ,he basic aim of initial margin is to co%er the largest potential loss in one day" Both buyer and seller ha%e to deposited before the opening of the position in the futures transaction" ,his margin is calculated by )PAC by considering the worst case scenario" B5 MARK TO MARKET MARGIN/ All daily losses must be met by depositing of further collateral0 nown as %ariation margin! which is required by the close of business! the following day" Any profits on the contract are credited to the clientKs %ariation margin account"

9" INVESTOR PROTECTION FUND/ ,he deri%ati%es segment has established an FIn%estor Protection FundF which is independent of the cash segment to protect the interest of the in%estors in the deri%ati%es mar et"

;" ARBITRATION: In case of any dispute between the members and the clients arising out of the trading or in relation to tradingJsettlement! the party thereto shall resol%e such complaint! dispute by arbitrations procedure as defined in the rules and regulations and Bye0 Aaws of the respecti%e e-changes"

REGULATORY FRAME0ORK
,he trading of deri%ati%es is go%erned by the pro%isions contained in the )2 4R5 A! the )6BI Act! the rules and regulations framed there under and the rules and bye0laws of stoc e-changes" S!2.#+t+!3 24,t#"2t3 5R!6.7"t+4,8 A2t, (9*& )24R5 A aims at pre%enting undesirable transactions in securities by regulating the business of dealing therein and by pro%iding for certain other matters connected therewith" ,his is the principal Act! which go%erns the trading of securities in India" ,he term FsecuritiesF has been defined in the )24R5A" As per )ection ?4h5! the K)ecuritiesK include/

7" )hares! scrips! stoc ! bonds! debentures! stoc or other mar etable securities of a li e nature in or of any incorporated company or other body corporate" ?" (eri%ati%e

:" .nits or any other instrument issued by any collecti%e in%estment scheme to the in%estors in such schemes" =" *o%ernment securities" <" )uch other instruments as may be declared by the 2entral *o%ernment to be securities B" Rights or interests in securities F(eri%ati%eF is defined to includes/ A security deri%ed from a debt instrument! share! loan whether secured or unsecured! ris instrument or contract for differences or any other form of security" A contract which deri%es its %alue from the prices! or inde- of price! of underlying securities" )ection 7;A pro%ides that notwithstanding anything contained in any other law for the time being in force! contracts in deri%ati%e shall be legal and %alid if such contracts are/ ,raded on a recogni1ed stoc e-change" )ettled on the clearinghouse of the recogni1ed stoc e-change! in accordance with the rules and bye0laws of such stoc e-changes"

REGULATIONS FOR DERIVATIVES TRADING

)6BI set up a ?=0member committee under the 2hairmanship of (r" A"2" *upta to de%elop the appropriate regulatory framewor for deri%ati%es trading in India" ,he committee submitted its report in March 788;" On May 77! 788; )6BI accepted the recommendations of the committee and appro%ed the phased introduction of deri%ati%es trading in India beginning with stoc inde- futures" )6BI also appro%ed the Fsuggesti%e bye0lawsF recommended by the committee for regulations and control of trading and settlement of deri%ati%es contracts" ,he pro%isions in the )24R5A and the regulatory framewor de%eloped there under go%ern trading in securities" ,he amendment of the )24R5A to include deri%ati%es within the ambit of KsecuritiesK in the )24R5A made trading in deri%ati%es possible with in the framewor of that Act" 7" Any 6-change fulfilling the eligibility criteria as prescribed in the A2 *upta committee report may apply to )6BI for grant of recognition under )ection = of the )24R5A! 78<B to start trading deri%ati%es" ,he deri%ati%es e-changeJsegment should ha%e a separate go%erning council and representation of tradingJclearing members shall be limited to ma-imum of =>N of the total members of the go%erning council" ,he e-change shall regulate the sales practices of its members and will obtain prior appro%al of )6BI before start of trading in any deri%ati%e contract" ?" ,he 6-change shall ha%e minimum <> members"

:" ,he members of an e-isting segment of the e-change will not atomically become the members of deri%ati%e segment" ,he members of the deri%ati%es segment need to fulfill the eligibility conditions as laid down by the A2 *upta committee" =" ,he clearing and settlement of deri%ati%es traders shall be through a )6BI appro%ed clearing corporationJhouse" 2learing corporationJhouse complying with the eligibility conditions as laid down by the committee ha%e to apply to )6BI for grant of appro%al" <" (eri%ati%e bro ersJdealers and clearing members are required to see registration from )6BI" ,his is in addition to their registration as bro ers of e-isting stoc e-changes" ,he minimum networth for clearing members of the deri%ati%es clearing corporationJhouse shall be Rs" :>> Aa h" ,he networth of the member shall be computed as follows/ 2apital W Fee reser%es Aess non0allowable assets %i1" a" b" c" d" e" f" g" h" i" Fi-ed assets Pledged securities MemberKs card Con0allowable securities 4unlisted securities5 Bad deli%eries (oubtful debts and ad%ances Prepaid e-penses Intangible assets :>N mar etable securities

B" ,he minimum contract %alue shall not be less than Rs" ? Aa h" 6-change should also submit details of the futures contract they propose to introduce" 9" ,he initial margin requirement! e-posure limits lin ed to capital adequacy and margin demands related to the ris of loss on the position shall be prescribed by )6BIJ6-changes from time to time" ;" ,he A"2" *upta committee report requires strict enforcement of F$now your customerF rule and requires that e%ery client shall be registered with the deri%ati%es bro er" ,he members of the deri%ati%es segment are also required to ma e their clients aware of the ris s in%ol%ed in deri%ati%es trading by issuing to the client the Ris (isclosure (ocument and obtain a copy of the same duly signed by the client" 8" ,he trading members are required to ha%e qualified appro%ed user and sales person who ha%e passed a certification programme appro%ed by )6BI"

DR. L.C.GUPTA COMMITTEE

,he )ecurities and e-change board of India 4)6BI5 appointed a committee with (r" A"2" *upta as its chairman in Co%ember! 788B to de%elop regulatory framewor for deri%ati%es trading in India" ,he committee recommended introduction of deri%ati%es mar et in a phased manner with the introduction of inde- futures and )6BI appointed a group with Prof" E"R" #arma as its 2hairman to recommend measures for ris containment in the deri%ati%e mar et in India" ,he recommendations of A"2" *upta 2ommittee at a glance/ a5 )toc inde- futures to be the starting point of equity deri%ati%es" b5 )6BI to appro%e rules! bye0laws and regulation of the deri%ati%es e-change and the deri%ati%es contracts" c5 )6BI need not be in%ol%ed in framing e-change le%el regulations" d5 )6BI should create a special (eri%ati%es 2ell as it in%ol%es special nowledge! and a (eri%ati%es ad%isory council may be created to tap outside e-perts for independent" e5 Aegal restrictions on institutions! including mutual funds! on use of deri%ati%es should be remo%ed" f5 6-isting stoc e-changes with cash trading to be allowed to trade deri%ati%es if they meet prescribed eligibility conditionOimportantly! a separate *o%erning 2ouncil and at least <> members" g5 ,wo categories of member0clearing members and non0clearing members! with the latter depending on the former for settlement of trades" ,his is no bring in more traders"

h5 Bro er members! dealers and sales persons in the deri%ati%es mar et must ha%e passed a certificate programme to be registered with )6BI" i5 2o0ordination between )6BI and the RBI of financial deri%ati%es mar et must ha%e passed a certificate programme to be registered with )6BI" j5 2learing corporation to be the center piece of the deri%ati%es mar et! both for implementing the margin system and pro%iding trade guarantee" In the near term! e-isting clearing corporation be allowed to participate in deri%ati%es" For the long0term! a centrali1ed clearing corporation has been recommended" 5 Minimum networth requirement of Rs" : crores for participants! ma-imum e-posure limits for each bro erJdealer on gross basis and capital adequacy requirements to be prescribed" l5 Mar 0to0mar et to be collected before ne-t dayKs trading starts" m5 As a conser%ati%e measure! margins for deri%ati%es purposes not to ta e into account positions in cash and futures mar et and across all stoc e-changes" n5 Margins to be systematically collected and not left to discretion of bro ersJdealers" o5 Much stricter regulation for deri%ati%es as compared to cash trading" p5 )trengthen cash mar et with uniform settlement cycles among all )6s and regulatory o%ersight" Proper super%ision of sales practices with registration of e%ery client with the dealerJbro er and ris disclosure as the corner0stone"

J.R. VARMA COMMITTEE

After the submission of A"2" *upta committee report and appro%al of the introduction of inde- futures trading by )6BI the board mandated the setting up of a group to recommend measures for ris containment in the deri%ati%e mar et in India" Prof" E"R" #arma was the chairman of the group"

ASSUMPTIONS
0#olatility in India mar ets are high" 0#olatility is not constant + %arying" 0,here is no data on the %olatility on Inde- futures" 06%en at 88N F#alue At Ris F model there could be possibility of default once in si- months" 0Cot efficient organi1ed arbitragers players" RECOMMENDATIONS 0 Only traders with high net worth be allowed to traded in (eri%ati%es" 0 Imposition of #AR margin system" 0 )ubmission of periodic reports by 22 and )6 to )6BI" 0 2ontinuously refining of Margin system" 0 (aily changes in the Margins be calculated and imposed" 0 Proper liquid net worth" 0Online position monitoring at customer! ,M! 2M and Mar et le%el"

RISK MANAGEMENT
C)22A has de%eloped a comprehensi%e ris containment mechanism for the F + O segment" ,he salient features of ris containment mechanism on the F + O segment are/ 7" ,he financial soundness of the members is the ey to ris management" ,herefore! the requirements for membership in terms of capital adequacy 4net worth! security deposits5 are quite stringent" ?" C)22A charges an upfront initial margin for all the open positions of a 2M" It specifies the initial margin requirements for each futuresJoptions contract on a daily basis" It also follows %alue0at0ris from the ,Ms and their respecti%e clients" :" ,he open positions of the members are mar ed to mar et based on contract settlement price for each contract" ,he difference is settled in cash on a , W 7 basis" =" C)22AKs on0line position monitoring system monitors a 2MKs open positions on a real0time basis" Aimits are set for each 2M based on his capital deposits" ,he on0line position monitoring system generates alerts whene%er a 2M reaches a position limit set up by C)22A" C)22A monitors the 2Ms for M,M %alue %iolation! while ,Ms are monitored for contract0wise position limit %iolation" <" 2Ms are pro%ided a trading terminal for the purpose of monitoring the open position of all the ,Ms clearing and settling through him" A 2M may set e-posure limits for a ,M clearing and settling through him" C)22A assists the 2M to monitor the intra0day e-posure limits set up by 4#aR5 based margining through )PAC" ,he 2M in turn collects the initial margin

a 2M and whene%er a ,M e-ceed the limits! it stops that particular ,M from further trading" B" A member is alerted of his position to enable him to adjust his e-posure or bring in additional capital" Position %iolations result in withdrawal of trading facility for all ,Ms a 2M is case of a %iolation by the 2M" 9" A separate settlement guarantee fund for this segment has been created out of the capital of members" ,he fund had a balance of Rs" B=; crore at the end of March ?>>?" ,he most critical component of ris containment mechanism for F + O segment is the margining system and on0line position monitoring" ,he actual position monitoring and margining is carried out on0 line through Parallel Ris Management )ystem 4PRI)M5" PRI)M uses )PAC 4r5 4)tandard Portfolio Analysis of Ris 5 system for the purpose of computation of on0line margins! based on the parameters defined by )6BI"

MICIM.M BA)6 2API,AA

A 2learing Member 42M5 is required to meet with the Base Minimum 2apital 4BM25 requirements prescribed by C)22A before acti%ation" ,he 2M has also to ensure that BM2 is maintained in accordance with the requirements of C)22A at all points of time! after acti%ation" 6%ery 2M is required to maintain BM2 of Rs"<> la hs with C)22A in the following manner/

475 2ash

Rs"?<

la hs

in

the

form

of

cash"

4?5 Rs"?< la hs in any one form or combination of the below forms/

FI1ED DEPOSIT RECEIPTS 4F(Rs5 issued by appro%ed ban s

and deposited with appro%ed 2ustodians or C)22A

BANK GUARANTEE in fa%our of C)22A from appro%ed ban s in

the specified format"

APPROVED SECURITIES
appro%ed 2ustodians"

in demat form deposited with

Any failure on the part of a 2M to meet with the BM2 requirements at any point of time! will be treated as a %iolation of the Rules! Bye0Aaws and Regulations of C)22A and would attract disciplinary action inter0alia including! withdrawal of trading facility andJore clearing facility! closing out of outstanding positions etc"

ADDITIONAL BASE CAPITAL

2learing members may pro%ide additional

marginJcollateral deposit 4additional base capital5 to C)22A andJor may wish to retain deposits andJor such amounts which are recei%able from C)22A! o%er and abo%e their minimum deposit requirements! towards initial margin andJ or other obligations"

EFFECTIVE DEPOSITS G LIQUID NET0ORTH

E;;!2t+D! :!=43+t3 All collateral deposits made by 2Ms are segregated into

cash

component and

non0cash

component"

For Additional Base 2apital! cash component means cash! ban guarantee! fi-ed deposit receipts! ,0bills and dated go%ernment securities" Con0cash component shall mean all other forms of collateral deposits li e deposit of appro%ed demat securities" At least <>N of the 6ffecti%e (eposits should be in the form of cash" L+I.+: N!t>4#th Aiquid Cetworth is computed by reducing the initial margin payable at any point deposits" ,he Aiquid Cetworth maintained by 2Ms at any point in time should not be less than Rs"<> la hs 4referred to as Minimum Aiquid Cet @orth5" in time from the effecti%e

MARGINS

C)22A has de%eloped a comprehensi%e ris containment mechanism for the Futures + Options segment" ,he most critical component of a ris

containment mechanism for C)22A is the online position monitoring and margining system" ,he actual margining and position monitoring is done on0 line! on an intra0day basis" C)22A uses the )PAC 4)tandard Portfolio Analysis of Ris 5 system for the purpose of margining! which is a portfolio based I,+t+"7 system M"#6+,

C)22A collects initial margin up0front for all the open positions of a 2M based on the margins computed by C)22A0)PAC "A 2M is in turn required to collect the initial margin from the ,Ms and his respecti%e clients" )imilarly! a ,M should collect upfront margins from his clients" Initial margin requirements are based on 88N %alue at ris o%er a one day time hori1on" 'owe%er! in the case of futures contracts 4on inde- or indi%idual securities5! where it may not be possible to collect mar to mar et settlement %alue! before the commencement of trading on the ne-t day! the initial margin may be computed o%er a two0day time hori1on! applying the appropriate statistical formula" ,he methodology for computation of #alue at Ris percentage is as per the recommendations of )6BI from time to time"

INITIAL MARGIN REQUIREMENT FOR A MEMBER: F4# 27+!,t =43+t+4,3 0 shall be netted at the le%el of indi%idual client and grossed across all clients! at the ,radingJ 2learing Member le%el! without any setoffs between clients"

F4# =#4=#+!t4#

=43+t+4,3 0 shall be netted at ,radingJ 2learing For the purpose of )PAC Margin! %arious

Member le%el without any setoffs between client and proprietory positions" parameters are specified from time to time" In case a trading member wishes to ta e additional trading positions his 2M is required to pro%ide Additional Base 2apital 4AB25 to C)22A" AB2 can be pro%ided by the members in the form of 2ash ! Ban *uarantee ! Fi-ed (eposit Receipts and appro%ed securities "

P#!/+./

M"#6+,

In addition to Initial Margin! Premium Margin would be charged to members" ,he premium margin is the client wise margin amount payable for the day and will be required to be paid by the buyer till the premium settlement is complete"

A33+6,/!,t

M"#6+,

Assignment Margin is le%ied on a 2M in addition to )PAC margin and Premium Margin" It is required to be paid on assigned positions of 2Ms towards Interim and Final 6-ercise )ettlement obligations for option contracts on indi%idual securities! till such obligations are fulfilled"

,he margin is charged on the Cet 6-ercise )ettlement #alue payable by a 2learing Member towards Interim and Final 6-ercise )ettlement and is deductible from the effecti%e deposits of the 2learing Member a%ailable towards margins" Assignment margin is released to the 2Ms for e-ercise settlement pay0in"

PAYMENT OF MARGINS
,he initial margin is payable upfront by 2learing Members" Initial margins can be paid by members in the form of 2ash ! Ban *uarantee! Fi-ed (eposit Receipts and appro%ed securities "

Con0fulfillment of either the whole or part of the margin obligations will be treated as a %iolation of the Rules! Bye0Aaws and Regulations of C)22A and will attract penal charges [ >">8N per day of the amount not paid throughout the period of non0payment" In addition C)22A may at its discretion and without any further notice to the clearing member! initiate other disciplinary action! inter0alia including! withdrawal of trading facilities andJ or clearing facility closing out of outstanding positions! imposing penalties! collecting appropriate deposits! in%o ing ban guaranteesJ fi-ed deposit receipts! etc"

POSITION LIMITS, VIOLATIONS A PRICE SCAN RANGE

P43+t+4, addition to initial margins requirements 6-posure Aimits ,rading Memberwise Position Aimit 2lient Ae%el Position Aimits

L+/+t3

2learing Members are subject to the following e-posure J position limits in

Mar et @ide Position Aimits 4for (eri%ati%e 2ontracts on .nderlying )toc s5 2ollateral limit for ,rading Members

VIOLATIONS
PRI)M 4Parallel Ris Management )ystem5 is the real0time position of each trading and clearing member is

monitoring and ris management system for the Futures and Options mar et segment at C)22A" ,he ris monitored on a real0time basis and alertsJdisablement messages are generated if the member crosses the set limits" Initial Margin #iolation 6-posure Aimit #iolation

 ,rading Memberwise Position Aimit #iolation 2lient Ae%el Position Aimit #iolation Mar et @ide Position Aimit #iolation #iolation arising out of misutilisation of trading memberJ constituent collaterals andJor deposits #iolation of 6-ercised Positions 2learing members who ha%e %iolated any requirement andJ or limits! may submit a written request to C)22A to either reduce their open position or! bring in additional collateral deposits by way of cash or ban guarantee or F(R or securities" C)22A renders a ser%ice to members! whereby the members can gi%e standing instructions to debit their account towards additional base capital"

A penalty of Rs" <>>>J0 is le%ied for each %iolation and is debited to the clearing account of clearing member on the ne-t business day" In respect of %iolation on more than one occasion on the same day! each instance is treated as a separate %iolation for the purpose of calculation of penalty" ,he penalty is charged to the clearing member irrespecti%e of whether the clearing member brings in margin deposits subsequently" 2learing Members 42Ms5 and ,rading Members 4,Ms5 are required to collect upfront initial margins from all their ,rading MembersJ 2onstituents" 2Ms are required to compulsorily report! on a daily basis! details in respect of such margin amount due and collected! from the ,MsJ 2onstituents clearing and settling through them! with respect to the

trades e-ecutedJ open positions of the ,MsJ 2onstituents! which the 2Ms ha%e paid to C)22A! for the requirements" purpose of meeting margin

)imilarly! ,Ms are required to report on a daily basis details in respect of such margin amount due and collected from the constituents clearing and settling through them! with respect to the trades e-ecutedJ open positions of the constituents! which the trading members ha%e paid to the 2Ms! and on which the 2Ms ha%e allowed initial margin limit to the ,Ms"

RESEARCH METHODOLOGY A ANALYSIS

RESEARCH METHODOLOGY Research is a procedure of logical and systematic application of the fundamentals of science to the general and o%erall questions of a study and scientific technique by which pro%ide precise tolls! specific procedures and technical! rather than philosophical means for getting and ordering the data prior to their logical analysis and manipulation" (ifferent type of research designs is a%ailable depending upon the nature of research project! a%ailability of able manpower and circumstances" ,he study about F ,rends and future of deri%ati%es in india F is descripti%e in nature" )o sur%ey method is used for the study" S"/=7+,6 P#42!:.#! ,he small representati%e selected out of large population is selected at random is called sample" @ell0selected sample may reflect fairly! accurately the characteristic of population" ,he chief aim of sampling is to ma e an inference about un nown parameters from a

measurable sample statistics" ,he statistical hypothesis relating t population" ,he sample si1e was B> which includes bro ers!dealers and in%estors"

S4.#2!3 4; D"t": ,he sources of data includes primary and secondary data sources" P#+/"# S4.#2!3: Primary data is collected by structured questionnaire administered by sitting with guide and discussing problems" S!24,:"# S4.#2!3: ,he secondary data is data! which is collected and compiled for the different purpose! which are used in research for this study" ,he secondary data include material collected from/ Cewspaper Maga1ine Internet D"t" 2477!2t+4, +,3t#./!,t3 ,he %arious method of data gathering in%ol%es the use of appropriate recording forms" ,hese are called KtoolsK or Kinstruments of data collection" 2ollection Instruments/ 7" Obser%ation ?" Inter%iew guide :" Inter%iew schedule

6ach tool is used for specific method of data gathering" ,he tool for data collection translates the research objecti%es in to specific termJquestions to the response! which will pro%ide research objecti%e" ,he instrument data collection in our study inter%iew schedule mainly" 6%ery respondent was conducted personally with an inter%iew

schedule containing questions" Inter%iew method was used because it can be e-plained more easily and clearly and ta es less time to answer" M!th4:4746 A33./=t+4,3: ,he research was based on the following assumption/ 7" ,he methodology used for this purpose are sur%ey and questionable method" It is assumed that this method is more suitable for collection of data" ?" It is assumed that the respondent ha%e sufficient nowledge to ensure questionable" :" It is assumed that the respondent ha%e filled right and correct option according to their %iew"

BROKERFS PERCEPTION ABOUT DERIVATIVES 5ANALYSIS8

TRADING PERIOD IN DERIVATIVES

Trading period in derivatives.

25 20 15 10 5 0 Less than 1 year 1 year 2 year 3 year More than 3 year 13 13 7 6 Series1 Series2 21

From my sample of B>! 7: 4??N5 bro ers and in%estors in%esting in deri%ati%es from last 7 year and less than this" ?74:<N5 are in%esting from last ? years !9 477N5 are in%esting from last : years and only B 47>N5 ha%e e-perience of more than : years of in%estment in deri%ati%es"

REASONS BEHIND ITS ADOPTION

Purpose for derivative Trading

30 25 20 15 10 5
S pe cu la tio n en t

24 15 14 7 Series1 Series2

0
H e dg in g

Reasons behind adoption of deri%ati%es are different by bro ers!in%estors and dealers e"g" liquidity! ris management hedging! in%estor

is

M a n ag e

Li !u id ity

demand4speculation5 etc" Out of B> bro ers!in%estors dealing in deri%ati%es 7= 4?:N5 adopt it due to characteristics of ris management! 7< 4?<N5 due to hedging ! ?= 4=>N5 for in%estor 4clientKs5 demand 4speculation5 and remaining 9 47?N5 due to liquidity"

E1PERIENCE 0ITH DERIVATIVE

Out of my sample si1e B>! only ?: 4:;N5 find deri%ati%es as quite profitable in%estment" 7= 4?:N5 find that deri%ati%es can3t gi%e big profits in future"79 4?8N5 feels that equities are better option for on%estment than deri%ati%ies"remaining B 47>N5 ha%e other opinion thatonly those in%estors!bro ers can deri%e good return from deri%ati%es those ha%e surplus funds and patience for long period""because deri%ati%e requires huge in%estment and ris also"

IC#6),6( AMO.C, IC (6RI#A,I#6)

Invested amount in derivative trading.
30 25 20 15 10 5 0 2 lacs 2lacs"5 lacs 5 lacs"10 #ny other lacs Series1 Series2 Series3

Out of my sample si1e B> !?9 4=<N5 in%estors and bro ers ha%e in%ested ? lacs normally"8 47<N5 in%ested between ? lacs to < lacs"and 7< 4?<N5 in%ested between < lacs to 7> lacs!and remaining ha%e in%ested in other amounts" Reason behind this is that those are in%esting from many years are ta ing the ris of in%esting huge amount"

TRADED PERIOD IN DERIVATIVES

Traded period for derivative investment.

25 20 15 10 5 0 %eekly Monthly More than More than 1 onth 2 onths 13 5 23 1$ Series1 Series2

7: 4??N5 in%estors and bro ers are in%esting wee ly in deri%ati%es!?: 4 :;N5 in%esting monthly!78 4:? N5 in%esting after more than 7 month and only < 4 ;N5 in%esting too late after ? months"

IMPACT ON CUSTOMER BASE

Impact on customer base.

50 40 30 20 10 0 &ncrease 'ecrease Re ain sa e 3 15 Series1 Series2 42

Out of B> bro ers and in%estors! : 4 <N5 of bro ers said that it doesnKt increase their customer base because introducing small sa%ings as in%estment! but deri%ati%es increases customer base of =? 49>N5 wich is more than half"it is basically beneficial for those who are in%esting from last ? or more years" In in%estment sector need minimum of Rs" ?!>>!>>> as in%estment so it is basically for corporate and in%estment sector only not for small in%estors"7< 4 ?<N5 said their customer base remain same because they ha%e started just now for in%esting in deri%ati%es"in future it will increase their customer base"

RELATIONSHIP 0ITH CASH MARKET

relation Between derivative and cash market.

30 20 10 0 )ositi*e +egati*e ,an-t say 5 27 2( Series1 Series2

Out of B> bro ers!dealers ?9 4=<N5 ha%e the positi%e response toward the relation between deri%ati%e and cash mar et and remaining < 4;N5 has negati%e response" ?; 4=9N5 are not able to say anything because they don3t ha%e proper nowledge about stoc mar et"they are in%esting with the guidance of bro ers and with the support of their close relati%es those are in%esting for last many years"

BROKERFS PERCEPTION TO0ARDS INDIAN INVESTOR i"e" is settled in Indian in%estor psyche\
Relation among derivative and cash market.
40 30 20 10 0 .es +o 23 Series1 37

out of total :9 4B?N5 of in%estors and dealers are saying it hasnKt settled in Indian in%estor psyche and ?: 4:;N5 are saying it has"

DERIVATIVES AND RISK

6%ery bro er says that there is a ris factor 4up to some e-tent5 in deri%ati%es also"

SHORTCOMINGS IN INDAIN DERIVATIVE SYSTEM

?9 4=<N5 bro ers!in%estors respond towards shortage of domestic technical e-pertise" :74<?N5 feel lac of awareness in in%estor about deri%ati%es and remaining ? 4:N5 mar et failure"

RESULTS G FINDINGS
7" ?" :" =" <" B" 9" Bro ers not dealing in deri%ati%es at present are also not going to adopt it in near futures" 'edging + Ris Mgt" Is the most important feature of deri%ati%es" It is not for small in%estors" It has increased bro ers turno%ers as well as helpful in aggregate in%estment" Bro ers ha%enKt adequate nowledge about options! so most by them are dealing in futures only" ,here is a ris factor in deri%ati%e also" Most of in%estors are not in%esting in deri%ati%es"

;"People are not aware of deri%ati%es! e%en people who ha%e in%ested in it! hasn3t adequate nowledge about it" ,hese people are interested to ta e it in their future portfolio also" ,hey consider it as a tool of ris management" 8",hey normally in%est in future contracts" 7>",hey are in%esting in future contract! because futures ha%e up to home e-tent similar quality as Badla"

REASON BEHIND LESS DEVELOPMENT OF FAO SEGMENT AT L.S.E. At A")"6" the is become possible by A")"6")"A! which is wor ing as a bro er at C")"6" and the bro er of A")"6" 4:>7 members5 are wor ing as a client of A)6) Atd" Itself 4in reality5" )o they canKt trade as a bro er of their client and sub0bro er concept does not e-ist in F+O segment" At Cational Ae%el 7" )ecurities and contractKs regulations act has recogni1ed Finde-F as a security %ery later i"e" in Co%" ?>>7" It will ta e time to ta e position in deri%ati%e or capital mar et" ?" :" =" ,he Aimited mutual faith in the parties in%ol%ed" It hasnKt a legali1ed mar et" 2ommodity F + O mar et has not yet been come to India" this will ma e easy to understand and ta e simple in%estor under in%estor base of deri%ati%e trading" <" B" 9" Mar et failures )candals Inadequate infrastructures

;" 8" 7>" 77" 7?"

)hortage to domestic technical e-pertise! in India e%en most of people are not aware of concept deri%ati%es" Aarge lot si1e! so small in%estors are not able to come under deri%ati%e segment" ,here are less scripts under deri%ati%es segment" 'igh margin as compare to Badla" In India there canKt be a long term trading in F + O! it is only for 7 to ? or ma-imum for : months"

SUGGESTIONS
(.

LOT SIEE/
Aot si1e should be reduced so that the major segment of

an India society i"e" small sa%ing class can come under F + O trading" ,here is strong need for re%ision of lot si1es as the lot si1es of some of the indi%idual scrips that were worth of Rs" ?>>>>> in starting! now same lot si1e amount to a much larger %alue"
?.

SUB BROKER/
)ub0bro er concept should be added and the actual

bro ers should gi%e all rights of bro ers in F + O segment also"
'.

SCRIPS:
More scrips of reputed companies etc" should be

introduced in FF + O segmentF"
4.

TRADING PERIOD/
,rading period should be increased"

*. TRAINING CLASSES OR SEMINARS/

,here should be proper classes on deri%ati%es for in%estors! traders! bro ers! students and employees of stoc e-changes" Because lac of nowledge is the main reason of its less de%elopment" ,he first step towards it should be seminars pro%ide to bro ers + A)6 employees and secondly seminar to students"

LIMITATIONS OF THE STUDY

Co study is complete in itself! howe%er good it may and e%ery study has some limitations/ ,ime is the main constraint of my study" A%ailability of information was not sufficient because of less awareness among in%estorsJbro ers )tudy is based only on C)6 because information and trading in B)6 is not a%ailable here" )ample si1e is not enough to ha%e a clear opinion"

CONCLUSION
On the basis of o%erall study on deri%ati%es it was found that deri%ati%e products initially emerged as hedging de%ices against fluctuation and commodity prices and commodity lin ed deri%ati%es remained the soul form of such products" ,he financial deri%ati%es came in spotlight in 789? due to growing in stability in financial mar et" I was really surprised to see during my study that a layman or a simple in%estor does not e%en now how to hedge and how to reduce ris on his portfolios" All these acti%ities are generally performed by big indi%idual in%estors! institutional in%estors! mutual funds etc" Co doubt that deri%ati%e growth towards the progress of economy is positi%e" But the problems confronting the deri%ati%e mar et segment are gi%ing it a low customer base" ,he main problems that it confronts are unawareness and bit lot si1es etc" these problems could be o%ercome easily

by re%ising lot si1es and also there should be seminar and general discussions on deri%ati%es at %aried places"

BIBLIOGRAPHY
(. BOOKS AND ARTICLES C2FM on deri%ati%es core module by C)6IA" ,he Indian 2ommodity0(eri%ati%es Mar et in Operations" ?. MAGAEINES ,he (alal )treet A)6 Bulletin '. INTERNET SITES www"nseindia"com www"deri%ati%eindia"com www"bseindia"com

www"sebi"go%"in

SAMPLE OF QUESTIONNAIRE
(ear Respondent! I am a student of MBA ? nd year" I am wor ing on the project F ,R6C() AC( F.,.R6 OF (6RI#A,I#6) IC IC(IA / A (6,AIA6( ),.(IM Iou are requested to fill in the questionnaire to enable! to underta e the study on the said project" CAM6/ O22.PA,IOC/ A((R6))/ P'OC6 CO"/

75 For how long you ha%e been trading in deri%ati%es\ a5 Aess than 7 year c5 ? Iear b5 7 Iear d5 : Iear e5 More than : years"

?5 @hat is your purpose for trading in deri%ati%es\ a5 'edging c5 Ris Management b5 )peculation d5 Aiquidity

:5 'ow will you describe your e-perience with deri%ati%e till date\ a5 I find these quite profitable b5 I donKt find deri%ati%es can gi%e big profits c5 I feel that equities are better than deri%ati%es d5 Any other ]]]]]]]]]]]]]]]]]]]]]]]]]]]]]]]]]] =5@hat is amount of money you are in%esting in normally\ a5 ?!>>!>>> b5 Rs" ?!>>!>>> to Rs" <!>>!>>> c5 Rs" <!>>!>>> to Rs" 7>!>>!>>> d5 Any other amount]]]]]]]]]]]] <5'ow often do you trade\ a5 @ee ly d5 More than ? month B5@hat is your customer base with introduction of deri%ati%es\ a5 Increase b5 (ecrease c5 Remain same b5 Monthly c5 More than 7 month

95@hat according to you is relationship between deri%ati%e mar et and cash mar et\ a5 Positi%e b5 Cegati%e c5 2anKt say

;5 According to you ha%e deri%ati%es settled in Indian in%estors psyche\ a5 Ies b5 Co

85@hat shortcomings do you feel in Indian deri%ati%e mar et\ a5 Aac of awareness among the in%estors about deri%ati%es" b5 )hortage of domestic technical e-pertise" c5 If any other]]]]]]]]]]]]]]]]]]]]]]]]]]] 7>5 @hich of following Media would you prefer the most for in%estor education\ a5 ,# b5 Cewspaper c5 Maga1ines

775 @hat suggestions do you want to ma e with regard to in%estors education in deri%ati%es mar et in India\

,'AC$) FOR IO.R 2OOP6RA,IOC