CHAPTER 1 BACKGROUND OF THE STUDY Consider a hypothetical situation in which ABC trading company has to import a raw material

for manufacturing goods. But this raw material is required only after 3 months. However in 3 months the prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the prices would go up or come down. Thus he is exposed to ris s with fluctuations in forex rates. !f he buys the goods in advance then he will incur heavy interest and storage charges. However" the availability of derivatives solves the problem of importer. He can buy currency derivatives. #ow any loss due to rise in raw material prices would be offset by profits on the futures contract and vice versa. Hence the company can hedge its ris through the use of derivatives INTRODUCTION : $erivatives are one of the most complex instruments. The word derivative comes from the word %to derive&. !t indicates that it has no independent value. A derivative is a contract whose value is derived from the value of another asset" nown as the underlying asset" which could be a share" a stoc mar et index" an interest rate" a commodity" or a currency. The underlying is the identification tag for a derivative contract. 'hen the price of the underlying changes" the value of the derivative also changes. 'ithout an underlying asset" derivatives do not have any meaning. (or example" the value of a gold futures contract derives from the value of the underlying asset i.e." gold. The prices in the derivatives mar et are driven by the spot or cash mar et price of the underlying asset" which is gold in this example. $erivatives are very similar to insurance. !nsurance protects against specific ris s" such as fire" floods" theft and so on. $erivatives on the other hand" ta e care of mar et ris s ) volatility in interest rates" currency rates" commodity prices" and share prices. $erivatives offer a sound mechanism for insuring against various inds of ris s arising in the world of finance. They offer a range of mechanisms to improve redistribution of ris " which can be extended to every product existing" from coffee to cotton and live cattle to debt instruments.

!n this era of globalisation" the world is a ris ier place and exposure to ris is growing. *is cannot be avoided or ignored. +an" however is ris averse. The ris averse characteristic of human beings has brought about growth in derivatives. $erivatives help the ris individuals by offering a mechanism for hedging ris s. $erivative products" several centuries ago" emerged as hedging devices against fluctuations in commodity prices. Commodity futures and options have had a lively existence for several centuries. (inancial derivatives came into the limelight in the post),-./ period0 today they account for .1 percent of the financial mar et activity in 2urope" #orth America" and 2ast Asia. The basic difference between commodity and financial derivatives lies in the nature of the underlying instrument. !n commodity derivatives" the underlying asset is a commodity0 it may be wheat" cotton" pepper" turmeric" corn" orange" oats" 3oya beans" rice" crude oil" natural gas" gold" silver" and so on. !n financial derivatives" the underlying includes treasuries" bonds" stoc s" stoc index" foreign exchange" and 2uro dollar deposits. The mar et for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. 4resently" most ma5or institutional borrowers and investors use derivatives. 3imilarly" many act as intermediaries dealing in derivative transactions. $erivatives are responsible for not only increasing the range of financial products available but also fostering more precise ways of understanding" quantifying and managing financial ris . $erivatives contracts are used to counter the price ris s involved in assets and liabilities. $erivatives do not eliminate ris s. They divert ris s from investors who are ris averse to those who are ris neutral. The use of derivatives instruments is the part of the growing trend among financial intermediaries li e ban s to substitute off)balance sheet activity for traditional lines of business. The exposure to derivatives by ban s have implications not only from the point of capital adequacy" but also from the point of view of establishing trading norms" business rules and settlement process. Trading in derivatives differ from that in equities as most of the derivatives are mar et to the mar et. DEFINITION OF DERIVATIVES : averse

$erivative is a product whose value is derived from the value of one or more basic variables" called bases 6underlying asset" index" or reference rate7" in a contractual manner. The underlying asset can be equity" forex" commodity or any other asset. According to Securities Contr cts !Re"u# tion$ Act% 1&'( )SC!R$A*" derivatives is A security derived 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 derives its value from the prices" or index of prices" of underlying securities.

$erivatives are securities under the 3ecurities Contract 6*egulation7 Act and hence the trading of derivatives is governed by the regulatory framewor under the 3ecurities Contract 6*egulation7 Act. HISTORY OF DERIVATIVES : The history of derivatives is quite colourful and surprisingly a lot longer than most people thin . (orward delivery contracts" stating what is to be delivered for a fixed price at a specified place on a specified date" existed in ancient 8reece and *ome. *oman emperors entered forward contracts to provide the masses with their supply of 2gyptian grain. These contracts were also underta en between farmers and merchants to eliminate ris arising out of uncertain future prices of grains. Thus" forward contracts have existed for centuries for hedging price ris . The first organi9ed commodity exchange came into existence in the early ,.//&s in :apan. The first formal commodities exchange" the C+ic "o Bo r, o- Tr ,e !CBOT$" was formed in ,;<; in the =3 to deal with the problem of %credit ris & and to provide centralised location to negotiate forward contracts. (rom %forward& trading in commodities emerged the commodity %futures&. The first type of futures contract was called %to arrive at&. Trading in futures began on the CB>T in the ,;?/&s. !n ,;?1" CB>T listed the first %exchange traded&

derivatives contract" nown as the futures contracts. (utures trading grew out of the need for hedging the price ris involved in many commercial operations. The C+ic "o .erc nti#e E/c+ n"e !C.E$" a spin)off of CB>T" was formed in ,-,-" though it did exist before in ,;.< under the names of 0C+ic "o Pro,uce E/c+ n"e1 !CPE$ and 0C+ic "o E"" n, Butter Bo r,1 !CEBB$ . The first financial futures to emerge were the currency in ,-.@ in the =3. The first foreign currency futures were traded on +ay ,?" ,-.@" on Intern tion # .onet r2 . r3et !I..$% a division of C+2. The currency futures traded on the !++ are the British 4ound" the Canadian $ollar" the :apanese Aen" the 3wiss (ranc" the 8erman +ar " the Australian $ollar" and the 2uro dollar. Currency futures were followed soon by interest rate futures. !nterest rate futures contracts were traded for the first time on the CB>T on >ctober @/" ,-.1. 3toc index futures and options emerged in ,-;@. The first stoc index futures contracts were traded on Bansas City Board of Trade on (ebruary @<" ,-;@. The first of the several networ s" which offered a trading lin between two exchanges" was formed between the Sin" 4ore Intern tion # .onet r2 E/c+ n"e !SI.E5$ and the C+2 on 3eptember ." ,-;<. >ptions are as old as futures. Their history also dates bac to ancient 8reece and *ome. >ptions are very popular with speculators in the tulip cra9e of seventeenth century Holland. Tulips" the brightly coloured flowers" were a symbol of affluence0 owing to a high demand" tulip bulb prices shot up. $utch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip cra9e collapsed in ,?3. as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier" *ussell 3age" in ,;.@. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in 2ngland and the =3. >ptions on shares were available in the =3 on the over the counter 6>TC7 mar et only until ,-.3 without much nowledge of valuation. A

group of firms nown as 4ut and Call bro ers and $ealer&s Association was set up in early ,-//&s to provide a mechanism for bringing buyers and sellers together. >n April @?" ,-.3" the Chicago Board options 2xchange 6CB>27 was set up at CB>T for the purpose of trading stoc options. !t was in ,-.3 again that blac " +erton" and 3choles invented the famous B# c36Sc+o#es O4tion For7u# . This model helped in assessing the fair price of an option which led to an increased interest in trading of options. 'ith the options mar ets becoming increasingly popular" the American 3toc 2xchange 6A+2C7 and the 4hiladelphia 3toc 2xchange 64HDC7 began trading in options in ,-.1. The mar et for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton 'oods regime of fixed parties and the introduction of floating rates for currencies in the international financial mar ets paved the way for development of a number of financial derivatives which served as effective ris uncertainties. The CB>T and the C+2 are two largest financial exchanges in the world on which futures contracts are traded. The CB>T now offers <; futures and option contracts 6with the annual volume at more than @,, million in @//,7.The CB>2 is the largest exchange for trading stoc options. The CB>2 trades options on the 3E4 ,// and the 3E4 1// stoc indices. The 4hiladelphia 3toc 2xchange is the premier exchange for trading foreign options. The most traded stoc indices include 3E4 1//" the $ow :ones !ndustrial Average" the #asdaq ,//" and the #i ei @@1. The =3 indices and the #i ei @@1 trade almost round the cloc . The #@@1 is also traded on the Chicago +ercantile 2xchange. DERIVATIVES IN INDIA : !ndia has started the innovations in financial mar ets very late. 3ome of the recent developments initiated by the regulatory authorities are very important in this respect. (utures trading have been permitted in certain commodity exchanges. +umbai 3toc 2xchange has started futures trading in cottonseed and cotton under the B>>2 and under the 2ast !ndia Cotton Association. #ecessary infrastructure has been created by the N tion # Stoc3 E/c+ n"e !NSE$ management tools to cope with mar et

and the Bo78 2 Stoc3 E/c+ n"e !BSE$ for trading in stoc commencement of operations in selected scripts.

index futures and the

Diberalised exchange rate management system has been introduced in the year ,--@ for regulating the flow of foreign exchange. A committee headed by 3.3.Tarapore was constituted to go into the merits of full convertibility on capital accounts. *B! has initiated measures for freeing the interest rate structure. !t has also envisioned .u78 i Inter B n3 O--er R te !.IBOR$ on the line of 9on,on Inter B n3 O--er R te !9IBOR$ as a step towards introducing (utures trading in !nterest *ates and (orex. Badla transactions have been banned in all @3 stoc exchanges from :uly @//,. #32 has started trading in index options based on the #!(TA and certain 3toc s. E:UITY DERIVATIVES IN INDIA !n the decade of ,--/&s revolutionary changes too place in the institutional

infrastructure in !ndia&s equity mar et. !t has led to wholly new ideas in mar et design that has come to dominate the mar et. These new institutional arrangements" coupled with the widespread nowledge and orientation towards equity investment and speculation" have combined to provide an environment where the equity spot mar et is now !ndia&s most sophisticated financial mar et. >ne aspect of the sophistication of the equity mar et is seen in the levels of mar et liquidity that are now visible. The mar et impact cost of doing program trades of *s.1 million at the #!(TA index is around /.@F. This state of liquidity on the equity spot mar et does well for the mar et efficiency" which will be observed if the index futures mar et when trading commences. !ndia&s equity spot mar et is dominated by a new practice called %(utures G 3tyle settlement& or account period settlement. !n its present scene" trades on the largest stoc exchange 6#327 are netted from 'ednesday morning till Tuesday evening" and only the net open position as of Tuesday evening is settled. The future style settlement has proved to be an ideal launching pad for the s ills that are required for futures trading. 3toc trading is widely prevalent in !ndia" hence it seems easy to thin that derivatives based on individual securities could be very important. The index is the counter piece of

portfolio analysis in modern financial economies. !ndex fluctuations affect all portfolios. The index is much harder to manipulate. This is particularly important given the wea nesses of Daw 2nforcement in !ndia" which have made numerous manipulative episodes possible. The mar et capitalisation of the #32)1/ index is *s.@.? trillion. This is six times larger than the mar et capitalisation of the largest stoc and 1// times larger than stoc s such as 3terlite" B4D and Hideocon. !f mar et manipulation is used to artificially obtain ,/F move in the price of a stoc with a ,/F weight in the #!(TA" this yields a ,F in the #!(TA. Cash settlements" which is universally used with index derivatives" also helps in terms of reducing the vulnerability to mar et manipulation" in so far as the %short) squee9e& is not a problem. Thus" index derivatives are inherently less vulnerable to mar et manipulation. A good index is a sound trade of between diversification and liquidity. !n !ndia the traditional index) the B32 G sensitive index was created by a committee of stoc bro ers in ,-;?. !t predates a modern understanding of issues in index construction and recognition of the pivotal role of the mar et index in modern finance. The flows of this index and the importance of the mar et index in modern finance" motivated the development of the #32)1/ index in late ,--1. +any mutual funds have now adopted the #!(TA as the benchmar for their performance evaluation efforts. !f the stoc derivatives have to come about" the should restricted to the most liquid stoc s. +embership in the #32)1/ index appeared to be a fair test of liquidity. The 1/ stoc s in the #!(TA are assuredly the most liquid stoc s in !ndia. The choice of (utures vs. >ptions is often debated. The difference between these instruments is smaller than" commonly imagined" for a futures position is identical to an appropriately chosen long call and short put position. Hence" futures position can always be created once options exist. !ndividuals or firms can choose to employ positions where their downside and exposure is capped by using options. *is management of the futures clearing is more complex when options are in the picture. 'hen portfolios contain options" the calculation of initial price requires greater s ill and more powerful computers. The s ills required for pricing options are greater than those required in pricing futures.

CO..ODITY DERIVATIVES TRADING IN INDIA !n !ndia" the futures mar et for commodities evolved by the setting up of the IBombay Cotton Trade Association Dtd.J" in ,;.1. A separate association by the name KBombay Cotton 2xchange DtdJ was established following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association. 'ith the setting up of the %8u5arati Hyapari +andaliJ in ,-//" the futures trading in oilseed began. Commodities li e groundnut" castor seed and cotton etc began to be exchanged. *aw 5ute and 5ute goods began to be traded in Calcutta with the establishment of the ICalcutta Hessian 2xchange Dtd.J in ,-,-. The most notable centres for existence of futures mar et for wheat were the Chamber of Commerce at Hapur" which was established in ,-,3. >ther mar ets were located at Amritsar" +oga" Dudhiana" :alandhar" (a9il a" $huri" Barnala and Bhatinda in 4un5ab and +u9affarnagar" Chandausi" +eerut" 3aharanpur" Hathras" 8a9iabad" 3i enderabad and Barielly in =.4. The Bullion (utures mar et began in Bombay in ,--/. After the economic reforms in ,--, and the trade liberali9ation" the 8ovt. of !ndia appointed in :une ,--3 one more committee on (orward +ar ets under Chairmanship of 4rof. B.#. Babra. The Committee recommended that futures trading be introduced in basmati rice" cotton" raw 5ute and 5ute goods" groundnut" rapeseedLmustard seed" cottonseed" sesame seed" sunflower seed" safflower seed" copra and soybean" and oils and oilca es of all of them" rice bran oil" castor oil and its oilca e" linseed" silver and onions. All over the world commodity trade forms the ma5or bac bone of the economy. !n !ndia" trading volumes in the commodity mar et have also seen a steady rise ) to *s 1".,"/// crore in (A/1 from *s ,"@-"/// crore in (A/<. !n the current fiscal year" trading volumes in the commodity mar et have already crossed *s 3"1/"/// crore in the first four months of trading. 3ome of the commodities traded in !ndia include Agricultural Commodities li e *ice 'heat" 3oya" 8roundnut" Tea" Coffee" :ute" *ubber" 3pices" Cotton" 4recious +etals li e 8old E 3ilver" Base +etals li e !ron >re" Aluminium" #ic el" Dead" Minc and 2nergy Commodities li e crude oil" coal. Commodities form around 1/F of the !ndian 8$4. Though there are no institutions or ban s in commodity exchanges" as yet" the mar et for commodities is bigger than the mar et for securities. Commodities mar et is estimated to be around *s <<"//"/// Crores in future.

Assuming a future trading multiple is about < times the physical mar et" in many countries it is much higher at around ,/ times. DEVE9OP.ENT OF DERIVATIVES .ARKET IN INDIA : The first step towards introduction of derivatives trading in !ndia was the promulgation of the 3ecurities Daws 6Amendment7 >rdinance" ,--1" which withdrew the prohibition on options in securities. The mar et for derivatives" however" did not ta e off" as there was no regulatory framewor to govern trading of derivatives. 32B! set up a @<Gmember committee under the Chairmanship of $r.D.C.8upta on #ovember ,;" ,--? to develop appropriate regulatory framewor for derivatives trading in !ndia. The committee submitted its report on +arch ,." ,--; prescribing necessary preGconditions for introduction of derivatives trading in !ndia. The committee recommended that derivatives should be declared as %securities& so that regulatory framewor applicable to trading of %securities& could also govern trading of securities. 32B! also set up a group in :une ,--; under the Chairmanship of 4rof.:.*.Harma" to recommend measures for ris containment in derivatives mar et in !ndia. The report" which was submitted in >ctober ,--;" wor ed out the operational details of margining system" methodology for charging initial margins" bro er net worth" deposit requirement and realGtime monitoring requirements. The 3ecurities Contract *egulation Act 6SCRA7 was amended in $ecember ,--- to include derivatives within the ambit of %securities& and the regulatory framewor was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recogni9ed stoc exchange" thus precluding >TC derivatives. The government also rescinded in +arch @///" the three decade old notification" which prohibited forward trading in securities. $erivatives trading commenced in !ndia in :une @/// after 32B! granted the final approval to this effect in +ay @//,. 32B! permitted the derivative segments of two stoc exchanges" #32 and B32" and their clearing houseLcorporation to commence trading and settlement in approved derivatives contracts. To begin with" 32B! approved trading in index futures contracts based on 3E4 C#C #ifty and B32G3/ 63ense7

index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in B32 3ensex options commenced on :une <" @//, and the trading in options on individual securities commenced in :uly @//,. (utures contracts on individual stoc s were launched in #ovember @//,. The derivatives trading on #32 commenced with 3E4 C#C #ifty !ndex futures on :une ,@" @///. The trading in index options commenced on :une <" @//, and trading in options on individual securities commenced on :uly @" @//,. 3ingle stoc futures were launched on #ovember -" @//,. The index futures and options contract on #32 are based on 3E4 C#C Trading and settlement in derivative contracts is done in accordance with the rules" byelaws" and regulations of the respective exchanges and their clearing houseLcorporation duly approved by 32B! and notified in the official ga9ette. (oreign !nstitutional !nvestors 6(!!s7 are permitted to trade in all 2xchange traded derivative products. The following are some observations based on the trading statistics provided in the #32 report on the futures and options 6(E>7N 3ingle)stoc futures continue to account for a si9able proportion of the (E> segment. !t constituted ./ per cent of the total turnover during :une @//@. A primary reason attributed to this phenomenon is that traders are comfortable with single)stoc futures than equity options" as the former closely resembles the erstwhile badla system. >n relative terms" volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically" options are considered more valuable when the volatility of the underlying 6in this case" the index7 is high. A related issue is that bro ers do not earn high commissions by recommending index options to their clients" because low volatility leads to higher waiting time for round)trips. 4ut volumes in the index options and equity options segment have increased since :anuary @//@. The call)put volumes in index options have decreased from @.;? in :anuary @//@ to ,.3@ in :une. The fall in call)put volumes ratio suggests that the traders are increasingly becoming pessimistic on the mar et.

 (arther month futures contracts are still not actively traded. Trading in equity options on most stoc s for even the next month was non)existent. $aily option price variations suggest that traders use the (E> segment as a less ris y alternative 6read substitute7 to generate profits from the stoc price movements. The fact that the option premiums tail intra)day stoc prices is evidence to this. !f calls and puts are not loo ed as 5ust substitutes for spot trading" the intra)day stoc price variations should not have a one)to)one impact on the option premiums. FACTORS CONTRIBUTING TO THE GRO;TH OF DERIVATIVES : (actors contributing to the explosive growth of derivatives are price volatility" globalisation of the mar ets" technological developments and advances in the financial theories. PRICE VO9ATI9ITY A price is what one pays to acquire or use something of value. The ob5ects having value maybe commodities" local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain" oil" petrol" metal" etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one&s own currency for a unit of another currency is called as an exchange rate. 4rices are generally determined by mar et forces. !n a mar et" consumers have %demand& and producers or suppliers have %supply&" and the collective interaction of demand and supply in the mar et determines the price. These factors are constantly interacting in the mar et causing changes in the price over a short period of time. 3uch changes in the price is nown as %price volatility&. This has three factors N the speed of price changes" the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in mar et ad5ustments through price changes. These price changes expose individuals" producing firms and governments to significant ris s. The brea down of the BRETTON ;OODS agreement

brought and end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The globalisation of the mar ets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the mar ets. #ations that were poor suddenly became a ma5or source of supply of goods. The +exican crisis in the south east)Asian currency crisis of ,--/&s have also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quic ly to the mar ets. !nformation which would have ta en months to impact the mar et earlier can now be obtained in matter of moments. 2ven equity holders are exposed to price ris of corporate share fluctuates rapidly. These price volatility ris pushed the use of derivatives li e futures and options

increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity" foreign exchange" equity shares and bonds.

G9OBA9ISATION OF .ARKETS 2arlier" managers had to deal with domestic economic concerns 0 what happened in other part of the world was mostly irrelevant. #ow globalisation has increased the si9e of mar ets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. !t has also exposed the modern business to significant ris s and" in many cases" led to cut profit margins !n !ndian context" south 2ast Asian currencies crisis of ,--. had affected the competitiveness of our products vis)O)vis depreciated currencies. 2xport of certain goods from !ndia declined because of this crisis. 3teel industry in ,--; suffered its worst set bac due to cheap import of steel from south east asian countries. 3uddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in !ndian exports. Thus" it is

evident that globalisation of industrial and financial activities necessitiates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent. TECHNO9OGICA9 ADVANCES < A significant growth of derivative instruments has been driven by technological brea through. Advances in this area include the development of high speed processors" networ systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. !mprovement in communications allow for instantaneous world wide conferencing" $ata transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on mar et price. Although price sensitivity to mar et forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price ris . The effect of this ris can easily destroy a business which is otherwise well managed. $erivatives can help a firm manage the price ris inherent in a mar et economy. To the extent the technological developments increase volatility" derivatives and ris management products become that much more important. ADVANCES IN FINANCIA9 THEORIES < Advances in financial theories gave birth to derivatives. !nitially forward contracts in its traditional form" was the only hedging tool available. >ption pricing models developed by B# c3 n, Sc+o#es in ,-.3 were used to determine prices of call and put options. !n late ,-./&s" wor of Dewis 2deington extended the early wor of :ohnson and started the hedging of financial price ris s with financial futures. The wor of economic theorists gave rise to new products for ris management which led to the growth of derivatives in financial mar ets. The above factors in combination of lot many factors led to growth of derivatives instruments.

CHAPTER = RESEARCH DESING TIT9E OF THE STUDY IA study of (inancial $erivativesJ STATE.ENT OF THE PROB9E. (inancial $erivatives are quite new to the !ndian (inancial +ar et" but the derivatives mar et has shown an immense potential which is visible by the growth it has achieved in the recent past" !n the present changing financial environment and an increased exposure towards financial ris s" !t is of immense importance to have a good wor ing nowledge of $erivatives. !n recent times the $erivative mar ets have gained importance in terms of their vital role in the economy. The increasing investments in derivatives 6domestic as well as overseas7 have attracted my interest in this area. Through the use of derivative products" it is possible to partially or fully transfer price ris s by loc ing)in asset prices. As the volume of trading is tremendously increasing in derivatives mar et" this analysis will be of immense help to the investors. OB>ECTIVES OF THE STUDY To study the trading procedures for $erivative products To study the features of $erivatives products such as (utures and >ptions. To study the clearing and settlement procedure of $erivatives products To analy9e the operations of futures and options. To find the profitLloss position of futures buyer and seller and also the option writer and option holder. To study about ris management with the help of derivatives.

SCOPE OF THE STUDY The study is limited to I$erivativesJ with special reference to futures and option in the !ndian context and the !nter)Connected 3toc 2xchange has been ta en as a representative sample for the study. The study can&t be said as totally perfect. Any alteration may come. The study has only made a humble attempt at evaluation derivatives mar et only in !ndia context. The study is not based on the international perspective of derivatives mar ets" which exists in #A3$AP" CB>T etc. RESEARCH .ETHODO9OGY : A research process consists of stages or steps that guide the pro5ect from its conception through the final analysis" recommendations and ultimate actions. The research process provides a systematic" planned approach to the research pro5ect and ensures that all aspects of the research pro5ect are consistent with each other. *esearch studies evolve through a series of steps" each representing the answer to a ey question. This chapter aims to understand the research methodology establishing a framewor of evaluation and revaluation of primary and secondary research. The techniques and concepts used during primary research in order to arrive at findings0 which are also dealt with and lead to a logical deduction towards the analysis and results. RESEARCH DESIGN ! propose to first conduct an intensive secondary research to understand the full impact and implication of the industry" to review and critique the industry norms and reports" on which certain issues shall be selected" which ! feel remain unanswered or liable to change" this shall be further ta en up in the next stage of exploratory research. This stage shall help me to restrict and select only the important question and issue" which inhabit growth and segmentation in the industry. T+e ? rious t s3s t+ t I + ?e un,ert 3en in t+e rese rc+ ,esi"n 4rocess re :

$efining the information need $esign the exploratory" descriptive and causal research.

RESEARCH PROCESS The research process has four distinct yet interrelated steps for research analysis !t has a logical and hierarchical orderingN $etermination of information research problem. Q$evelopment of appropriate research design. Q2xecution of research design. QCommunication of results. 2ach step is viewed as a separate process that includes a combination of tas " step and specific procedure. The steps underta e are logical" ob5ective" systematic" reliable" valid" impersonal and ongoing. E5P9ORATORY RESEARCH The method ! used for exploratory research was

4rimary $ata 3econdary data

PRI.ARY DATA

#ew data gathered to help solve the problem at hand. As compared to secondary data which is previously gathered data. An example is information gathered by a questionnaire. Pualitative or quantitative data that are newly collected in the course of research" Consists of original information that comes from people and includes information gathered from surveys" focus groups" independent observations and test results. $ata gathered by the researcher in the act of conducting research. This is contrasted to secondary data which entails the use of data gathered by someone other than the researcher information that is obtained directly from first) hand sources by means of surveys" observation or experimentation. 4rimary data is basically collected by getting questionnaire filled by the respondents. SECONDARY DATA !nformation that already exists somewhere" having been collected for another purpose. 3ources include census reports" trade publications" and subscription services. $ata that have already been collected and published for another research pro5ect 6other than the one at hand7. There are two types of secondary dataN internal and external secondary data. !nformation compiled inside or outside the organi9ation for some purpose other than the current investigation. $ata that have already been collected for some purpose other than the current study. *esearching information which has already been published. +ar et information compiled for purposes other than the current research effort0 it can be internal data" such as existing sales)trac ing information" or it can be research conducted by someone else" such as a mar et research company or the =.3. government. 4ublished" already available data that comes from pre)existing sets of information" li e medical records" vital statistics" prior research studies and archival data. 3econdary source of data used consists of boo s and websites DESCRIPTIVE RESEARCH 3T243 in the descriptive researchN 3tatement of the problem

 !dentification of information needed to solve the problem 3election or development of instruments for gathering the information !dentification of target population and determination of sampling 4lan. $esign of procedure for information collection Collection of information Analysis of information 8enerali9ations andLor predictions DATA CO99ECTION $ata collection too place with the help of filling of questionnaires. The questionnaire method has come to the more widely used and economical means of data collection. The common factor in all varieties of the questionnaire method is this reliance on verbal responses to questions" written or oral. ! found it essential to ma e sure the questionnaire was easy to read and understand to all spectrums of people in the sample. !t was also important as researcher to respect the samples time and energy hence the questionnaire was designed in such a way" that its administration would not exceed <)1 mins. These questionnaires were personally administered. The first hand information was collected by ma ing the people fill the questionnaires. The primary data collected by directly interacting with the people. The respondents were contacted at shopping malls" mar ets" places that were near to showrooms of the consumer durable products etc. The data was collected by interacting with @// respondents who filled the questionnaires and gave me the required necessary information. The respondents consisted of house wives" students" business men" professionals etc. the required information was collected by directly interacting with these respondents. DETER.INATION THE SA.P9E P9AN AND SA.P9E SI@E

TARGET POPU9ATION !t is a description of the characteristics of that group of people from whom a course is intended. !t attempts to describe them as they are rather than as the describer would li e them to be. Also called the audience the audience to be served by our pro5ect includes ey demographic information 6i.e.0 age" sex etc.7.The specific population intended as beneficiaries of a program. This will be either all or a subset of potential users" such as adolescents" women" rural residents" or the residents of a particular geographic area. Topic areasN 8overnance" Accountability and 2valuation" >perations +anagement and Deadership. A population to be reached through some action or intervention0 may refer to groups with specific demographic or geographic characteristics. The group of people you are trying to reach with a particular strategy or activity. The target population is the population ! want to ma e conclusions about. !n an ideal situation" the sampling frames to matches the target population. A specific resource set that is the ob5ect or target of investigation. The audience defined in age" bac ground" ability" and preferences" among other things" for which a given course of instruction is intended. SA.P9E SI@E : This involves figuring out how many samples one need. The numbers of samples we need are affected by the following factorsN 4ro5ect goals How you plan to analy9e your data How variable your data are or are li ely to be How precisely you want to measure change or trend The number of years over which you want to detect a trend How many times a year you will sample each point

 How much money and manpower you have SA.P9ING TECHNI:UE 3imple random sampling technique has been used to select the sample. A si74#e r n,o7 s 74#e is a group of sub5ects 6a sample7 chosen from a larger group 6a population7. 2ach sub5ect from the population is chosen randomly and entirely by chance" such that each sub5ect has the same probability of being chosen at any stage during the sampling process. This process and technique is nown as Si74#e R n,o7 S 74#in"" and should not be confused with *andom 3ampling. ERRORS IN THE STUDY Inter?ieAer error There is interviewer bias in the questionnaire method. >pen)ended questions can be biased by the interviewer&s views or probing" as interviewers are guiding the respondent while the questionnaire is being filled out. The attitudes the interviewer revels to the respondent during the interview can greatly affect their level of interest and willingness to answer openly. As interviewers probing and clarifications maximi9e respondent understanding and yield complete answers" these advantages are offset by the problems of prestige see ing" social desirability and courtesy biases.

:uestionn ire error The questionnaire designing has to careful so that only required data is concisely reveled and there is no redundant data generated. The questions have to be worded carefully so that the questions are not loaded and does not lead to a bias in the respondents mind Res4on,ent error

The respondents selected to be interviewed were not always available and willing to co operate also in most cases the respondents were found to not have the nowledge" opinion" attitudes or facts required additionally uninformed response errors and response styles also led to survey error. S 74#in" error 'e have ta en the sample si9e of ,//" which cannot determine the buying behavior of the total population. The sample has been drawn from only #ational Capital *egion. Rese rc+ Desi"n *esearch design is a

conceptual structure within which research is conducted. A research

RESEARCH DESIGN

design is the detailed blueprint used to guide a research study towards its ob5ective. !t is a series of advanced decision ta en together comprising a master plan or a
CAUSAL RESEARCH

EXPLORATORY RESEARCH DESIGN

CONCLUSIVE RESEARCH DESIGN

DESCRIPTIVE RESEARCH

model for conducting the research in consonance with the research ob5ectives. *esearch design is needed because it facilitates the

smooth sailing of the various research operations" thereby ma ing research as efficient as possible yielding maximum information with the minimum effort" time and money. 9i7it tions o- t+e stu,2 All the research pro5ects are hindered in their smooth flow by some unforeseen problems. The problems arise in the form of constraints by budget" time and scope of the study. The current pro5ect was also faced by certain problem. 3ome of the problems faced in the course of the research are as followsN

A strong unwillingness on the part of the owners of various cars" to participate and aid the research.

The boredom and wavering concentration that set in among the respondents while answering the long questionnaireN thus in turn led to the difficulty of preventing incomplete questionnaires.

3ampling errorN the research include a sample si9e of ,// customers which is not enough to determine the brand perception of the consumers for buying the cars. 3ince its not a census survey there is always a chance of error while extrapolating the results of a sample study over the population especially in those researches where the qualitative aspects are concerned. 3o it&s always doubtful to map the qualitative aspects using a quantitative measure.

The study was limited to the geographical region of Bangalore

CHAPTER B CO.PANY PROFI9E O?er?ieA (ounded in ,--<" 3+C 8roup is one of !ndia&s leading financial services and investment solutions providers and has been rated as !ndia&s Best 2quity" $erivatives E Currency Bro er and Bro ing house with the largest $istribution #etwor . *ecently" !t has been awarded with the Best 2quity Bro ing House G $erivative 3egment E (astest 8rowing 2quity Bro ing House )Darge (irm." 63ourceN B32 !4( and $EB 2quity Bro ing Awards @/,3" @/,@ E @/,, and Bloomberg)=TH (inancial Deadership Awards @/,@ E @/,,7. A blend of extensive experience" diverse talent and client focus has made us achieve this landmar . >ver the years" 3+C has expanded its operations domestically as well as internationally. 2xisting networ includes regional offices at +umbai" Bol ata" Chennai" Ahmedabad" :aipur" Hyderabad" Bangalore plus a growing networ of branches E @1//R registered sub)bro ers and authori9ed persons spread across 1//R cities and towns in !ndia. 'e offer a diverse range of financial services which includes institutional and retail bro erage of equity" derivatives" commodities" currency" online trading" depository services" distribution of !4>s "mutual funds" fixed deposits E bonds" dedicated des for #*!s and institutional clients" insurance bro ing6both life E general7" clearing services" margin financing" investment ban ing" portfolio management" wealth advisory E research. 'e have a wor force of more than @-// employees and over @//// registered associatesL service providers serving the financial needs of a large base of investors efficiently. 'e are also amongst the first financial firms in !ndia to expand operations in the lucrative gulf mar et" by acquiring license for bro ing and clearing member with $ubai 8old and Commodities exchange 6$8CC7.

T+e S.C A,? nt "e : ,. Darge avenues of investment solutions and financial services under one roof @. 4ersonali9ed solution and attention offered to each investors 3. *esearch support and timely advice by our high)tech research wing <. An extensive networ of branch offices 1. A perfect blend of latest technology and rich experience ?. Honesty" transparency and fairness imbibed in our dealings 4roviders of one of the best trading platforms in terms of speed" convenience and ris management to trade in #32 6Cash" (E>" Currency7" B326Cash" (E>7" #C$2C" +CC" #+C2" !C2C" AC2" =32" #C$2C 34>T" +CC)3C E $8CC. Ke2 Directors

+r. 3 C Aggarwal 6Chairman E +anaging $irector" 3+C 8roup7 +r. Aggarwal is a promoter of the 3+C 8roup.He has rich and extensive experience of more than @3 years. He is a fellow member of the !nstitute of Chartered Accountants of !ndia 6!CA!7. He has an in)depth nowledge and strong understanding of various intricacies of 3ecurities +ar et and (inancial 3ervices. !t is through his exceptional leadership s ills and outstanding commitment towards the company that 3+C recived several accolades.His efforts

have led to the diversification of group business from 3toc

Bro ing and Arbitrage to

Commodity Bro ing" !4>s E +utual (unds distribution" !nsurance 4roducts" +erchant Ban ing" 'ealth +anagement and Advisory 3ervices. He is the chairman of the !ndia 2uropean =nion Business 4romotion Council of A33>CHA+" co)chairman of the #ational Council of Capital +ar ets and a senior member of the management committee of A33>CHA+. He has also acted as a member of the expert group on behalf of A33>CHA+ 'or ing 8roup constituted by the +inistry of Corporate Affairs and the Cost Accounting Board.

+r. +ahesh C 8upta 6Hice Chairman E +anaging $irector" 3+C 8roup7 +r. +ahesh C 8upta is a 4romoter of the 3+C 8roup with more than @3 years of widespread experience in 3ecurities +ar et. He is a fellow member of the !nstitute of Chartered Accountants of !ndia. His extraordinary leadership s ill" astute business acumen and disciplined life style have helped 3+C strongly diversify to a fully fledged financial services firm with presence across 1// cities providing Bro erage services in equity" commodity" currency E derivatives" depository services" clearing services" !nvestment ban ing" portfolio E wealth management" distribution of !nsurance" !4>s" +utual (unds" (ixed $eposits and other 3rd party products. His principles of honesty" transparency and moral integrity have given 3+C strong foundation based on which it has become !ndia&s leading financial services provider. +r. 8upta has also given his vital contribution in various conferences E seminars on securities mar et.

+r. $ B Aggarwal 6Chairman E +anaging $irector G 3+C Comtrade Dimited 0 Chairman E +anaging $irector ) 3+C Capitals Dimited0 Chairman E +anaging $irector ) 3+C !nvestments E Advisors Dtd 7

+r. $B Aggarwal is a promoter and one of the ey architects of success of the 3+C 8roup. !nnovation in offerings" Branding" *esearch and Arbitrage are his forte. He has more than @/ years of wide and rich experience in 2quity and Commodity Bro ing and Arbitrage. He is an eminent spea er and regularly presents his views and expertise on various mar et related issues through print and television media. He is also a fellow member of the !nstitute of Chartered Accountants of !ndia. He is the !mmediate 4ast 4resident of Commodity 4articipants Association of !ndia.

+r. 4radeep Aggarwal 'hole Time $irector) 3+C 8lobal 3ecurities Dimited0 :oint +anaging $irector) 3+C Comtrade Dtd.7 +r. 4radeep Aggarwal is a self motivated person having a professional approach emphasising on ethics and integrity. He possesses excellent communication and inter)personal s ills E operates collaboratively with his team members to achieve a common goal. 'ith an experience of more than ,. years in equity and commodity mar et" he innovates" develops and effectively implements new ideas for the growth and progress of the Arbitrage business of the company&s 3ecurities and Commodities business. +r Aggarwal is a person with unmatched sharp calculative s ills and analytical bent of mind.

+r. A5ay 8arg 6'hole Time $irector) 3+C 8lobal 3ecurities Dimited E $irector)3+C !nsurance Bro ers 4vt Dtd.7 +r. A5ay 8arg is a fellow member of the !nstitute of Chartered Accountants of !ndia 6!CA!7. He has a wide experience of more than ,1 years in the Capital +ar et. +r. 8arg leads the Bro ing >perations of 3+C 8roup including Bac office operations" entire technological functioning of the business" *is +anagement E 3urveillance" Degal E Compliance" Corporate

Communications E Brand +anagement and !T E 3oftware $evelopment. His roles and responsibilities also include Business $evelopment of Corporate Client 8roup 6CC87 and handling of Corporate Hedging $es 63CH$7. He is responsible and instrumental for !nternet Based Trading and +obile Trading" P(!" #*! and B@B Businesses. =nder his able guidance within last few years" 3+C has evolved into a well nown and a preferred brand in the !ndian Capital +ar et.

+r Anurag Bansal 6'hole Time $irector G 3+C 8lobal 3ecurities Dtd.7 +r. Anurag Bansal" aged 3. years" is a ran holder and fellow member of the !nstitute of Chartered Accountants of !ndia 6!CA!7 and a member of !nstitute of Cost and 'or s Accountants of !ndia 6!C'A!7. He has extensive experience of over ,1 years with 3+C in Capital +ar ets. His roles and responsibilities include management and supervision of business development in the field of primary E secondary mar et through branches spread all over the country" !nstitutional 2quities business and distribution division apart from legal and other strategic functions of the organisation. His rich experience and efforts have helped 3+C establish as a reliable name and renowned brand in the country.

+r. *avi Aggarwal 6$irector) 3+C !nsurance Bro ers 4vt. Dtd.7 +r. *avi Aggarwal has more than ,@ years of experience in 2quity and Commodity +ar et. An innovative mind having a rich academic and professional bac ground" his roles and responsibilities include the establishment and development of !nsurance Bro ing venture" developing pan)!ndia branch networ " designing of systems and processes and innovative mar eting programs. He possesses excellent communication and inter)personal s ills E operates

collaboratively with his team members to achieve a common goal. He is also a member of !nstitute of Chartered Accountants of !ndia.

+r. Dalit Aggarwal 6$irector) +oneywise (inancial 3ervices 4vt. Dtd.7 +r. Dalit Aggarwal has a rich wor ing experience of more than ,. years in 3ecurities and Commodities mar et. He is actively involved in the development and functioning of 3+C&s Arbitrage business His great dedication and devotion to his wor is an inspiration for his team. A man of great intellect" his ideas have helped 3+C in the introduction of new services in the Arbitrage business. His style of wor ing is highly motivational to his team members. +r Aggarwal is a person with unmatched sharp calculative s ills and analytical bent of mind.

+s. 3hweta Aggarwal 6$irector) 3+C Capitals Dimited7 +s. Aggarwal 5oined the 3+C group in @//1 and in a short span of time" she has successfully handled multiple critical assignments. !n her very first assignment at 3+C" she was the catalyst in successfully setting up of the Human *esource function. 3he heads the investment ban ing vertical of 3+C.

+r. 4ravin Agarwal 6$irector) 3+C !nsurance Bro ers 4vt. Dtd.7

+r. 4ravin Agarwal possesses a result oriented professional approach towards the functions of the organi9ation. 'ith more than a decade of wor experience in !nsurance and (inancial !ndustry" he is actively involved in the development of insurance bro ing venture" devising strategies for insurance bro ing and underta ing business development responsibilities. He is a man with a vision to create a wide)spread business of excellence" he is the inspiration as he spearheads the company&s management and operations0 strategi9ing and directing it through its next phase of growth. Cor4or te Et+os Our Vision To be a global ma5or in providing complete investment solutions" with relentless focus on investor care" through superior efficiency and complete transparency. Core V #ues Et+ic # ,e #s : Honesty is the only policy. E/4erience n, trust : >ver ,1 years of experience has made 3+C earn the trust of a large base of !nvestors. E/4ertise : Bnow)how and s ills to provide investors an edge. 4ersonalised 3olutionsN 2very investor is unique. 2very solution is unique. Our A44ro c+ Halue for investor&s trustN3+C values the trust reposed in by the clients and is committed to uphold it at all cost. Inte"rit2 n, +onest2 : !ntegrity" honesty and transparency are the underlying principles in all our dealings. Person #iCe, ttention :The most valued asset is our relationship with the clients" which has been built over years by giving personali9ed attention.

NetAor3 A+ic+ Aor3s : 3+C has a vast networ extending to 1//R cities and towns ensuring easy accessibility" convenience and hassle free trading experience. *esearch based advisory Ser?ices : 3+C offers proactive and timely world class research based advice and guidance to its clients to enable them to ta e informed decisions Our Cre,enti #s ,. Best 2quity Bro ing house in $erivative 3egment in !ndia 63ourceN B32 !4()$EB 2quity Bro ing Awards" @/,3 E @/,@7 @. (astest 8rowing 2quity Bro ing House )Darge (irm63ourceN B32 !4()$EB 2quity Bro ing Awards" @/,37 3. 2merging !nvestment Ban er of the year 63ourceN 3+2s 2xcellence Awards @/,3 organised by A33>CHA+7 <. Best 2quity Bro ing House in !ndia 63ourceN B32 !4( ) $EB 2quity Bro ing Awards" @/,@ E @/,/7 1. Best Currency Bro er in !ndia 63ourceN Bloomberg ) =TH (inancial Deadership awards" @/,@ E @/,,7 ?. Bro ing House with the Dargest $istribution #etwor in !ndia 63ourceN B32 !4()$EB 2quity Bro ing Awards" @/,@" @/,, E @/,/7 .. Best *esearch Analyst Award in 2quity (undamentals )!nfrastructure 63ourceN Mee Business ) !ndiaSs Best +ar et Analyst Awards" @/,37 ;. Best 2quity *esearch Analyst in !4> segment and Best Commodity *esearch Analyst) HiewerSs Choice 63ourceN Mee Business !ndiaSs Best +ar et Analyst Awards" @/,@7 -. Award for Continuous !nnovation in H* 3trategy at 'or by 2mployer Branding Award @/,@),3

,/. Dearning and Talent Technology 2xcellence Award by 3tar #ews H* and Deadership Awards" @/,@. ,,. !ndia&s Best 'ealth +anagement Company 63ourceN Business 3phere" @/,,7 ,@. (astest 8rowing *etail $istribution #etwor in financial services 63ourceN Business 3phere" @/,/7 ,3. +a5or Holume $river award from B32 for 3 consecutive years 6@//?)/." @//1)/? E @//<)@//1 In,ustr2 Pro-i#e : Histor2 o- Deri? ti?es . r3ets in In,i $erivatives mar ets in !ndia have been in existence in one form or the other for a long time. !n the area of commodities" the Bombay Cotton Trade Association started futures trading way bac in ,;.1. !n ,-1@" the 8overnment of !ndia banned cash settlement and options trading. $erivatives trading shifted to informal forwards mar ets. !n recent years" government policy has shifted in favour of an increased role of mar et)based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in !ndia was the promulgation of the 3ecurities Daws 6Amendment7 >rdinance" ,--1. !t provided for withdrawal of prohibition on options in securities. The last decade" beginning the year @///" saw lifting of ban on futures trading in many commodities. Around the same period" national electronic commodity exchanges were also set up. $erivatives trading commenced in !ndia in :une @/// after 32B! granted the final approval to this effect in +ay @//, on the recommendation of D. C 8upta committee. 3ecurities and 2xchange Board of !ndia 632B!7 permitted the derivative segments of two stoc exchanges" #323 and B32<" and their clearing houseLcorporation to commence trading and settlement in approved derivatives contracts. !nitially" 32B! approved trading in index futures contracts based on various stoc mar et indices such as" 3E4 C#C" #ifty and 3ensex. 3ubsequently" index)based trading was permitted

in options as well as individual securities. The trading in B32 3ensex options commenced on :une <" @//, and the trading in options on individual securities commenced in :uly @//,. (utures contracts on individual stoc s were launched in #ovember @//,. The derivatives trading on #32 commenced with 3E4 C#C #ifty !ndex futures on :une ,@" @///. The trading in index options commenced on :une <" @//, and trading in options on individual securities commenced on :uly @" @//,. 3ingle stoc futures were launched on #ovember -" @//,. The index futures and options contract on #32 are based on 3E4 C#C. !n :une @//3" #32 introduced !nterest *ate (utures which were subsequently banned due to pricing issue. Re"u# tion o- Deri? ti?es Tr ,in" in In,i The regulatory framewor in !ndia is based on the D.C. 8upta Committee *eport" and the :.*. Harma Committee *eport. !t is mostly consistent with the !>3C>1 principles and addresses the common concerns of investor protection" mar et efficiency and integrity and financial integrity. The D.C. 8upta Committee *eport provides a perspective on division of regulatory responsibility between the exchange and the 32B!. !t recommends that 32B!&s role should be restricted to approving rules" bye laws and regulations of a derivatives exchange as also to approving the proposed derivatives contracts before commencement of their trading. !t emphasises the supervisory and advisory role of 32B! with a view to permitting desirable flexibility" maximi9ing regulatory effectiveness and minimi9ing regulatory cost. *egulatory requirements for authori9ation of derivatives bro ersLdealers include relating to capital adequacy" net worth" certification requirement and initial registration with 32B!. !t also suggests establishment of a separate clearing corporation" maximum exposure limits" mar to mar et margins" margin collection from clients and segregation of clients& funds" regulation of sales practice and accounting and disclosure requirements for derivatives trading. The :.*. Harma committee suggests a methodology for ris containment measures for index)based futures and options" stoc options and single stoc futures. The ris containment measures include calculation of margins" position limits" exposure limits and reporting and disclosure Deri? ti?es . r3et In,i

The !ndian derivative mar et has become multi)trillion dollar mar ets over the years. +ar ed with the ability to partially and fully transfer the ris by loc ing in assets prices" derivatives are gaining popularity among the investors. 3ince the economic reforms of ,--," maximum efforts have been made to boost the investors& confidence by ma ing the trading process more users& friendly. 3till" there are some issues in this mar et. !nspite of the growth in the derivative mar et" there are many issue 6e.g." the lac of economies of scale" tax and legal bottlenec s" increased off)balance sheet exposure of !ndian ban s need for an independent regulator etc7" which need to be immediately resolved to enhance the investors& confidence in the !ndian derivative mar et. (ixed exchange rate was in existence under the Bretton 'oods system. According to Avadhani 6@///7" (inancial derivatives came into the spotlight" when during the post) ,-./ period" the =3 announced its decision to give up gold) dollar parity" the basic ing pin of the Bretton 'ood 3ystem of fixed exchange rates. 'ith the dismantling of this system in ,-.," exchange rates couldn&t be ept fixed. !nterest rates became more volatile due to high employment and inflation rates. Dess developed countries li e !ndia opened up their economies and allowed prices to vary with mar et conditions. 4rice fluctuations made it almost impossible for the corporate sector to estimate future production costs and revenues. The derivatives provided an effective tool to the problem of ris and uncertainty due to fluctuations in interest rates" exchange rates" stoc mar et prices and the other underlying assets. The derivative mar ets have become an integral part of modern financial system in less than three decades of their emergence. This paper describes the evolution of !ndian derivatives mar et" trading mechanism in its various securities" the various unsolved issues and the future prospects of the derivatives mar et. De?e#o47ent o- Deri? ti?es . r3ets in In,i !ndian $erivatives mar ets have been in existence in one form or the other for a long time. !n the area of commodities" the Bombay Cotton Trade Association started futures trading in ,;.1. !n ,-1@" with the ban on cash settlement and option trading by the 8overnment of !ndia" derivatives trading shifted to informal forwards mar ets. !n recent years" government policy has

shifted in favor of an increased role of mar et)based pricing and less suspicious derivatives trading. The first step towards the introduction of financial derivatives trading in !ndia was the promulgation of the 3ecurities Daws 6Amendment7 >rdinance" ,--1. This provided for withdrawal of prohibition on options in securities. !n the last decade" beginning the year @///" ban on futures trading in many commodities was lifted out. $uring the same period" #ational 2lectronic Commodity 2xchanges were also set up. $erivatives trading commenced in !ndia in :une @/// after 32B! granted the final approval to this effect in +ay @//, on the recommendation of D. C 8upta committee. 3ecurities and 2xchange Board of !ndia 632B!7 permitted the derivative segments of two stoc exchanges" #32 and B32" and their clearing houseLcorporation to commence trading and settlement in approved derivatives contracts. !nitially 32B! approved trading in index futures contracts based on various stoc mar et indices such as" 3E4 C#C" #ifty and 3ensex. 3ubsequently" index)based trading was permitted in options as well as individual securities.

CHAPTER D DATA ANA9YSIS AND INTERPRETATION

BIB9IOGRAPHY Boo3s re-erre,: ,. >ptions (utures" and other $erivatives by :ohn C Hull @. $erivatives (AP by A5ay 3hah 3. #32&s Certification in (inancial +ar etsN ) $erivatives Core module <. (inancial +ar ets E 3ervices by 8ordon E #atara5an

Re4orts: ,. *eport of the *B!) 2B! standard technical committee on exchange traded Currency (utures @. *egulatory (ramewor for (inancial $erivatives in !ndia by $r.D.C.8=4TA

;e8sites ?isite,: ,. www.nse)india.com @. www.bseindia.com 3. www.sebi.gov.in <. www.ncdex.com 1. www.derivativesindia.com

CHAPTER < B

Types of $2*!HAT!H23

(=T=*23 H3. (>*'A*$ +A*B2T3

CHAPTER B

TYPES OF DERIVATIVES :

There are mainly four types of derivatives i.e. (orwards" (utures" >ptions and swaps.

Deri? ti?es

ForA r,s

Futures

O4tions

SA 4s

1E

FOR;ARDS 6

A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price" amount and date in the future is nown as a forward contract. (orward contracts are the important type of forward)based derivatives. They are the simplest derivatives. There is a separate forward mar et for multitude of underlyings" including the traditional agricultural or physical commodities" as well as currencies and interest rates. The change in the

value of a forward contract is roughly proportional to the change in the value of its underlying asset. These contracts create credit exposures. As the value of the contract is conveyed only at the maturity" the parties are exposed to the ris of default during the life of the contract. (orward contracts are customised with the terms and conditions tailored to fit the particular business" financial or ris management ob5ectives of the counter parties. #egotiations often ta e place with respect to contract si9e" delivery grade" delivery locations" delivery dates and credit terms.

=E

FUTURES 6

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. (utures contracts are the special types of forward contracts in the sense that are standardi9ed exchange)traded contracts.

2quities" bonds" hybrid securities and currencies are the commodities of the investment business. They are traded on organised exchanges in which a clearing house interposes itself between buyer and seller and guarantees all transactions" so that the identity of the buyer or the seller is a matter of indifference to the opposite party. (utures contract protect those who use these commodities in their business.

(utures trading are to enter into contracts to buy or sell financial instruments" dealing in commodities or other financial instruments for forward delivery or settlement on standardised terms. The futures mar et facilitates stoc holding and shifting of ris . They act as a mechanism for collection and distribution of information and then perform a forward pricing function. The futures trading can be performed when there is variation in the price of the actual commodity and there exists economic agents with commitments in the actual mar et. There must be a possibility to specify a standard grade of the commodity and to measure deviations from this grade. A

futures mar et is established specifically to meet purely speculative demands is possible but is not nown. Conditions which are thought of necessary for the establishment of futures trading are the presence of speculative capital and financial facilities for payment of margins and contract settlement. !n addition" a strong infrastructure is required" including financial" legal and communication systems.

BE

OPTIONS 6

A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price" called the stri e price" during a period or on a specific date in exchange for payment of a premium is nown as 0o4tion1. =nderlying asset refers to any asset that is traded. The price at which the underlying is traded is called the 0stri3e 4rice1.

There are two types of options i.e." CA99 OPTION AND PUT OPTION.

CA99 OPTION :

A contract that gives its owner the right but not the obligation to buy an underlying asset)stoc or any financial asset" at a specified price on or before a specified date is nown as a 0C ## o4tion1. The owner ma es a profit provided he sells at a higher current price and buys at a lower future price.

8E PUT OPTION :

A contract that gives its owner the right but not the obligation to sell an underlying asset)stoc or any financial asset" at a specified price on or before a specified date is nown as a % Put o4tion1. The owner ma es a profit provided he buys at a lower current price and sells at a higher future price. Hence" no option will be exercised if the future price does not increase.

4ut and calls are almost always written on equities" although occasionally preference shares" bonds and warrants become the sub5ect of options.

DE

S;APS 6

3waps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals nown as payment or settlement dates. They can be regarded as portfolios of forwardSs contracts. A contract whereby two parties agree to exchange 6swap7 payments" based on some notional principle amount is called as a 0S;AP1. !n case of swap" only the payment flows are exchanged and not the principle amount. The two commonly used swaps areN

INTEREST RATE S;APS :

!nterest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed

rate payer ta es a short position in the forward contract whereas" the floating rate payer ta es a long position in the forward contract.

8E

CURRENCY S;APS :

Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. =nder a currency swap" cash flows to be exchanged are determined at the spot rate at a time when swap is done. 3uch cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.

cE FINANCIA9 S;AP :

(inancial swaps constitute a funding technique which permit a borrower to access one mar et and then exchange the liability for another type of liability. !t also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

T+e ot+er 3in, o- ,eri? ti?es% A+ic+ re not% 7uc+ 4o4u# r re s -o##oAs :

'E

BASKETS 6

Bas ets options are option on portfolio of underlying asset. 2quity !ndex >ptions are most popular form of bas ets.

(E

9EAPS 6

#ormally option contracts are for a period of , to ,@ months. However" exchange may introduce option contracts with a maturity period of @)3 years. These long)term option contracts are popularly nown as Deaps or Dong term 2quity Anticipation 3ecurities.

FE

;ARRANTS 6

>ptions generally have lives of up to one year" the ma5ority of options traded on options exchanges having a maximum maturity of nine months. Donger)dated options are called warrants and are generally traded over)the)counter.

GE

S;APTIONS 6

3waptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. *ather than have calls and puts" the swaptions mar et has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Futures . r3et

ForA r, . r3et

+argin deposits are to be required of Typically" no money changes hands all participants. until delivery" although a small margin deposit might be required of non)dealer customers on certain occasions. Contract terms are standardised with all All respect to price. #on)member participants deal through 4articipants bro ers 6exchange members represent them on the exchange floor7 4articipants corporations" include financial ban s" 4articipants are primarily institutions institutions" dealing with one other and other interested parties dealing through one or more dealers. The clearing house of the exchange A participant must examine the credit becomes the opposite side to each ris and establish credit limits for each cleared credit transactions0 ris for a therefore" futures the opposite party. mar et deal typically on a contract terms are negotiated

buyers and sellers negotiating only with privately by the parties.

who principal)to)principal basis.

individual investors" and speculators.

participant is always the same and there is no need to analyse the credit of other mar et participants.

3ettlements are made daily through the 3ettlement occurs on date agreed upon exchange clearing house. 8ains on between the parties to each transaction. open positions may be withdrawn and losses are collected daily. Dong and short positions are usually (orward positions are not as easily liquidated easily. offset or transferred to the other participants. 3ettlements are normally made in cash" +ost transactions result in delivery. with only a small percentage of all contracts resulting actual delivery. A single" round trip 6in and out of the #o commission is typically charged if mar et7 commission is charged. !t is the transaction is made directly with negotiated between bro er and another dealer. A commission is customer and is relatively small in charged to born buyer and seller" relation to the value of the contract. Trading is regulated. The delivery price is the spot price. however" if transacted through a bro er. Trading is mostly unregulated. The delivery price is the forward price.

CHAPTER < D

4articipants in derivatives mar et

role of derivatives

CHAPTER D

PARTICIPANTS IN THE DERIVATIVES .ARKET :

The participants in the derivatives mar et are as followsN

AE* TRADING PARTICIPANTS :

1EH HEDGERS <

The process of managing the ris or ris management is called as hedging. Hedgers are those individuals or firms who manage their ris with the help of derivative products. Hedging does not mean maximising of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the ris .

=EH SPECU9ATORS <

3peculators do not have any position on which they enter into futures and options +ar et i.e." they ta e the positions in the futures mar et without having position in the underlying cash mar et. They only have a particular view about future price of a commodity" shares" stoc index" interest rates or currency. They consider various factors li e demand and supply" mar et positions" open interests" economic fundamentals" international events" etc. to ma e predictions. They ta e ris in turn from high returns. 3peculators are essential in all mar ets G commodities" equity" interest rates and currency. They help in providing the mar et the much desired volume and liquidity.

BEH ARBITRAGEURS <

Arbitrage is the simultaneous purchase and sale of the same underlying in two different mar ets in an attempt to ma e profit from price discrepancies between the two mar ets. Arbitrage involves activity on several different instruments or assets simultaneously to ta e advantage of price distortions 5udged to be only temporary.

Arbitrage occupies a prominent position in the futures world. !t is the mechanism that eeps prices of futures contracts aligned properly with prices of underlying assets. The ob5ective is simply to ma e profits without ris " but the complexity of arbitrage activity is such that it is reserved to particularly well)informed and experienced professional traders" equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.

BE* INTER.EDIARY PARTICIPANTS :

DEH BROKERS <

(or any purchase and sale" bro ers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges" may be any commodity or finance" one need not be a speculator" arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange. This transaction can be in the pit of the trading hall or on online computer terminal. All persons hedging their transaction exposures or speculating on price movement" need not be and for that matter cannot be members of futures or options exchange. A non)member has to deal in futures exchange through member only. This provides a member the role of a bro er. His existence as a bro er ta es the benefits of the futures and options exchange to the entire economy all transactions are done in the name of the member who is also responsible for final settlement and

delivery. This activity of a member is price ris free because he is not ta ing any position in his account" but his other ris is clients default ris . He cannot default in his obligation to the clearing house" even if client defaults. 3o" this ris premium is also inbuilt in bro erage recharges. +ore and more involvement of non)members in hedging and speculation in futures and options mar et will increase bro erage business for member and more volume in turn reduces the bro erage. Thus more and more participation of traders other than members gives liquidity and depth to the futures and options mar et. +embers can attract involvement of other by providing efficient services at a reasonable cost. !n the absence of well functioning bro ing houses" the futures exchange can only function as a club.

'EH .ARKET .AKERS AND >OBBERS <

2ven in organised futures exchange" every deal cannot get the counter party immediately. !t is here the 5obber or mar et ma er plays his role. They are the members of the exchange who ta es the purchase or sale by other members in their boo s and then square off on the same day or the next day. They quote their bid)as rate regularly. The difference between bid and as is nown as bid)as spread. 'hen volatility in price is more" the spread increases since 5obbers price ris increases. !n less volatile mar et" it is less. 8enerally" 5obbers carry limited ris . 2ven by incurring loss" they square off their position as early as possible. 3ince they decide the mar et price considering the demand and supply of the commodity or asset" they are also nown as mar et ma ers. Their role is more important in the exchange where outcry system of trading is present. A buyer or seller of a particular futures or option contract can approach that particular 5obbing counter and quotes for executing deals. !n automated screen based trading best buy and sell rates are displayed on screen" so the role of 5obber to some extent. !n any case" 5obbers provide liquidity and volume to any futures and option mar et.

CE* INSTITUTIONA9 FRA.E;ORK :

(EH E5CHANGE <

2xchange provides buyers and sellers of futures and option contract necessary infrastructure to trade. !n outcry system" exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions. !n online trading system" exchange provide access to members and ma e available real time information online and also allow them to execute their orders. (or derivative mar et to be successful exchange plays a very important role" there may be separate exchange for financial instruments and commodities or common exchange for both commodities and financial assets.

FEH C9EARING HOUSE <

A clearing house performs clearing of transactions executed in futures and option exchanges. Clearing house may be a separate company or it can be a division of exchange. !t guarantees the performance of the contracts and for this purpose clearing house becomes counter party to each contract. Transactions are between members and clearing house. Clearing house ensures solvency of the members by putting various limits on him. (urther" clearing house devises a good managing system to ensure performance of contract even in volatile mar et. This provides confidence of people in futures and option exchange. Therefore" it is an important institution for futures and option mar et.

GEH CUSTODIAN I ;ARE HOUSE <

(utures and options contracts do not generally result into delivery but there has to be smooth and standard delivery mechanism to ensure proper functioning of mar et. !n stoc index futures and options which are cash settled contracts" the issue of delivery may not arise" but it would be there in stoc futures or options" commodity futures and options and interest rates futures. !n the absence of proper custodian or warehouse mechanism" delivery of financial assets and commodities will be a cumbersome tas and futures prices will not reflect the equilibrium price for convergence of cash price and futures price on maturity" custodian and warehouse are very relevant.

&EH BANK FOR FUND .OVE.ENTS <

(utures and options contracts are daily settled for which large fund movement from members to clearing house and bac is necessary. This can be smoothly handled if a ban wor s in association with a clearing house. Ban can ma e daily accounting entries in the accounts of members and facilitate daily settlement a routine affair. This also reduces a possibility of any fraud or misappropriation of fund by any mar et intermediary.

1JEH REGU9ATORY FRA.E;ORK <

A regulator creates confidence in the mar et besides providing Devel playing field to all concerned" for foreign exchange and money mar et" *B! is the regulatory authority so it can ta e initiative in starting futures and options trade in currency and interest rates. (or capital mar et" 32B! is playing a lead role" along with physical mar et in stoc s" it will also regulate the stoc index futures to be started very soon in !ndia. The approach and outloo of regulator directly affects the strength and volume in the mar et. (or commodities" (orward +ar et Commission is wor ing for settling up national #ational Commodity 2xchange.

RO9E OF DERIVATIVES :

$erivative mar ets help investors in many different ways N

1EH

RISK .ANAGE.ENT <

(utures and options contract can be used for altering the ris of investing in spot mar et. (or instance" consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract" or by buying a 4ut option. !f the spot price falls" the short hedgers will gain in the futures mar et" as you will see later. This will help offset their losses in the spot mar et. 3imilarly" if the spot price falls below the exercise price" the put option can always be exercised.

$erivatives mar ets help to reallocate ris among investors. A person who wants to reduce ris " can transfer some of that ris to a person who wants to ta e more ris . Consider a ris )averse individual. He can obviously reduce ris by hedging. 'hen he does so" the opposite position in the mar et may be ta en by a speculator who wishes to ta e more ris . 3ince people can alter their ris exposure using futures and options" derivatives mar ets help in the raising of capital. As an investor" you can always invest in an asset and then change its ris to a level that is more acceptable to you by using derivatives.

=EH

PRICE DISCOVERY <

4rice discovery refers to the mar ets ability to determine true equilibrium prices. (utures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen" futures mar ets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such mar ets. Accurate prices are essential for ensuring the correct allocation of resources in a free mar et economy. >ptions mar ets provide information about the volatility or ris of the underlying asset.

BEH

OPERATIONA9 ADVANTAGES <

As opposed to spot mar ets" derivatives mar ets involve lower transaction costs. 3econdly" they offer greater liquidity. Darge spot transactions can often lead to significant price changes. However" futures mar ets tend to be more liquid than spot mar ets" because herein you can ta e large positions by depositing relatively small margins. Consequently" a large position in derivatives mar ets is relatively easier to ta e and has less of a price impact as opposed to a transaction of the same magnitude in the spot mar et. (inally" it is easier to ta e a short position in derivatives mar ets than it is to sell short in spot mar ets.

DEH

.ARKET EFFICIENCY <

The availability of derivatives ma es mar ets more efficient0 spot" futures and options mar ets are inextricably lin ed. 3ince it is easier and cheaper to trade in derivatives" it is possible to exploit arbitrage opportunities quic ly and to eep prices in alignment. Hence these mar ets help to ensure that prices reflect true values.

'EH

EASE OF SPECU9ATION <

$erivative mar ets provide speculators with a cheaper alternative to engaging in spot transactions. Also" the amount of capital required to ta e a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair mar ets. 3peculators always ta e calculated ris s. A speculator will accept a level of ris only if he is convinced that the associated expected return" is commensurate with the ris that he is ta ing.

CHAPTER < '

H>' BA#B3 =32 $2*!HAT!H23

A332T liability management

CHAPTER '

HO; BANKS USE DERIVATIVES :

ASSET 9IABI9ITY .ANAGE.ENT 6

Ban s have traditionally ta en deposits from their customers and put those deposits to wor as loans. Because the deposits and the loans are dominated in the same currency" this activity has no associated foreign exchange ris . But it does limit ban s to lending to customers which need to borrow in the currencies which the ban s have available on deposits.

!f a ban is as ed to lend to a customer in a currency other than one of those it has on deposits it creates a currency exposure for the ban . 3uppose a customer wants to borrow 2=*>3 from a =3 Ban for 1 years and that the =3 ban has no natural source of 2=*>3. !t is possible for the ban s to cover this exposure in the forward mar et by selling 2=*>3 forwards and buying =3 dollars. The transaction costs associated with this" in particular the bid L offer spread in the medium term foreign exchange forward mar et" would ma e the resultant cost of the loan prohibitively expensive for the borrower.

Currency swaps provide an economic alternative to this problem for ban s. !n order to cover the exposure created by a loan to a customer in 2=*>3 funded by a ban &s deposit in =3 dollar" a ban could receive fixed rate =3 dollars in a currency swap and pay fixed rate 2=*>3.

>ne of the consequences of the development of the currency swap mar et is that ban s now often ma e much more competitive medium term forward foreign exchange prices than they used to. +ost ban s quote forward foreign exchange and currency swap prices from the same des and increases liquidity in the latter has improved liquidity in the former. Ban s therefore" need no longer restrict their lending activities to the currencies in which they have natural deposits. They are free to fund themselves in the most competitively priced currency and to lend

to their customers in the currency of the customer&s preference" using a currency swap as an asset and liability matching tool

The I#ormal yield curveJ" reflects that it is much easier for ban s to borrow at the short end of the curve than the long end. This means that ban s can fund themselves much more effectively in the inter ban mar et in maturities such as the overnight" tom L next 6overnight from tomorrow" or tomorrow to the next day7" spot L next" one wee " one month" three months and six months than they can in maturities such as five years or @/ years.

'ith the development of the swaps mar et it is possible for ban s to satisfy their customers demands for fixed rate funding while ensuring that the ban s assets and liabilities are matched. 3uppose a ban has a customer who needs 1 years fixed rate funds. Det us say that the ban finances in this loan in the interban mar et at 3 month D!B>*. The ban now has a 3 month liability and a 1 year asset 6(igure ,7.

The ban is short floating rate interest at 3 month D!B>* and long fixed rate interest at the rate at which it lends to its customer. This is called the asset liability mismatch. 3o in order to hedge its position the ban s needs to match its exposure to 3 month D!B>* by receiving on a floating rate basis in an interest rate swap" and match its exposure on a fixed rate basis by paying a fixed rate in a interest rate swap. This is a hedge which is ideally suited to an interest rate swap which the ban receives a floating rare of interest and pays a fixed rare 6(igure @7.

This structure has the benefit for the ban that it eliminates the ban &s exposure to interest rate ris . The ban can no longer profit from a fall in interest rates but it cannot lose money on its asset and liability mismatch as a result of an increase in rates. The ban will ma e or lose money based on its pricing of the credit ris in the transaction and its overall loan exposure rather than on its ability to forecast interest rates. Hence the interest rate swaps provide ban s with an opportunity to change their ris s from interest rate to credit.

CHAPTER < (

CA32 3T=$!23

hedging interest rate ris

Hedging foreign exchange ris

CHAPTER (

CASE STUDIES :

CASE STUDY 1

Hedging interest rate ris

Scen rio

A ma5or aircraft manufacturer has decided to replace his mainframe computer. The cost after trade in is U ,/ million" payable on delivery.

De#i?er2

+id $ecember" @//?.

Fun,in"

A pro5ected cash flow short fall will create a U ,/ million borrowing requirement.

BorroAin" R te

D!B>* R 1/ Basis points

Out#oo3 The treasurer is worried that the central ban &s future policy directions will lead to an increase in short term rates.

. r3et Con,itions

Current D!B>* ) ;.3; F 2uro)$ollar >ptions >n (utures N $ecember -,.@1 6implied rate of ;..1F7 4ut" 4remium of .@1 $ecember -,.// 6implied rate of -.//F7 4ut" 4remium of .,1

Str te"2

The treasurer buys the $ecember 4ut >ption with a stri e price of -,.@1 6implied rate of ;..1F7" which allows the manufacturer to enter into a 2uro G $ollar futures contract for a premium price of .@1. the notional principal" that is the si9e of the contract is U , million" so ten contracts are ta en to cover the full short)term borrowing cost. The put will ma e money only if the underlying future falls below the stri e price less the price paid for the option. *emember" the 2uro)$ollar future is quoted as an index on a base of ,//" a lower price means a higher rate of interest

Resu#ts

!n +id)$ecember" depending upon how the D!B>* rate has changed" the treasurer will use or not use the put option on the future which was purchased. !f the cost of short)term borrowing has remained the same or declined" the put option will expire worthless. The money expended upon the premium" of /.@1 F per U , million contract" will have been lost. !f" however" interest rates were to rise" the put option contract on the 2uro)$ollar future will be exercised. !f" for example" 2uro G $ollar *ates rise to ,/..?F 6;-.,/ on the index7 which would have given the treasurer a borrowing cost of ,,.@?F 6D!B>* R 1/ bases points7" the 4ut would be utilised" exercising the right to sell the option on the future at the stri e price of -,.@1" for an intrinsic value of @., 6>r @F in interest terms7.

The gain in value on the 4ut options contract compensates for the increased cost of borrowing on the D!B>* *ate. The ris of funding the new mainframe computer has been managed.

CASE STUDY =

Hedging foreign exchange rate ris

Scen rio

An American manufacturer of clothing imports fabric from the =nited Bingdom. !n ? months time" in anticipation of the @//1)/? winter season" he will need to purchase , million 4ounds 3terling" in order to pay for the desired imports" in order for his finished goods to be competitive and ensure adequate margins" the exchange rate must not fluctuate significantly. A wea ening of the =3 dollar by more than 1F may create problems in terms of price competitiveness and profit margins.

De#i?er2

!n +id :une" @//1" the manufacturer is scheduled to receive and pay for the imports.

Fun,in"

The manufacturer has no funding exposure as the imports will be paid from wor ing capital.

E/c+ n"e R te

The present rate is 3T8L =3$ V ,.1/" which is satisfactory with respect to commercial ob5ectives" but a wea ening of more than 1F will result in diminished margins or a non competitive position.

Out#oo3

The manufacturer is worried that because of declining rates of interests and the current account deficits" the =3 dollar may wa en against the 4ound 3terling" from its current rate of ,.1/.

. r3et Con,itions

Current spot rate ) 3T8L=3$ V ,.1/

:une calls W stri e price of 3T8L=3$ V U,.1," premium of @.1/F per contract" that is < =3 cents.

:une calls W 3tri e price of 3T8L=3$ V U,.1@" premium of @.//F per contract" that is 3 =3 cents.

Str te"2

The manufacturer buys one call option contract with a 3tri e or 2xercise price of ,.1,. !f the =3 dollar wea ens the call contract will be used to buy the 4ounds G 3terling at the set price. !f" the =3 dollar stays the same or strengthens" the contract will expire worthless and the premium paid for the option will have been lost.

Resu#ts

!n :une @//1" the =s dollar does wea en and the new spot exchange rate is 3T8L=3$ V ,.?/. Hence" the call option at ,.1, has intrinsic value of - =3 cents. !nstead of the , million 4ound 3terling required by the manufacturer costing ,.? million =3 dollars" the exercise of the call contract will net U -//// =3 6 U ,.? million G U ,.1, million7.

After subtracting the price of the premium of @.1F" the net gain will be U 1//// =3 6 U ,.? million G U ,.11 million7" which partially off)sets the depreciation in the =3 $ollar exchange *ate" and is within the manufacturer&s target range of 1F to remain competitive on pricing.

Through this hedging technique the underlying commercial ob5ective will be ensured. !f the =3 $ollar exchange rate had not wea ened" the expenditure on the premium would still have ept his net cost of the imports within the self imposed 1F competitive range.

RECO..ENDATIONS

*B! should play a greater role in supporting derivatives.

$erivatives mar et should be developed in order to

eep it at par with other

derivative mar ets in the world.

3peculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

32B! should conduct seminars regarding the use of derivatives to educate

individual investors.

BIB9IOGRAPHY :

BOOKS

(utures mar ets G 3unil. B. 4arameswaran

=nderstanding futures mar et G *obert. '. Blob

$erivatives +ar et in !ndia G 3usan Thomas

(inancial $erivatives G H. B. Bhalla

(inancial 3ervices and +ar ets G $r. 3. 8uruswamy

(utures and >ptions G $. C. 8ardner

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ABBREVIATION

A+2C ) American 3toc 2xchange.

B32 ) Bombay 3toc 2xchange.

CH2 ) Calcutta Hessian 2xchange Dtd.

CB>2 ) Chicago Board options 2xchange.

CB>T ) Chicago Board of Trade.

C2BB ) Chicago 2gg and Butter Board.

C+2 ) Chicago +ercantile 2xchange.

C42 ) Chicago 4roduce 2xchange.

!++ ) !nternational +onetary +ar et.

D!B>* ) Dondon !nter Ban >ffer *ate.

D2A43 ) Dong term 2quity Anticipation 3ecurities.

+CC G +ulti Commodity 2xchange

+!B>* ) +umbai !nter Ban >ffer *ate.

#C$C G #ational Commodities and $erivatives 2xchange

#32 ) #ational 3toc 2xchange.

>TC ) >ver the counter.

4HDC ) 4hiladelphia 3toc 2xchange.

3!+2C ) 3ingapore !nternational +onetary 2xchange.

3E4 ) 3tandard and 4oor.

3C6*7 A ) 3ecurities Contracts 6*egulation7 Act" ,-1?.