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RESEARCH PROJECT REPORT

on
CURRENT

SCENARIO OF DERIVATIVES
MARKET IN INDIA.

FOR PARTIAL FULFILMENT OF


THE DEGREE OF
MASTER OF BUSINESS
ADMINISTRATION

Submitted By :
Mitransu Sekhar Jadab
(Roll No: 521102633)

Under the Supervision of:


Dr.Nihar Ranjan Misra
Assistant Professor

STUDENTS DECLARATION
I hereby declare that the data collection and analysis of
work related to research report Current Scenario Of Derivatives
Market In India has been carried out exclusively on my efforts
under the guidance of Dr Nihar Ranjan Misra at Berhampur
University.
I, further declare that this work was neither published nor
submitted to any other institution for the award of any other degree
or diploma.

With Warm Regards,


Mitransu Sekhar Jadab

PREFACE
The successful completion of this Research report was a
unique experience for me because by visiting many place and
interacting various person, I achieved a better knowledge about this
project. The experience which I gained by doing this Research
project was essential at this turning point of my carrier this project is
being submitted which content detailed analysis of the research under
taken by me.
The research provides an opportunity to the student to devote
his skills knowledge and competencies required during the technical
session.
The research is on the topic Current Scenario of Derivatives
market in India

Mitransu Sekhar Jadab

ACKNOWLEDGEMENT
I take this opportunity to express my deep sense of
gratitude to all my friends and seniors who helped and guide me to
complete this project successfully. I am highly grateful and indebted
to my project guide Dr Nihar Ranjan Misra for their excellent and
expert guidance in helping me in completion of Research report.

Mitransu Sekhar Jadab

Page No.
PARTICULARS

PART 1
Introduction.. 7
Statement of the problem.. 10
Need and Importance of the Study. 10
Review of Literature. . 11
Definition of derivatives.. 12
Perquisites for derivatives market 13
Derivatives market in India.. 15
Types of Derivatives. 25
Type of Options.... 29
Type of future36
Trading Mechanics in Indian Derivatives Market43
Trading Introduction ... 46
Clearing and Settlement53
Regulatory Framework.74
INDUSTRY PROFILE 91
HISTORY OF STOCK EXCHANGE. . 91
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI). 93

BOMBAY STOCK EXCHANGE 93


NATIONAL STOCK EXCHANGE. 94

PART 2
Research Methodology.96
Objectives of the Research96
Limitation 97
Data Analysis & interpretation . 98
Findings & recommendations 113
Conclusion.114
Bibliography. 116
6

CONTENT

INTRODUCTION
A derivative instrument broadly is a financial contract whose payoff structure is
determined by the value of underlying commodity, security, interest rate, share price
index, exchange rate, oil price, or the like. So a derivative is an instrument which derives
its values from some underlying variable /asset. A derivative instrument by itself does not
constitute ownership. It is, instead, a promise to convey ownership.
All derivatives are based on some cash products. The underlying asset of a derivative
instrument may be any product of the following types: 1. Commodities (grain, coffee, beans, orange juice etc.)
2. Precious metals (Gold, Silver, Copper)
3. Foreign exchange rate
4. Bonds of different types including medium to long-term negotiation debt
securities.
5. Short term debt securities like T- bills
6. over the counter (OTC) money market products such as loans or deposits.
Financial derivatives came into the spotlight along with the rise in uncertainty of post
1970, when the US announced an end to the Breton Woods System of fixed
exchange rates leading to introduction of currency derivatives followed by other
innovations, including stock index futures.
Indian-capital markets have gone through a remarkable transformation in last ten years.
In these years, Indian capital markets have been witness to more than 100% increase in
the companies listed on stock exchanges emergence of Securities and Exchange Board
of India (SEBI) as a truly national level of securities regulator, free pricing of public
issues, screen based trading systems, more than six times increase in the turnover the stock
exchanges, emergence of self regulatory organization in the fields of Merchant banking,
mutual funds, emergence of investors associations, implementation of trade guarantees
besides others.
A Derivative is a financial instrument that derives its value from an underlying asset.
Derivative is an financial contract whose price/value is dependent upon price of one or
more basic underlying asset, these contracts are legally binding agreements made on
trading screens of stock exchanges to buy or sell an asset in the future. The most commonly
used derivatives contracts are forwards, futures and options, which we shall discuss in
detail later.
The main objective of the study is to analyze the derivatives market in India and
to analyze the operations of futures and options. Analysis is to evaluate the profit/loss
position futures and options. Derivates market is an innovation to cash market.

Approximately its daily turnover reaches to the equal stage of cash market.
In cash market the profit/loss of the investor depend the market price of the
underlying asset. Derivatives are mostly used for hedging purpose. In bullish market the
call option writer incurs more losses so the investor is suggested to go for a call option to
hold, where as the put option holder suffers in a bullish market, so he is suggested to write a
put option. In bearish market the call option holder will incur more losses so the investor is
suggested to go for a call option to write, where as the put option writer will get more
losses, so he is suggested to hold a put option

BACKGROUND OF THE STUDY


The evolution occurred in stages. The Chicago Board of Trade (CBOT), which opened in
1848, is, to this day, the largest futures market in the world. The general rules framed by
CBOT in 1865 became a pacesetter for many other markets. In 1870, the New York cotton
exchange was founded.
The London metal exchange was established in 1877 and is now the leading market in
metal trading (both spot and forward). Thereafter many new futures market were started.
The first financial futures market was the international monetary, founded in 1972 by the
Chicago mercantile exchange. The London international financial futures exchange
followed this in 1982.
As already mentioned, some form of forward trading probably existed in India also. The
th
th
first organized forward markets came into existence in India in the late 19 and early 20
century in Calcutta (for jute and jute goods) and Mumbai (for cotton).
Chronologically, Indias experience in organized forward trading is almost as long as that
of the United Kingdom, and certainly longer than many developed nations. However, the
tidal wave of price control, nationalization and state intervention in markets, which
swept through all economic policy making after independence, led to a rapid decline in
number of futures markets. Frequently markets were closed due to the feeling that they
were responsible for sudden movements of price in the commodities.

Statement of the problem


The problem is to analyze Derivative ways of minimizing the Risk in Indian Capital
market and to analyze the current scenario of Derivative markets in India.

Importance of the Study


World financial market has witnessed a spectacular change in the field of derivative
markets in the past one decade, especially in the field of option, futures and swaps. India
also could not become aloof from the world trend and mainly after the liberalization has set
in motion. India introduced the different types in phased manner. A derative market has
gained momentum since its introduction in India and has played a major role in Indian

financial markets. Today the derivative volume in India is Rs. 25000 crores. In this context
the study of Current scenario of Indian derivative market is very contextual and important
as well. That is why this subject is the topic of this dissertation. Similarly, on the equity
market, many retail investors who are uncomfortable about the equity market would
enter if they were given the alternative of buying insurance, which controls their
downside risk. This would enhance the action of the savings of the country, which are
routed through the equity market. More importantly, derivative is one of the important tools
of hedging risk. Therefore, the study of current scenario of derivative market in India is
very importance.

Scope of the study:


The study is limited to Derivatives with special reference to futures and option in the
Indian context and the Inter-Connected Stock Exchange has been taken as a representative sample
for the study. The study cant be said as totally perfect. Any alteration may come. The study has
only made a humble attempt at evaluation derivatives market only in India context. The study is
not based on the international perspective of derivatives markets, which exists in NASDAQ,
CBOT etc.

REVIEW OF LITERATURE
PURPOSE
Literature review is one of the prime parts of dissertation. The very basic purpose of the
literature review is to gain insight on the theoretical background of the research problem. It
helps the researcher to gain strong theoretical basis of the problem under study and also
helps to explore whether any one has done research on the related issue. That is why
literature review helps one to find out the path of problem solving. In this regard, the very
basic purpose of literature review in this dissertation is same as mentioned above.

METHODOLOGY
For simplicity, the literature review has been divided into the following parts.
Definition of derivatives
Perquisites for derivatives market
Types of Derivatives
Derivatives market in India
Type of Options

DEFINITION OF DERIVATIVES
Derivatives are the financial instruments, which derive their value from some other
financial instruments, called the underlying. The foundation of all derivatives market is the

underlying market, which could be spot market for gold, or it could be a pure number such
as the level of the wholesale price index of a market price.
A derivative is a financial instrument whose value depends on the value of other
basic underlying variables John c hull

According to the Securities Contract (Regulation) Act, 1956, derivatives include:


A security derived from a debt instrument, share, and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security.
A contract, which derives its value from the prices or index of prices of
underlying securities.
Therefore, derivatives are specialized contracts to facilitate temporarily for hedging which
is protection against losses resulting from unforeseen price or volatility changes. Thus,
derivatives are a very important tool of risk management.
Derivatives perform a number of economic functions like price
discovery, risk transfer and market completion.
The simplest kind of derivative market is the forward market. Here a buyer
and seller write a contract for delivery at a specific future date and a specified future
price. In India, a forward market exists in the form of the dollar-rupee market. But
forward market suffers from two serious problems; counter party risk resulting in
comparatively high rate of contract non- compliance and poor liquidity.
Futures markets were invented to cope with these two difficulties of forward markets.
Futures are standardized forward contracts traded on an organized stock exchange. In
essence, a future contract is a derivative instrument whose value is derived from the
expected price of the underlying security or asset or index at a pre-determined future date.
The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very
nature, the financial markets are marked by a very high degree of volatility. Through the
use of derivative products, it is possible to partially or fully transfer price risks by locking
in asset prices. As instruments of risk management, these generally do not influence the
fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative
products minimize the impact of fluctuations in asset prices on the profitability and cash
flow situation of risk-averse investors.
Derivatives are risk management instruments, which derive their value from an
underlying asset. The underlying asset can be bullion, index, share, bonds, currency,
interest etc. Banks, securities firms, companies and investors to hedge risks, to gain access
to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even
at a faster rate in future.

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FUNCTIONS OF DERIVATIVES MARKET:


The following are the various functions that are performed by the derivatives markets.
They are:
Prices in an organized derivatives market reflect the perception of market participants about
the future and lead the prices of underlying to the perceived future level.
Derivatives market helps to transfer risks from those who have them but may not like them
to those who have an appetite for them.
Derivative trading acts as a catalyst for new entrepreneurial activity.
Derivatives markets help increase savings and investment in the long run.

PREREQUISITES FOR DERIVATIVES MARKET


There are five essential prerequisites for derivatives market to flourish in a country.
a) Large market capitalization
At a market capitalization of near $1.5 trillion, India is well ahead of many other countries
where derivatives markets have succeeded.
b) Liquidity in the underlying
A few years ago, the total trading volume in India used to be around Rs-300 crores a day.
Today, daily trading volume in India is around Rs-15000 crores a day. This implies a degree
of liquidity, which is around six times superior to the earlier conditions. There is empirical
evidence to suggest that there are many financial instruments in the country today,
which have adequate to support derivative market.
c) Clearing house that guarantees trades
Counter party risk is one of the major factors recognized as essential for starting a strong
and healthy derivatives market. Trade guarantee therefore becomes imperative before a
derivatives
market could start. The first clearinghouse corporation guarantees
trades have become fully functional from July 1996 in the form of National Securities
Clearing Corporation (NSCC). NSCC is responsible for guaranteeing all open positions on
the National Stock Exchange (NSE) for which it does the clearing. Other exchanges are
also moving towards setting up separate and well-funded clearing corporations for
providing trade guarantees.

11

d) Physical infrastructure
Indias equity markets are all moving towards satellite connectivity, which allows investors
and traders anywhere in the country to buy liquidity services from anywhere else. This
telecommunications infrastructure, Indias capabilities in computer hardware and
software, will enable the establishment of computer system for creation of derivatives
markets. Setting up of automated trading system as an experience with various prospective
exchanges will also be beneficial while setting up the derivative market.
e) Risk-taking capability and Analytical skills
Indias investors are very strong in their risk-bearing capacity and can cope with the risk
that derivatives pose. Evidence of the volumes traded on the capital markets, which are akin
to a futures market, is indicative of this capacity. In contrast, in some other countries,
investors simply lack the risk-bearing capacity to sustain the growth of even the equity
market. It is expected that such a barrier will not appear in India.
On the subject of analytical skills, derivatives require a high degree
of analytical capability for many subtle trading strategies to pricing. India has an enormous
pool of mathematically literate finance professionals, who would excel in this field.
Lastly, an obvious advantage for the Indian market is that we have
enormous experience with futures markets through the settlement cycle oriented equity
which is not truly a spot market but a futures market (including concepts like
market-to-market margin, low delivery ratios, and last-day-of settlement abnormalities in
prices). We also have active futures markets on six commodities. With this state of
development of the capital markets it is felt that there is no major hurdle left for the
creation of development of the capital markets. Hence on July 2, 1996 the SEBI board gave
an in principal approval for the launch of derivatives markets in India.

DERIVATIVES MARKET IN INDIA:Prior to liberalization, in India financial markets, there were only a few financial products
and the stringent regulatory products and the stringent regulation environment also eluded
any possibility of development of a derivatives market in country. All Indian corporate
were mainly relying on term lending institution for meeting their project financing or
any other financing requirements and on commercial banks for meeting working capital
finance requirement. Commercial banks are on their assets and liabilities. The only
derivative product they were aware of is the foreign exchange forward contract. But this
scenario
changed in the post liberalization period. Conservative Indian business
practitioners began to take a different view of various aspects of their operations to remain
competitive. Financial risks were given adequate attention and treasury function has
assumed a significance role in all major corporate since then.
Initially, banks were allowed to pass on gains arising out of
cancellation of forwards contracts to the customers and customers were permitted to
cancel and re-book the forward contracts. This remarkable change was followed by the

12

introduction of cross currency forward contacts. But the major milestone in developing
forex derivatives market in India was the introduction of cross currency options. The RBIs
objective of introducing cross currency options was to provide a complicated hedging
strategy for the corporate in their risk management activities.
The concept of derivatives is of course not new to the Indian market. Though
derivatives in the financial markets have nothing to talk about home, in the commodity
markets they have a long history of over hundred years. In 1875, the first commodity
futures exchange was set up in Mumbai under the guidance of Bombay Cotton Traders
Association. A clearinghouse for clearing and settlement of these traders was set up in
1918. Over a period of twenty years during 1900-1920, other futures markets were set up in
various places. Futures market in raw jute in Kolkata (1912), wheat futures market in Hapur
(1913), and bullion futures market in Mumbai (1920).
When it comes to financial markets, derivatives in equities claim a long
existence. The official history of Bombay Stock Exchange (then known as Native Share
and Stock Brokers Association) reveals that the concept of options existed since 1898 as is
reflected from a quote given by one of the MPs-India being the original home of options, a
native broker would give a few points to the brokers of the other nations in the
manipulation of puts and calls.
However, such an early expertise gained by Indian traders in derivatives trading
has come to an end with the Government of Indias ban on forward contract during the
1960s on the ground of their intrinsic undesirability. But ironically, the same were reintroduced by the government in the 1980s as essential instruments for eliminating wide
fluctuations in prices and more so because of the World Bank UNCTAD report, which
strongly urged the Indian government to start futures trading in major cash crops,
especially in view of Indias entry to WTO.
With the world embracing the derivative trading on large scale, the Indian
market obviously cannot remain aloof, especially after liberalization has been set in motion.
Now we are in the threshold of introducing trading in derivatives, beginning with the stock
index futures to be well set for the introduction of derivative trading. With L.C. Gupta
committee having recently submitted its report on the subject, SEBI is engaged in the
process of assessing the feasibility and desirability of introducing such trading.
The NSE and BSE are two exchanges on which financial derivatives are
traded. The combined notional value of the daily volumes on both the bourses stands at
around RS.150000 cr. In developed markets trading in the derivatives segment are thrice as
large as in the cash markets. In India, the figure is hardly 20% of cash markets. Quite
clearly our derivative markets have a long way to go.
According to the Executive Director of Association of NSE Member of India
(Amni), Vinod Jain, Volumes in derivatives segment are stagnating due to lack of growth
in the number of markets participants. Besides these products are still to catch up with the
masses who are keeping away from this segment due to lack of understanding of the
products and high contract price
a) COMMODITIES DERIVATIVES MARKETS
In order to give more thrust on agricultural sector, the National Agricultural Policy, 2000
has envisaged and domestic market reforms and dismantling of all controls and regulations
in agricultural commodity markets. It has also proposed to extend the coverage of futures

13

markets to minimize the wide fluctuations in commodity market prices and for hedging the
risk from price fluctuations.
As a result of these recommendations, there are presently, 15 exchanges
carrying out futures trading in as many as 30 commodity items. Out to these, two
exchanges viz. IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have
been upgraded to international exchanged to deal international contracts in peeper and
castor oil respectively. Moreover, permission has been given to two more exchange viz. the
First Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil and oilcake),
and Keshave Commodity Exchange Ltd. Delhi (for potato), where futures trading started
very recently.
The government has also permitted four exchange viz., EICA, Mumbai. The
Central Gujarat Cotton Dealers Association, Vadodara The South India cotton
Association Coimbatore; and
the
Ahmadabad Cotton Merchants
Association,
Ahmadabad, for conducting forward (non-transferable specific delivery) contracts in
cotton. Lately as part of further liberalization of trade in agriculture and dismantling of
ECA, 1955 futures trade in sugar has been permitted and three new exchanges viz., ECommodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and E-Sugar India.com,
Mumbai have been given approval for conducting sugar futures (Ministry of Food and
Consumer Affairs, 1999).
In the recent past, the GOI has set up a committee to explore and appraise
matters important to the establishment and financing of the proposed national commodity
exchange for the nationwide trading of commodity futures contracts. The usage of
warehouse receipts as a means for delivery of commodities under the contracts is also being
explored. The warehouse receipts system has been operational zed in COFEI (coffee
futures exchange of India) with effect from 1998. The Government of India is on the move
to establish a system of warehouse receipts in other commodity stock exchanges at
various places of the country.
Besides these domestic developments, during 1998, Reserve Bank
of India permitted the Indian Corporate Sector to access the exchanges subject to
certain conditions with a view to enable domestic metal manufacturers to compete with
global players. The de-regulation of oil-imports being on the cards, government should
create the right atmosphere for oil sector to participate in the international oilderivatives Markets. Despite these developments, there are still many impediments that
hold back the farming community from entering the futures market and reap full benefits.
A brief description of commodity exchanges are those which trade in
particular commodities, neglecting the trade of securities, stock index futures and options
etc. In the middle of 19th century in the United States, businessmen began organizing
market forums to make the buying and selling of commodities easier. These central
marketplaces provided a place for buyers and sellers to meet, set quality and quantity
standards, and establish rules of business. Agricultural commodities were mostly traded
but as long as there are buyers and sellers, any commodity can be traded. In 1872, a group
of Manhattan dairy merchants got together to bring chaotic condition in New York market
to a system in terms of storage, pricing, and transfer of agricultural products. In 1933,
during the Great Depression, the Commodity Exchange, Inc. was established in New York
through the merger of four small exchanges the National Metal Exchange, the Rubber
Exchange of New York, the National Raw Silk Exchange, and the New York Hide
Exchange. The major commodity markets are in the United Kingdom and in the USA. In
India there are 25 recognized future exchanges, of which there are three national

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level multi- commodity exchanges. After a gap of almost three decades, Government of
India has allowed forward transactions in commodities through Online Commodity
Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to
facilitate better risk coverage and delivery of commodities.
The three exchanges are:
National Commodity & Derivatives Exchange Limited (NCDEX)
Multi Commodity Exchange of India Limited (MCX)
National Multi-Commodity Exchange of India Limited (NMCEIL)
All the exchanges have been set up under overall control of Forward Market Commission
(FMC) of Government of
India.
National

Commodity &

Derivatives

Exchange

Limited (NCDEX):-

National Commodity & Derivatives Exchange Limited (NCDEX) located in Mumbai is a


public limited company incorporated on April 23, 2003 under the Companies Act, 1956 and
had commenced its operations on December 15, 2003.This is the only commodity
exchange in the country promoted by national level institutions. It is promoted by ICICI
Bank Limited, Life Insurance Corporation of India (LIC), National Bank for Agriculture
and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE).
It is a professionally managed online multi commodity exchange. NCDEX is regulated by
Forward Market Commission and is subjected to various laws of the land like the
Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and
various other legislations.
Multi Commodity

Exchange

of

India Limited(MCX):-

Headquartered in Mumbai Multi Commodity Exchange of India Limited (MCX), is an


independent and de-metalized exchange with a permanent recognition from Government of
India. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of
India, Union Bank of India, Corporation Bank, Bank of India and Canara Bank. MCX
facilitates online trading, clearing and settlement operations for commodity futures markets
across
the country.
MCX started offering trade in November 2003 and has built strategic alliances with
Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors Association of
India, Pulses Importers Association and Shetkari Sanghatana.
National
Multi-Commodity
(NMCEIL):-

Exchange

of

India Limited

National Multi Commodity Exchange of India Limited (NMCEIL) is the first demetalized, Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was
granted approval by the Government to organize trading in the edible oil complex. It has

15

operationalised from November 26, 2002. Central Warehousing Corporation Ltd., Gujarat
State Agricultural Marketing Board and Neptune Overseas Limited are supporting
it. It got its recognition in October 2002.
Commodity exchange in India plays an important role where
the prices of any commodity are not fixed, in an organized way. Earlier only the buyer of
produce and its seller in the market judged upon the prices. Others never had a say. Today,
commodity exchanges are purely speculative in nature. Before discovering the price, they
reach to the producers, end-users, and even the retail investors, at a grassroots level. It
brings a price transparency and risk management
in the vital market.
A big difference between a typical auction, where a single auctioneer
announces the bids and the Exchange is that people are not only competing to buy but also
to sell. By Exchange rules and by law, no one can bid under a higher bid, and no one can
offer to sell higher than someone elses lower offer. That keeps the market as efficient as
possible, and keeps the traders on their toes to make sure no one gets the purchase or sale
before they do. A brief description of commodity exchanges is those which trade in
particular commodities, neglecting the trade of securities, stock index futures and options
Etc.
In the middle of 19th century in the United States, businessmen began organizing
market forums to make the buying and selling of commodities easier. These central
marketplaces provided a place for buyers and sellers to meet, set quality and quantity
standards, and establish rules of
business. Agricultural commodities were mostly
traded but as long as there are buyers and sellers, any commodity can be traded. In 1872, a
group of Manhattan dairy merchants got together to bring chaotic condition in New York
market to a system in terms of storage, pricing, and transfer of agricultural products.
b) CURRENCY DERIVATIVES
Foreign exchange derivatives market is one of the oldest derivatives markets in India.
Presently, India has got a well-established dollar-rupee forward market with contrast
traded for one month, two months and three months expiration. Currency derivatives
markets have begun to evolve with the allowing of banks to pass on the gains upon
cancellation of a forward to the customer and permitting customer to cancel and rebook
forward contracts.
Introduction of cross currency options can be considered as another major step
towards developing forex derivatives markets in India.
Today, Indian corporate is permitted to purchase cross currency options to hedge
exposures arising out of trade. Authorized dealers who offer these products have to
necessarily cover their exposure in international markets i.e., they shall not carry the risk in
their own books. Cross currency options are essentially meant for buying or selling any
foreign currency in terms of US dollar. They are therefore, useful only to those traders who
invoice their exports and imports in currencies other than US dollar or for corporate who
borrow in currencies other than US dollar. As against this, majority of Indian trade is
invoiced in the US dollars. Thus, they have almost no relevance in the Indian context.
Indian banks are allowed to use the foreign currency interest rate swaps, forward
rate agreements/interest rate options/swaps, and forward rate agreements/interest rate
option/swaption/caps/floors to hedge interest rate and currency mismatch in their balance
sheets. Resident and the non-resident clients are also permitted to use the above products as

16

hedges for liabilities on their balance sheets.


Here it is worth remembering that globally, foreign exchange traders are
becoming as common as stock traders. But in India, forex dealers still play second fiddle to
stock traders and merely meet the needs of the exporters deposits. This may be due to their
risk averting behavior and perhaps lack of proper research. Such being the position of the
forex market, it is too premature to expect that once, foreign currency-Indian rupee options
are introduced, the market will pick up momentum.
This is all the more essential in a market where exchange rates though stated to be
market determined, are often found influenced by RBIs intervention in the exchange
market. As a result, exchange rate movements hardly obey the principle of interest rate
differentials. The incongruence in the domestic money rates as derived from the
USD/INR forwards yield curve supports this assertion. For example, the one-year
domestic term money is around 6-6.25% whereas that of the one-year implied forward rate
is around 5.40%. In such a scenario, it is difficult for a currency trader to take a firm view
on the exchange rate movement
c) STOCK MARKET DERIVATIVES
Today trading on the spot markets for equity in India has always been a futures market with
weekly/fortnightly settlements. These markets features the risks and difficulties of
futures market, But without the gains in price discovery and hedging services that come
with separation the spot market from the futures market. Indias primary market is
acquainted with two types of derivatives
Convertible bonds
Warrants
As these warrants are listed and traded, it could be said that options market of a limited sort
already exist in our market.
Besides, a wide range of interesting derivatives markets exists in the
informal sector. Contracts such as bhav-bhav teji-mandi etc. are traded in these
markets. These informal markets enjoy a very limited participation and have their presence
outside the conventional institutions of Indias financial system.
The first step towards introduction of derivatives trading in India in its current format
was the promulgation of the securities laws (Amendment) Ordinance, 1995 that withdrew
the prohibition on options in securities. The real push to derivatives market in India was
however given by the SEBI. The security market watchdog, in November 1996 by setting
up a committee under the chairmanship of Dr L C Gupta to develop appropriate
regulatory framework for derivatives trading in India.
In 2000, SEBI permitted NSE and BSE to commence trading in index futures
contracts based on S&P CNX Nifty and BSE 30(Sensex) index. This was followed by
approval for trading in options based on these two indexes and options on individual
securities. Futures contracts on Individual stocks were launched on November 9, 2001.
Trading and settlement is done in accordance with the rules of the respective exchanges.
But the trading volumes were initially quite modest.

17

This could be due to ---- Initially, few members have been permitted by SEBI to trade on derivatives;
FIIS, MFS have been allowed to have a very limited participation;
Mandatory requirements for brokerage firms to have SEBI approved-certification- testpassed brokers for undertaking derivatives trading and
Lack of clarity on taxation and accounting aspects under derivatives trading.

The current trading behavior in the derivatives segments reveals that single stock
futures continues to account for sizeable proportion. A recent press report indicates that
futures in Indian exchanges have reached global volumes. One possible reason for such
skewed behavior of the traders could be that futures closely resemble the erstwhile badla
system. Such distortions are not however in the interest of the market.
SEBI has permitted trading in options and futures on individual stocks, but not on
all the listed stocks. It was very selective, stocks that are said to be highly volatile with a
low market capitalization are not allowed for option trading. This act of SEBI is strongly
resented by a section of the market.
Their
argument is that equity options are
indispensable to investors who need to protect their investment from volatility. The higher
the volatility of a stock the more necessary it is to list options on that stock. They are highly
vocal in arguing that SEBI should design an effective monitoring, surveillance and risk
management system at the level of the exchanges and clearing house to avert and manage
the default risks that are likely to arise owing to high volatility in low market capital stocks
instead of simply banning trading in options on them. SEBI needs to examine these
arguments. It may have to take a stand to nip in the bud all kinds of manipulations by
handling out severe punishments to all such erring companies.
Today, mutual funds are permitted to use equity derivatives products for hedging
and portfolio rebalancing. However, such usage is not favored by fund managers as
they strongly apprehend that the dividing line between hedging and speculation being
thin, they may always get exposed to the questioning by the regulatory authorities.
d) CREDIT DERIVATIVES AND OTHERS
A credit derivative is a financial transaction whose pay-off depends on whether or not a
credit event occurs.
A credit event can be:
Bankruptcy
Default

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Upgrade
Downgrade
Interest rate movement
Mortgage defaults
Unforeseen pay-offs
A credit derivative, like any other derivative, derives its value from an case is the credit. In
the event of the underlying asset failing to perform as expected, credit derivatives,
ensures that someone other than the principal lender absorbs the resulting financial loss.
Credit derivatives market in India though could be said as non-existent holds huge
potential. Some of the important factors/situation such as opening up of the insurance
sector to foreign private players, relief to investors, tax benefits to corporate, proxy
hedgers etc., could provide the momentum to the credit derivatives market in India,
boosting yields and bringing down risk for both the corporate and banks.
Secondly, Indian banking system is saddled with huge NPAs, which it is of course,
eagerly trying to get rid of. The mounting pressure on profitability is making banks more
credit-averse. In such a situation, if markets can offer credit-insurance in the form of
derivatives, everyone would jump for it.

Types of participants in a derivatives market


Hedgers, speculators and arbitrators are the types of traders in derivatives market.
Hedgers:
Hedgers are those who protect themselves from the risk associated with the price of an
asset by using derivatives. A person keeps a close watch upon the prices discovered in
trading and when the comfortable price is reflected according to his wants, he sells futures
contracts. In this way he gets an assured fixed price of his produce.
In general, hedgers use futures for protection against adverse future price movements in the
underlying cash commodity. Hedgers are often businesses, or individuals, who at one point
or another deal in the underlying cash commodity.
Take an example: A Hedger pays more to the farmer or dealer of a produce if its prices
go up. For protection against higher prices of the produce, he hedges the risk exposure by
buying enough future contracts of the produce to cover the amount of produce he expects to
buy. Since cash and futures prices do tend to move in tandem, the futures position will
profit if the price of the produce raise enough to offset cash loss on the produce.

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Speculators:
Speculators are somewhat like a middleman. They are never interested in actual owing the
commodity. They will just buy from one end and sell it to the other in anticipation of future
price movements. They actually bet on the future movement in the price of an asset.
They are the second major group of futures players. These participants include
independent floor traders and investors. They handle trades for their personal clients or
brokerage firms.
Buying a futures contract in anticipation of price increases is known as going long.
Selling a futures contract in anticipation of a price decrease is known as going short.
Speculative participation in
futures trading has increased with the availability of
alternative methods of participation.
Speculators have certain advantages over other investments they are
as follows:
If the traders judgment is good, he can make more money in the futures market faster
because prices tend, on average, to change more quickly than real estate or stock prices.
Futures are highly leveraged investments. The trader puts up a small fraction of the
value of the underlying contract as margin, yet he can ride on the full value of the contract
as it moves up and down. The money he puts up is not a down payment on the underlying
contract, but a performance bond. The actual value of the contract is only exchanged on
those rare occasions when delivery takes place.
Arbitrators:
According to dictionary definition, a person who has been officially chosen to make a
decision between two people or groups who do not agree is known as Arbitrator. In
commodity market Arbitrators are the person who takes the advantage of a
discrepancy between prices in two different markets. If he finds future prices of a
commodity edging out with the cash price, he will take offsetting positions in both the
markets to lock in a profit. Moreover the commodity futures investor is not charged interest
on the difference between margin and the full contract value.

Types of Derivatives
DERIVATIVES

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FUTURE

FORWARDS

OPTIONS

SWAPS

One form of classification of derivatives is between commodity derivatives and financial


derivatives. Thus futures, option or swaps on gold, sugar, jute, pepper etc are commodity
derivatives. While futures, options or swaps on currencies, gilt-edged securities, stock and
Share stock market indices etc are financial derivatives.

Derivatives

Forwards

Future

Security

Commodity

Swap

Option

Put

Security

Commodity

Call

Types of Derivatives

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Currency

Interest rate

A) OPTIONS:
The concept of options is not new one. In Fact, options have been in use for centuries. The
idea of an option existed in ancient Greece and Rome. The Romans wrote options on the
cargo that were transported by their ship. In the 17th century, there was an active option
markets in Holland. In fact, options were used in a large measure in the tulip bulb mania
of that century. However, in the absence of mechanism to guarantee the performance of the
contract, the refusal of many put option writers to take delivery of The tulip bulb and pay
the high prices of the bulb they had originally agreed to, led to bursting of the bulb bubble
during the winter of 1637.A number of speculators were wiped out in the process.
In India, options on stocks of companies were illegal until 25th January 1995
according to sec. 20 of Securities Contracts (Regulation) Act, 1956. When Securities Laws
(Amendment) Act, 1956 sec. 20. Thus making the introduction of options as legal act.
An options contract is an agreement between a buyer and a seller. Such a contract
confers on the buyer a right but not an obligation to buy or sell a specified quantity of the
underlying asset at a fixed price on or up to a fixed day in the future on a payment of a
premium to the seller. The premium paid by the buyer to the seller is the price of an option
contract
Options on a futures contract have added a new dimension to future trading like futures
options provide price protection against adverse price move. Present day options trading on
the floor of an exchange began in April 1973. When the Chicago Board of trade created the
Chicago Board Options Exchange (CBOE) for the sole purpose of trading Options on a
limited number of NEW YORK STOCK EXCHAGE listed equities
B) FORWARDS:
A forward is an agreement between two parties to exchange an agreed quantity of asset at a
specified future date at a predetermined price specified in the agreements. The parties
concerned agree the settlement date and price in advance. The promised asset may be
currency, commodity, instrument etc. It is the oldest type of all the derivatives. The party
who promises to buy but he specified asset at an agreed price at a fixed future date is said to
be in the long position and the party who promises to sell at an agreed price at a future
date is said to be in short position.

C) FUTURES:
It is similar to the forward contract in all the respect. In fact, a future is a standardized form
of forward contract. A future is a contract or an agreement between two parties to exchange
assets / currency or commodity at a certain future date at an agreed price. The trader who
promises to buy is said to be in long position and the party who promises to sell said be
in short position.
Futures contracts are contracts specifying a standard volume of a
particular currency to be exchanged on a specific settlement date. A future contract is an
agreement between a buyer and a seller. Such a contract confers on the buyer an obligation

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to buy from the seller, and the seller an obligation to sell to the buyer a specified quantity of
an underlying asset at a fixed price on or before a fixed day in future. Such a contract can
be for delivery of an underlying asset.
To eliminate counter party risk and guarantee traders, futures markets use
a clearing house which employs initial margin, daily market to market margin, exposures
limits etc. to ensure contract compliance and guarantee settlement standardized futures
contracts generate liquidity. In addition, due to these instruments being traded on
recognized exchanges results in greater transparency, fairness and efficiency. Due to these
inherent advantages, futures markets have been enormously successful in comparison
with forward markets all over the world
the difference between forward
contract and future is that future is a standardized contract in terms of quantity, date and
delivery. It is traded on organized exchanges. So it has secondary markets. Future contract
is always settled daily, irrespective of the maturity date, which is called marking to the
market.

D) SWAP:
Swap is an agreement between two parties to exchange one set of financial
obligations with other. It is widely used throughout the world but is recent in India. Swap
may be interest swap or currency swaps.
Swaps give companies extra flexibility to exploit their comparative
advantage in their respective borrowing markets.
Swaps allow companies to focus on their comparative advantage in
borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of
the maturity spectrum.
Swaps allow companies to exploit advantages across a matrix of currencies and
maturities.

TYPES OF OPTIONS
Inboard sense, an option is a claim without any liability. More specifically, an option is a
contract that gives the holder aright, without any obligation, to buy or sell an asset at an
agreed price on or before a specified period of time.
The option to buy an asset is known as a call option and the option to sell an asset
is called a put option. The price at which option is exercised is called an exercise price or
a strike price. The asset on which the call or put option is created is referred to as the
underlying asset. Depending on when an option can be exercised, it is classified as follows:
European Option: When an option is allowed to exercise only on the maturity
date, it is called a European Option.
American Option: When an option can be exercised any time before its maturity is

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called an American Option.


Capped Option: When an option is allowed to exercise only during a specified
period of time prior to its expiration unless the option reaches the cap value prior to
expiration in which the option is automatically exercised.
The holder of an option has to pay a price for obtaining a call or put option. The
price will have to be paid whether the holder exercises his option and it is called option
premium.
Option Terminology
There are several important terms used in option they are: 1). Call option: - Gives the buyer the right, but not the obligation to buy a specific futures
contract at a predetermined price within a limited period of time.
A call option is a contract, which gives the owner the right to buy an asset for a certain
price on or before a specified date. For example, if you buy a call option on a certain share
of XYZ Company, you have the right to purchase 100 shares (assuming of course, that the
option involves 100 shares).
Suppose current share price (S) of Reliance Industries is Rs. 291. You expect that price
in a three months period will go up Rs. 300. But you also fear that the price may also fall
below Rs. 291. To reduce the chance of risk and at the same time to have the opportunity of
making profit, instead of buying the share, you can buy a 3-month call option on Reliance
Industries at an agreed exercise price (E) of, say, RS.280. Ignoring the option premium,
taxes, transaction costs and the time value of money, the decision to exercise your option
depends upon the share price after three months. You will exercise option when the share
price after three months is above Rs. 280 and you will not exercise when the share price
after three month is below Rs. 240.
Thus option should be exercised when:
Share price at expiration > Exercise price = St>E
Do not exercise option when:
Share price at expiration <= Exercise price =St<E
The value of call option at expiration is:
Value of call option at expiration= Maximum [(share price exercise price), 0]
Ct = Max [(St - E), 0]
The expression above indicates that the value of call option at expiration is the
maximum of the share price minus the exercise price and zero. The call option holders
opportunity to make profit is unlimited. It depends on the actual market price of the
underlying share when the option is exercised. Greater the market value of the underlying
asset, the larger is the value of the option. The following figure shows the value of call

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option.
For the call option writer, he will gain when share price is below the strike price and
will lose when stock price is above the strike price. The call buyers gain is call sellers loss.
The figure 1.2 shows the pay-off of a call option writer.
2). Put option: - Gives the buyer the right, but not the obligation, to sell a specific futures
contract at a predetermined price within a limited period of time.
Put option is a contract that gives the holder a right to sell specified shares at
an agreed price on or before a given maturity. Thus, if you buy a put option on shares of
XYZ Company, you have the right to sell 100 shares of this company at the specified price
at any time between today and the specified date.
Suppose the current price (S) of Reliance Industries is Rs. 291 and
you expect that the price will fall within a three months. Therefore, you can buy a 3-month
put option on Reliance Industries at an agreed exercise price (E), say, Rs. 295. If the price
actually falls to (St) Rs. 280 after three months, you will exercise your option. You will buy
the share for Rs. 280 from the market and deliver it to the put-option writer to receive Rs.
295. Your gain is Rs.15 ignoring the put option premium, transaction cost and taxes. You
will not exercise if the share price rises above exercise price; the put option is worthless and
its value is zero.
Thus, exercise the put option when
Exercise price >Share price at expiration = E > St
Do not exercise put option when
Exercise price <=Share price at expiration = E<St

The value of put option at expiration will be


Value of put option at expiration= Maximum [(Exercise price Share price), 0]
Pt = Max [(E-St), 0]
The put option buyers gain is the sellers loss. The potential loss of the put option is
limited to the exercise price. Since the buyer has to pay a premium to the seller for
purchasing a put option, the potential profit of the buyer and the potential loss of the seller
will reduce by the amount of premium.
Combination
Puts and calls represent basic options. They serve as a building for developing more
complex options. The algebra corresponding to combination of buying option and equity
stock is as follows:

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Pay -offs just before expiration date


If St< E
If St > E
1) Put option
2) Equity stock

E - S1
S1

0
S1

= Combination

S1

Thus if you buy a stock with a put option on that stock (exercisable at price E), your payoff
will be E if the price of the stock is less that E, otherwise your payoff will be S1. Consider a
more complex combination that consists of
1. Buying stock
2. Buying a put option on that stock and
3. Borrowing an amount equal to the exercise price.

The payoff from this combination is identical to the payoff from buying a call option. The
algebra of this equivalence is shown as follows:
Pay - off just before expiration date
If S1< E
1) Buy the equity stock
2) Buy a put option
3) Borrow an amount equal
To exercise price
(1) + (2) + (3) = Buy a call option

If S1 >E

S1

S1
E-S1

-E

0
-E

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S1-E

If C1 is the terminal value of the call option (remember that C1 = Max (S1-E, 0), P1 the
terminal value of the put option (remember that P1= Max (E-S1, 0), S1 the price of the
stock, and E the amount borrowed, then we have
C1= S1+P1-E
This is referred to as the put-call parity.
3) Holder: - The buyer of the option.
4) Premium: -The amount paid by the buyer of the option to the seller.
5) Writer: - The option seller.
6) Strike price: -The predetermined price at which a given futures contract bought or sold.
So called the exercise price these levels are set at regular intervals.
7) At-the money: - An option is at-the money when the underlying futures price equals or
nearly equals the strike price.
For e.g.: - A T-bond Put or Call option is at-the-money if
the option strike
price is at 78 and the price of the T-Bond futures contract is at or near 78.00
8) In-the money: - A call option is in-the money when the underlying futures price is
greater than the strike price.
For e.g.: - If T-Bond futures are at 80.00 and the T-Bond call option strike price is
78.00, the call is in-the money
Whereas the put option is in-the money when the strike price of the option is greater
than the price of the underlying futures contract.
For e.g.: - If the strike price of the put option is 80.00 and
T-Bond futures are
trading at 77.00 the put option is in- the money
9) Out-of-the money: - A call option is out-of-the money if the Strike price is greater than
the underlying futures price.
For e.g.: - if T-Bond futures are at 80.00 and the T-Bond
call option strike price is 82.00 the option is out-of-the money.
The put option is out-of-the money if the underlying futures price is greater than the
strike price
For e.g.: - if T-Bond futures are at 77.00 and the T- Bond put option strike price is
76.00 the put option is out-of-the money.

Call option

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Put option

In-the money

Futures > strike

Futures < strike

Futures = strike

Futures = strike

Futures < strike

Futures > strike

At-the money

Out-of-the money

Factors Determining the Option Value:


The precise location of the option value depends on five key factors:
Exercise price
Expiration date
Stock price
Stock price variability
Interest rate
Exercise Price:
Other things being constant, higher the exercise price, the lower the value of call
option. It should be remembered that the value of call option could never be negative;
regardless of how high the exercise price is set.
Expiration Date:
Other things being constant, the longer the time to expiration date, the more
valuable the call option. Consider two American calls with maturities of one year and two
years. The two-year call obviously is more valuable than one-year call because it gives its
holder one more year within which it can be exercised.
Stock Price:
The value of a call option, other things being constant, increases with the stock price.

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Stock Price Variability:


A call option has value when there is possibility that the stock price exceeds the
exercise price before the expiration date. Other things being equal, the higher the variability
of the stock price, the greater the likelihood that stock price will exceed the exercise.
REASONS FOR USING OPTIONS
The reasons for using options on futures are reflected in the structure of an option contract.
1) An option, when purchased gives the buyer the right, but not the obligation, to buy or sell a
specific amount of a specific commodity at a specific price within a specific period of time.
2) The decision to exercise the option is entirely that of the buyer.
3) The purchaser of the options can lose no more than the initial amount of money invested
(premium).
4) An option buyer is never subject to margin calls. This enables the purchaser to maintain
a market position, despite any adverse moves without putting up additional funds.
MOTIVES for BUYING and SELLING OPTIONS
One may be buyer or seller of call or put option for a variety of reasons.
A call option buyer for e.g. is bullish that he is or she believes the price of the underlying
futures contract will rise. If price do rise, the call option buyer has three course of action
available.
First is to exercise the option and acquires the underlying futures contract at the strike price
Second is to offset the long call position with a sale and realize a profit.
Third is to let the option expires worthless and forfeit the unrealized profit.
The seller of the call option expects futures prices to remain relatively stable or to
decline modestly. If prices remain stable, the receipt of the option premium enhances the
rate of return on a covered position. If prices decline, selling the call against a long futures
position enables the writer to use the premium as a cushion to provide protection to the
extent of the premium received. For instance, if T-bond futures were purchased at 80.00
And call option with an 80.00 strike price were sold for 2.00, T-bond futures could decline
to the 78.00 levels before there would be a net loss in the position. However, T-bond futures
rise to 82.00 the call option seller forfeits the opportunity for profit because the buyer
would likely exercise the call against him and acquire a future position at 80.00(strike

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price).
The perspective of the put buyer and put seller are completely different. The buyer of
the put option believes for the underlying futures will decline for e.g.: - if a T- Bond put
option with a strike price of 82.00 is purchased for 2.00 while T-Bond futures also are at
82.00, the put option will be profitable for the purchaser to exercise if T-Bond futures
decline below 80.00

Types of futures:
On the basis of the underlying asset they derive, the futures are divided into two types:
Stock futures:
The stock futures are the futures that have the underlying asset as the individual
securities. The settlement of the stock futures is of cash settlement and the settlement price
of the future is the closing price of the underlying security.
Index futures:
Index futures are the futures, which have the underlying asset as an Index. The Index
futures are also cash settled. The settlement price of the Index futures shall be the closing
value of the underlying index on the expiry date of the contract.
PARTIES IN THE FUTURES CONTRACT:
There are two parties in a future contract, the Buyer and the Seller. The buyer of the
futures contract is one who is LONG on the futures contract and the seller of the futures
contract is one who is SHORT on the futures contract.
The pay off for the buyer and the seller of the futures contract are as follows.

PAYOFF FOR A BUYER OF FUTURES:

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PROFIT

LOSS

CASE 1:
The buyer bought the future contract at (F); if the futures price goes to E1 then the buyer
gets the profit of (FP).
CASE 2:
The buyer gets loss when the future price goes less than (F), if the futures price goes to
E2 then the buyer gets the loss of (FL).
PAYOFF FOR A SELLER OF FUTURES:

P
PROFIT

LOSS
L

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F FUTURES PRICE
E1, E2 SETTLEMENT PRICE.
CASE 1:
The Seller sold the future contract at (f); if the futures price goes to E1 then the Seller
gets the profit of (FP).
CASE 2:
The Seller gets loss when the future price goes greater than (F), if the futures price goes
to E2 then the Seller gets the loss of (FL).
MARGINS:
Margins are the deposits, which reduce counter party risk, arise in a futures contract. These
margins are collected in order to eliminate the counter party risk. There are three types of
margins:
INITIAL MARGIN:
Whenever a futures contract is signed, both buyer and seller are required to post initial
margin. Both buyer and seller are required to make security deposits that are intended to
guarantee that they will in fact be able to fulfill their obligation. These deposits are Initial
margins and they are often referred as performance margins. The amount of margin is
roughly 5% to 15% of total purchase price of futures contract.

MARKING TO MARKET MARGIN:


The process of adjusting the equity in an investors account in order to reflect the change in
the settlement price of futures contract is known as MTM Margin.

MAINTENANCE MARGIN:
The investor must keep the futures account equity equal to or greater than certain
percentage of the amount deposited as Initial Margin. If the equity goes less than that
percentage of Initial margin, then the investor receives a call for an additional deposit of
cash known as Maintenance Margin to bring the equity up to the Initial margin.

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ROLE OF MARGINS:
The role of margins in the futures contract is explained in the following example.
S sold a Satyam June futures contract to B at Rs.300; the following table shows the effect
of margins on the contract. The contract size of Satyam is 1200. The initial margin amount
is say Rs.20000, the maintenance margin is 65% of Initial margin.

D
A
Y

PRICE
OF
SATYAM

EFFECT ON
BUYER (B)

EFFECT
ON
SELLER
(S)

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REMARKS

MTM
P/L
Bal. in Margin
1

MTM
P/L
Bal.
Margin

300.00

in

Contract is entered and initial margin is d

B got profit and S got loss, S deposited m

B got loss and deposited maintenance ma


2

311(price
increased)

3
287

+13,200
-13,200
+13,200

-28,800
+15,400

+28,800

+21,600
305

-21,600

Pricing the Futures:

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B got profit, S got loss. Contract settled


and S got loss.

The fair value of the futures contract is derived from a model known as the Cost of Carry
model. This model gives the fair value of the futures contract.
Cost of Carry Model:
F=S (1+r-q) t
Where
F Futures Price
S Spot price of the Underlying
r Cost of Financing
q Expected Dividend Yield
T Holding Period.

Futures terminology:
Spot price:
The price at which an asset trades in the spot market.
Futures price:
The price at which the futures contract trades in the futures market.
Contract cycle:
The period over which a contract trades. The index futures contracts on the NSE have onemonth, two-months and three-month expiry cycles which expire on the last Thursday of the
month. Thus a January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three-month expiry is introduced for
trading.
Expiry date:
It is the date specified in the futures contract. This is the last day on which the contract will
be traded, at the end of which it will cease to exist.
Contract size:
The amount of asset that has to be delivered under one contract. For instance, the contract
size on NSEs futures market is 200 Nifties.

Basis:
In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal
market, basis will be positive. This reflects that futures prices normally exceed spot prices.

35

Cost of carry:
The relationship between futures prices and spot prices can be summarized in terms of
what is known as the cost of carry. This measures the storage cost plus the interest that is
paid to finance the asset less the income earned on the asset.
Open Interest:
Total outstanding long or short positions in the market at any specific time. As total long
positions for market would be equal to short positions, for calculation of open interest, only
one side of the contract is counted.

Trading Mechanics in Indian Derivatives Market:a)Spot market


In a spot market transactions are settled on the spot. Once a trade is agreed upon, the
settlement- i.e. the actual exchange of money for goods takes place with minimum possible
delay.
There are two real-world implementations of a spot market. Rolling settlement and real
time gross settlement (RTGS). With rolling settlement trades are netted through one day,
and settled x working days later; this is called T+X rolling settlement. For example: with
T+5 rolling settlement, traders are netted through Monday, and the net open position as of
Monday evening is settled on the coming Monday. Similarly, traders are netted through
Tuesday, and settled on the coming Tuesday.
With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a close
approximation and RTGS is a true spot market
b) Forward transaction
In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a
stated price and quantity. No money changes hands at the time the trade is agreed upon.
Suppose a buyer L and seller S agrees to do a trade in 100 grams of gold on 31Dec 2009 at
Rs. 10,000/tola. Here, Rs. 10,000/tola is the forward price of 31 Dec 2012 Gold. The
buyer L is said to be long and the seller S is said to be short. Once the contract has been
entered into, L is obligated to pay S Rs. 10, 00,000 on Dec 31, 2012, and take delivery of
100 tolas of gold. Similarly S is obligated to be ready to accept Rs.10, 00,000 on 31 Dec,
and give 100 tolas of gold in exchange.
c)
Exchange traded versus OTC derivatives
Derivatives, which trade on an exchange, are called exchange-traded. Trades on the
exchange generally take place with anonymity. Traders at an exchange generally go through
the clearing corporation.

36

A derivative contract that is privately negotiated is called OTC derivatives. OTC trades
have no anonymity, and they generally do not go through a clearing corporation. Every
derivative product can either trade OTC (i.e. through private negotiation) or on an
exchange. In one specific case the jargon demarcates this clearly: OTC futures contracts are
called forwards (or, exchange-traded forwards are called futures). In other cases, there is no
such distinguishing notation. There are exchange-traded options as opposed to OTC
options; but both are called options.
d) Carry forward
Badla is a mechanism to avoid the discipline of a spot market; to do trades on the spot
market but not actually do settlement. The carry forward activities are mixed together with
the spot market. A well functioning spot market has no possibility of carry- forward.
Derivatives trades take place distinctively from the spot market. The spot price is separately
observed from the derivative price. A modern financial system consists of a spot market,
which is a genuine spot market, and a derivatives market is separate from the spot market.
e)
Intermediation in Indian derivatives market
There are two kinds of brokerage firms on the index futures market: trading members
(TMs) and clearing members (CMs). NSCC only deals with clearing members: NSCC
bears the full of default by a clearing member. Trading members obtain the right to trade
through a clearing member; the CM adopts the full credit risk of the TM. If a TM fails,
NSCC holds the relevant CM responsible.
f)
Margin Money
The aim of margin money is to minimize the risk of default by either counter-party. The
payment of margin ensures that the risk is limited to the previous days price movement on
each outstanding position. However, even this exposure is offset by the initial margin
holdings. Margin money is like a security deposits or insurance against a possible future
loss of value.
There are different types of margin like: Initial margin
The basic aim of initial margin is to cover the largest potential loss in one day. Both buyer
and seller have to deposit margins. The initial margin is deposited before the opening of the
position in the futures transaction.

Mark to Market Margin


Mark to market margin is collected in cash for all futures contracts and adjusted against the
available liquid net worth for option position. In the case of futures contracts mark to

37

margin may be considered as mark to market Settlement. All daily losses must be met by
depositing of further collateral known as variation margin, which is required by the close of
business, the following day. Any profits on the contract are credited to the clients variation
margin account.
Maintenance margin
Some exchanges work on the system of maintenance margin, which is slightly less than
initial margin. The margin is required to be replenished to the level of initial margin, only if
the margin level drops below the maintenance margin limit.

TRADING INTRODUCTION:-

1)
2)
3)
4)

NSE introduced for the first time in India, fully automated screen based trading. It uses a
modern, fully computerized trading system designed to offer investors across the length and
breadth of the country a safe and easy way to invest.
The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a
fully automated screen based trading system, which adopts the principle of an order driven
market. The futures & Options trading system of NSE, called NEAT-F&O trading system,
provides a fully automated screen-based trading for Nifty futures & options and stock
futures & Options on a nationwide basis as well as an online monitoring and surveillance
mechanism. It supports an order driven market and provides complete transparency of
trading operations. It is similar to that of trading of equities in the cash market segment.
The software for the F&O market has been developed to facilitate efficient and
transparent trading in futures and options instruments. Keeping in view the familiarity of
trading members with the current capital market trading system, modifications have been
performed in the existing capital market trading system so as to make it suitable for trading
futures and options.
On starting NEAT (National Exchange for Automatic Trading) Application, the log on
(Password) Screen Appears with the Following Details.
User ID
Trading Member ID
Password NEAT CM (default Pass word)
New Pass Word
Note: - 1) User ID is a Unique
2) Trading Member ID is Unique & Function; it is Common for all user of the Trading
Member
3) New password Minimum 6 Characteristic, Maximum 8 characteristics only
3 attempts are accepted by the user to enter the password to open the Screen
4) If password is forgotten the User required informing the Exchange in writing
to reset the Password.
Trading System
The Futures and Options Trading System provides a fully automated trading

38

environment for screen-based, floor-less trading on a nationwide basis and an online


monitoring and surveillance mechanism. The system supports an order driven market and
provides complete transparency of trading operations. Orders, as and when they are
received, are first time stamped and then immediately processed for potential match. If a
match is not found, then the orders are stored in different 'books'. Orders are stored in pricetime priority in various books in the following sequence:
Best Price
Within Price, by time priority.
Trading on the derivatives segment takes place on all days of the week (except Saturdays
and Sundays and holidays declared by the Exchange in advance).
Trading Locations
Till the advent of NSE, an investor wanting to transact in a security not traded on the
nearest exchange had to route orders through a series of correspondent brokers to the
appropriate exchange. This resulted in a great deal of uncertainty and high transaction costs.
One of the objectives of NSE was to provide a nationwide trading facility and to enable
investors spread all over the country to have an equal access to NSE.
NSE has made it possible for an investor to access the same market and order book,
irrespective of location, at the same price and at the same cost. NSE uses sophisticated
telecommunication technology through which members can trade remotely from their
offices located in any part of the country. NSE trading terminals (F&O segment) are present
in various cities and towns all over India.
REGULATORY FRAMEWORK:
The trading of derivatives is governed by the provisions contained in the SC (R) A, the
SEBI Act and the regulations framed there under the rules and byelaws of stock exchanges.
Regulation for Derivative Trading:
SEBI set up a 24 member committed under Chairmanship of Dr.L.C.Gupta develop the
appropriate regulatory framework for derivative trading in India. The committee submitted
its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the
committee and approved the phased introduction of Derivatives trading in India beginning
with Stock Index Futures. SEBI also approved he Suggestive bye-laws recommended by
the committee for regulation and control of trading and settlement of Derivatives contracts.
The provisions in the SC (R) A govern the trading in the securities. The amendment of
the SC (R) A to include DERIVATIVES within the ambit of Securities in the SC (R ) A
made trading in Derivatives possible within the framework of the Act.

39

1. Eligibility criteria as prescribed in the L.C. Gupta committee report may apply to SEBI
for grant of recognition under Section 4 of the SC ( R ) A, 1956 to start Derivatives
Trading. The derivatives exchange/segment should have a separate governing council
and representation of trading / clearing members shall be limited to maximum of 40% of
the total members of the governing council. The exchange shall regulate the sales
practices of its members and will obtain approval of SEBI before start of Trading in any
derivative contract.
2. The exchange shall have minimum 50 members.
3. The members of an existing segment of the exchange will not automatically become the
members of the derivative segment. The members of the derivative segment need to
fulfill the eligibility conditions as lay down by the L.C.Gupta Committee.
4. The clearing and settlement of derivates trades shall be through a SEBI Approved
Clearing
Corporation
/
Clearing
house.
Clearing
Corporation
/Clearing House complying with the eligibility conditions as lay down committee have
to apply to SEBI for grant of approval
5. Derivatives broker/dealers and Clearing members are required to seek registration from
SEBI.
6. The Minimum contract value shall not be less than Rs.2 Lakh. Exchanges should also
submit details of the futures contract they purpose to introduce.
7. The trading members are required to have qualified approved user and sales person who
have passed a certification programmed approved by SEBI.

TRADING NETWORK

40

HUB ANTENNA

SATELLITE

NSE MAIN FRAME


BROKERS PREMISES

Holding of Shares (Voting Right) disclosing obligation


1)
2)
3)
4)

Any person or Director or officer or the company


More than 5% share or voting Right
Within 4th day inform to company is necessary
Company inform with in 5th day to stock exchange is compulsory

41

First Started

Future trading: Chicago Board of Trading 1848


Financial Future Trading: CME (Chicago Mercantile Exchange 1919)
Stock Index Futures: Kansas City Board of trade
Option First Trade: Holland - Tulip Balabmania

BROKER (Trading Member)


(Broker means a member in recognized stock exchange)

Eligibility: 21 tears, graduation, 2 years experience in stock market relative Affairs and

30 Lakhs paid up capital


100 lakhs net worth
125 lakhs interest free security deposit
25 lakhs collator security deposit
1 lakhs annual business subscription
BROKER & CLIENT RELATION SHIP:-

1)
2)
3)
4)
5)
6)
7)
8)
9)

Fill the client Registration Application form (for all details of clients).
Agreement on non-judicial form (Specified by SEBI that form)
PAN, Pass Port, Driving License or voter Identity card (SEBI Registration Number in
case of FIIs) - Pan Cards is must to future and option trading.
And then Allot-Unique client code
Take copy of instruction in writing before placing order, cancellation & modification.
If order values exceed 1 lakh maintain the client record for 7 years.
On conformation any order, issue contract note within 24 hours.
Collect margin of 50,000 & multiple with 10,000.
NOTE: - PAN is compulsory if the transaction cost exceed Rs.1 lakh.
Issuing the know your client form is must.

For Continuing Membership-Trading Member Fulfill the following documents.

1)
2)
3)
4)

Audited two important Financial Statements (profit & Loss account, balance Sheet)
Net worth certificate (Certificate by CA)
Details of Directors, share holders (certificate by CA)
Renewal insurance covering proof.

42

SUB BROKER:-

1)
2)
3)
4)
5)

Eligibility: - 21 years, 10+2 qualification and paid up capital 5 lakhs.


Not convicted involving fraud and dishonesty.
Not debarred by SEBI previously.
51% of shares as dominant promoters his/her and his/her spouse.
First application to stock exchange-Stock exchange send his application to SEBI-SEBI
satisfied issued Certificate Registration.
6) A registered sub-broker, holding registration, granted by SEBI on the Recommendations of
a trading member, can transact through the member (broker) who had recommend his
application for registration.
7) Maximum Brokerage Commission 2%.
8) Purchase note and sales note issued by the sub broker with 24 hours.
Investor protection Fund:-

1)
2)
3)
4)

Investor protection fund setup under Bombay public trust Act 1950.
IPF maintained by NSE Exact name of this fund is NSE Investors Protection Fund Trust.
Any Member defaulted the IPF paid maximum 10 lakhs only to each investor.
Client against default member, customer have right to apply within 3 months from the date
of Publishing notice by a widely circulated minimum one daily News paper.
Demat of the Shares:-

1)
2)
3)
4)
5)

Agreement with depository by security holder (at the time opening the Demat account)
Surrender the security certificates to issuer (Company)for cancellation
Issuer (company) informs the depository about the transfer of the shares.
Participant (Company) informs the depository about the transfer of the shares.
Depository records the transferee name as beneficial owner in book entry form in
his records.
6) Each custodian/clearing member is requiring maintaining a Clear pool account with
depositaries.
7) The investor has no restriction and has full right to open many (number of) depository
accounts
8) Shares or securities are transferred from one account to another account only on the
instruction of the beneficial owner.
ISIN (International Securities Identification Number)

Any company going to foe dematerialized with shares that company get this ISIN for
Demat shares.
ISIN is assigned by SEBI.
ISIN is allotted by NSDL.

43

Main Objectives of Demat Trading


1) Freely transferability
2) Dematerialized in depository mode
3) Maintenance of ownership records in book entry form

Clearing and Settlement


National Securities Clearing Corporation Limited (NSCCL) undertakes clearing
and settlement of all trades executed on the futures and options (F&O) segment of the NSE.
It also acts as legal counterparty to all trades on the F&O segment and guarantees their
financial settlement. This chapter gives a detailed account of clearing mechanism, settlement
procedure and risk management systems at the NSE for trading of derivatives contracts.
Clearing Entities
Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the
help of the following entities:
Clearing Members
In the F&O segment, some members, called self clearing members, clear and settle their
trades executed by them only either on their own account or on account of their clients.
Some others called trading member-cum-clearing member, clear and settle their own trades
as well as trades of other trading members (TMs). Besides, there is a special category of
members, called professional clearing members (PCM) who clear and settle trades executed
by TMs. The members clearing their own trades and trades of others, and the PCMs are
required to bring in additional security deposits in respect of every TM whose trades they
undertake to clear and settle.
Clearing Banks
Funds settlement takes place through clearing banks. For the purpose of settlement all
clearing members are required to open a separate bank account with NSCCL designated
clearing bank for F&O segment. The Clearing and Settlement process comprises of the
following three main activities:
1)

Clearing

2)

Settlement

3)

Risk Management

44

Clearing Mechanism
The clearing mechanism essentially involves working out open positions and obligations of
clearing (self-clearing/trading-cum-clearing/professional clearing) members. This position is
considered for exposure and daily margin purposes. The open positions of CMs are arrived
at by aggregating the open positions of all the TMs and all custodial participants clearing
through him, in contracts in which they have traded. A TMs open position is arrived at as
the summation of his proprietary open position and clients open positions, in the contracts
in which he has traded. While entering orders on the trading system, TMs are required to
identify the orders. These orders can be proprietary (if they are their own trades) or client (if
entered on behalf of clients) through Pro/ Cli indicator provided in the order entry screen.
Proprietary positions are calculated on net basis (buy - sell) for each contract. Clients
positions are arrived at by summing together net (buy - sell) positions of each individual
client. A TMs open position is the sum of proprietary open position, client open long
position and client open short position (as shown in the example below).
Consider the following example given from Table 8.1 to Table 8.4. The proprietary open
position on day 1 is simply = Buy - Sell = 200 - 400 = 200 short. The open position for
client A = Buy (O) Sell (C) = 400 - 200 = 200 long, i.e. he has a long position of 200 units.
The open position for Client B = Sell (O) Buy (C) = 600 - 200 = 400 short, i.e. he has a
short position of 400 units. Now the total open position of the trading member Madanbhai at
end of day 1 is 800, where 200 is his proprietary open position on net basis plus 600 which
is the client open positions on gross basis.
The proprietary open position at end of day 1 is 200 short. We assume here that the
position on day 1 is carried forward to the next trading day i.e. Day 2. On Day 2, the
proprietary position of trading member for trades executed on that day is 200 (buy) 400
(sell) = 200 short (see table 8.3). Hence the net open proprietary position at the end of day 2
is 400 short. Similarly, Client As open position at the end of day 1 is 200 long (table 8.2).
The end of day open position for trades done by Client A on day 2 is 200 long (table 8.4).
Hence the net open position for Client A at the end of day 2 is 400 long. Client Bs open
position at the end of day 1 is 400 short (table 8.2). The end of day open position for trades
done by Client B on day 2 is 200 short (table 8.4). Hence the net open position for Client B
at the end of day 2 is 600 short. Therefore the net open position for the trading member at
the end of day 2 is sum of the proprietary open position and client open positions. It works
out to be 400 + 400 + 600, i.e. 1400.
Table 8.1: Proprietary position of trading member Madanbhai on Day 1
Trading member Madanbhai trades in the futures and options segment for himself and two
of his clients. The table shows his proprietary position. Note: A buy position 200@
1000means 200 units bought at the rate of Rs. 1000.

Trading member Madanbhai


Proprietary position

Buy

45

Sell

200@1000

400@1010

Client position of trading member Madanbhai on Day 1


Trading member Madanbhai trades in the futures and options segment for himself
and two of his clients. The table shows his client position.
Trading member
Madanbhai

Buy

Sell

Sell

Buy

Client position

Open

Close

Open

Close

Client A

400@11
09

200@100
0
600@110
0

200@109
9

Client B

Proprietary position of trading member Madanbhai on Day 2


Assume that the position on Day 1 is carried forward to the next trading day and the
following trades are also executed.

Trading member Madanbhai

Proprietary position

Buy

Sell

200@1000

400@1010

Client position of trading member Madanbhai on Day 2


Trading member Madanbhai trades in the futures and options segment for himself and two
of his clients. The table shows his client position on Day 2.

46

Trading member Madanbhai


Client position

Buy
Open

Sell
Close

Client A

400@110
9

200@10
00

Client B

Sell Open

Buy Close

600@110
0

200@1099

The following table determination of open position of a CM, who clears for two TMs
having two clients.

Determination of open position of a clearing member

TMs
clearing

Proprietary
trades

Trades: Client 1

47

Trades: Client 1

O
p

e
n
through
CM

Position
B
u
y

ABC

4
0
0
0

PQR

2
0
0
0

Total

6
0
0
0

Ne
t

B
u
y

20
00

3
0
0
0

30
00

(1
00
0)

2
0
0
0

50
00

+2
00
0

5
0
0
0

Se
ll

20
00

10
00

Ne
t

B
u
y

20
00

4
0
0
0

10
00

10
00

1
0
0
0

20
00

+3
00
0

5
0
0
0

Se
ll

10
00

Ne
t

L
o
n
g

S
ho
rt

20
00

6
0
0
0

20
00

(10
00)

1
0
0
0

20
00

40
00

+2
00
0

7
0
0
0

20
00

Se
ll

20
00

10
00

48

Settlement Procedure
All futures and options contracts are cash settled, i.e. through exchange of cash. The
underlying for index futures/options of the Nifty index cannot be delivered. These contracts,
therefore, have to be settled in cash. Futures and options on individual securities can be
delivered as in the spot market. However, it has been currently mandated that stock options
and futures would also be cash settled. The settlement amount for a CM is netted across all
their TMs/ clients, with respect to their obligations on MTM, premium and exercise
settlement.
1) Settlement of Futures Contracts
Futures contracts have two types of settlements, the Mark-to-Market (MTM) settlement
which happens on a continuous basis at the end of each day, and the final settlement which
happens on the last trading day of the futures contract.
MTM settlement:
All futures contracts for each member are marked-to-market (MTM) to the daily settlement
price of the relevant futures contract at the end of each day. The profits/losses are computed
as the difference between:
1. The trade price and the days settlement price for contracts executed during the day but
not squared up.
2. The previous days settlement price and the current days settlement price for brought
forward contracts.
3. The buy price and the sell price for contracts executed during the day and squared up.
Table 8.6 explains the MTM calculation for a member. The settlement price for the contract
for today is assumed to be 105.
Computation of MTM at the end of the day
Quantity bought/

Settlement

Trade details

MTM
sold

Brought forward from previous day

price
105

500

Traded during day Bought Sold

100@100
200@100
100@102

102

200

Open position (not squared up)

100@100

105

500

Total

1200

The table shows the buy price and the sell price determines the MTM. In this example, 200
units are bought @ Rs. 100 and 100 units sold @ Rs. 102 during the day. Hence the MTM
for the position closed during the day shows a profit of Rs.200. Finally, the open position of

contracts traded during the day, is margined at the days settlement price and the profit of
Rs.500 credited to the MTM account. So the MTM account shows a profit of Rs. 1200.
The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount in
cash which is in turn passed on to the CMs who have made a MTM profit. This is known as
daily mark-to-market settlement. CMs are responsible to collect and settle the daily MTM
profits/ losses incurred by the TMs and their clients clearing and settling through them.
Similarly, TMs are responsible to collect/pay losses/profits from/to their clients by the next
day. The pay-in and pay-out of the mark-to-market settlement are effected on the day
following the trade day. In case a futures contract is not traded on a day, or not traded during
the last half hour, a theoretical settlement price is computed as per the following formula:
F = SerT
This formula has been discussed in chapter 3.
After completion of daily settlement computation, all the open positions are reset to the
daily settlement price. Such positions become the open positions for the next day.
Final settlement for futures:
On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all
positions of a CM to the final settlement price and the resulting profit/loss is settled in cash.
Final settlement loss/profit amount is debited/ credited to the relevant CMs clearing bank
account on the day following expiry day of the contract.
Settlement prices for futures
Daily settlement price on a trading day is the closing price of the respective futures contracts
on such day. The closing price for a futures contract is currently calculated as the last half an
hour weighted average price of the contract in the F&O Segment of NSE. Final settlement
price is the closing price of the relevant underlying index/security in the capital market
segment of NSE, on the last trading day of the contract.
2) Settlement of options contracts
Options contracts have two types of settlements, daily premium settlement and final
exercise settlement.
Daily premium settlement
Buyer of an option is obligated to pay the premium towards the options purchased by him.
Similarly, the seller of an option is entitled to receive the premium for the option sold by
him. The premium payable amount and the premium receivable amount are netted to
compute the net premium payable or receivable amount for each client for each option
contract
Final exercise settlement
Final exercise settlement is effected for all open long in-the-money strike price options
existing at the close of trading hours, on the expiration day of an option contract. All such
long positions are exercised and automatically assigned to short positions in option

contracts with the same series, on a random basis. The investor who has long in-the-money
options on the expiry date will receive the exercise settlement value per unit of the option
from the investor who is short on the option.
Exercise process
The period during which an option is exercisable depends on the style of the option. On
NSE, index options and options on securities are European style, i.e. options are only
subject to automatic exercise on the expiration day, if they are in-the-money. Automatic
exercise means that all in-the-money options would be exercised by NSCCL on the
expiration day of the contract. The buyer of such options need not give an exercise notice in
such cases.
Exercise settlement computation
In case of option contracts, all open long positions at in-the-money strike prices are
automatically exercised on the expiration day and assigned to short positions in option
contracts with the same series on a random basis. Final exercise is automatically effected by
NSCCL for all open long in-the-money positions in the expiring month option contract, on
the expiry day of the option contract. The exercise settlement price is the closing price of the
underlying (index or security) on the expiry day of the relevant option contract. The exercise
settlement value is the difference between the strike price and the final settlement price of
the relevant option contract. For call options, the exercise settlement value receivable by a
buyer is the difference between the final settlement price and the strike price for each unit of
the underlying conveyed by the option contract, while for put options it is difference
between the strike price and the final settlement price for each unit of the underlying
conveyed by the option contract. Settlement of exercises of options is currently by payment
in cash and not by delivery of securities.
The exercise settlement value for each unit of the exercised contract is computed as follows:
Call options = Closing price of the security on the day of exercise Strike price
Put options = Strike price Closing price of the security on the day of exercise
The closing price of the underlying security is taken on the expiration day. The exercise
settlement value is debited / credited to the relevant CMs clearing bank account on T + 1
day (T = exercise date).
Special facility for settlement of institutional deals
NSCCL provides a special facility to Institutions/Foreign Institutional Investors
(FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared and
settled by their own CM. Such entities are called custodial participants (CPs). To avail of
this facility, a CP is required to register with NSCCL through his CM. A unique CP code is
allotted to the CP by NSCCL. All trades executed by a CP through any TM are required to
have the CP code in the relevant field on the trading system at the time of order entry. Such
trades executed on behalf of a CP are confirmed by their own CM (and not the CM of the
TM through whom the order is entered), within the time specified by NSE on the trade day
though the on-line confirmation facility.

Till such time the trade is confirmed by CM of concerned CP, the same is
considered as a trade of the TM and the responsibility of settlement of such trade vests with
CM of the TM. Once confirmed by CM of concerned CP, such CM is responsible for
clearing and settlement of deals of such custodial clients. FIIs have been permitted to trade
subject to compliance of the position limits prescribed for them and their sub-accounts, and
compliance with the prescribed procedure for settlement and reporting. A FII/a sub-account
of the FII, as the case may be, intending to trade in the F&O segment of the exchange, is
required to obtain a unique Custodial Participant (CP) code allotted from the NSCCL. FII/
sub-accounts of FIIs which have been allotted a unique CP code by NSCCL are only
permitted to trade on the F&O segment.
Risk Management
NSCCL has developed a comprehensive risk containment mechanism for the F&O segment.
Risk containment measures include capital adequacy requirements of members, monitoring
of member performance and track record, stringent margin requirements, position limits
based on capital, online monitoring of member positions and automatic disablement from
trading when limits are breached. The salient features of risk containment mechanism on the
F&O segment are:
There are stringent requirements for members in terms of capital adequacy measured in
terms of net worth and security deposits.
1.

NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies
the initial margin requirements for each futures/options contract on a daily basis. The CM in
turn collects the initial margin from the TMs and their respective clients.

2.

Client margins: NSCCL intimates all members of the margin liability of each of their
client. Additionally members are also required to report details of margins collected from
clients to NSCCL, which holds in trust client margin monies to the extent reported by the
member as having been collected form their respective clients.

3.

The open positions of the members are marked to market based on contract settlement
price for each contract. The difference is settled in cash on a T+1 basis.

4.

NSCCLs on-line position monitoring system monitors a CMs open positions on a


realtime basis. Limits are set for each CM based on his capital deposits. The on-line position
monitoring system generates alerts whenever a CM reaches a position limit set up by
NSCCL. At 100% the clearing facility provided to the CM shall be withdrawn. Withdrawal
of clearing facility of a CM in case of a violation will lead to

withdrawal of trading facility for all TMs and/ or custodial participants clearing and settling
through the CM
5.

CMs are provided a trading terminal for the purpose of monitoring the open positions of
all the TMs clearing and settling through him. A CM may set exposure limits for a TM
clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure
limits set up by a CM and whenever a TM exceed the limits, it stops that particular TM from
further trading. Further trading members are monitored based on positions limits. Trading
facility is withdrawn when the open positions of the trading member exceeds the position
limit.

6.

A member is alerted of his position to enable him to adjust his exposure or bring in
additional capital.

7.

A separate settlement guarantee fund for this segment has been created out of the capital
of members.
The most critical component of risk containment mechanism for F&O segment is the
margining system and on-line position monitoring. The actual position monitoring and
margining is carried out on-line through Parallel Risk Management System (PRISM).
PRISM uses SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of
computation of on-line margins, based on the parameters defined by SEBI.
1) NSCCL-SPAN
The objective of NSCCL-SPAN is to identify overall risk in a portfolio of all futures and
options contracts for each member. The system treats futures and options contracts
uniformly, while at the same time recognizing the unique exposures associated with options
portfolios, like extremely deep out-of-the-money short positions and inter-month risk. Its
over-riding objective is to determine the largest loss that a portfolio might reasonably be
expected to suffer from one day to the next day based on 99% VaR methodology.
2) Types of margins
The margining system for F&O segment is explained below:

Initial margin: Margin in the F&O segment is computed by NSCCL upto client level for
open positions of CMs/TMs. These are required to be paid up-front on gross basis at
individual client level for client positions and on net basis for proprietary positions. NSCCL
collects initial margin for all the open positions of a CM based on the margins computed by
NSE-SPAN. A CM is required to ensure collection of adequate initial margin from his TMs
and his respective clients. The TM is required to collect adequate initial margins up-front
from his clients.

Premium margin: In addition to initial margin, premium margin is charged at client level.
This margin is required to be paid by a buyer of an option till the premium settlement is
complete.

Assignment margin: Assignment margin is levied in addition to initial margin and premium
margin. It is required to be paid on assigned positions of CMs towards exercise settlement
obligations for option contracts, till such obligations are fulfilled. The margin is charged on
the net exercise settlement value payable by a CM.
Margining System
NSCCL has developed a comprehensive risk containment mechanism for the Futures &
Options segment. The most critical component of a risk containment mechanism is the
online position monitoring and margining system. The actual margining and position
monitoring is done online, on an intra-day basis using PRISM (Parallel Risk Management
System) which is the realtime position monitoring and risk management system. The risk of
each trading and clearing member is monitored on a real-time basis and alerts/disablement
messages are generated if the member crosses the set limits.
SPAN approach of computing initial margins
The objective of SPAN is to identify overall risk in a portfolio of futures and options
contracts for each member. The system treats futures and options contracts uniformly, while
at the same time recognizing the unique exposures associated with options portfolios like
extremely deep out-of-the-money short positions, inter-month risk and inter-commodity
risk.
Because SPAN is used to determine performance bond requirements (margin requirements),
its overriding objective is to determine the largest loss that a portfolio might reasonably be
expected to suffer from one day to the next day.
In standard pricing models, three factors most directly affect the value of an option at a
given point in time:

1.

Underlying market price

2.

Volatility (variability) of underlying instrument

3.

Time to expiration
As these factors change, so too will the value of futures and options maintained within a
portfolio. SPAN constructs sixteen scenarios of probable changes in underlying prices and
volatilities in order to identify the largest loss a portfolio might suffer from one day to the
next. It then sets the margin requirement at a level sufficient to cover this one-day loss.
The computation of worst scenario loss has two components. The first is the valuation of
each contract under sixteen scenarios. The second is the application of these scenario
contract values to the actual positions in a portfolio to compute the portfolio values and the
worst scenario loss. The scenario contract values are updated at least 5 times in the day,
which may be carried out by taking prices at the start of trading, at 11:00 a.m., at 12:30
p.m., at 2:00 p.m., and at the end of the trading session.

Mechanics of SPAN
The results of complex calculations (e.g. the pricing of options) in SPAN are called risk
arrays. Risk arrays, and other necessary data inputs for margin calculation are then provided
to members on a daily basis in a file called the SPAN Risk Parameter file. Members can
apply the data contained in the risk parameter files, to their specific portfolios of futures and
options contracts, to determine their SPAN margin requirements. SPAN has the ability to
estimate risk for combined futures and options portfolios, and re-value the same under
various scenarios of changing market conditions.
Risk arrays
The SPAN risk array represents how a specific derivative instrument (for example, an option
on NIFTY index at a specific strike price) will gain or lose value, from the current point in
time to a specific point in time in the near future, for a specific set of market conditions
which may occur over this time duration.
The results of the calculation for each risk scenario i.e. the amount by which the futures and
options contracts will gain or lose value over the look-ahead time under that risk scenario is called the risk array value for that scenario. The set of risk array values for each futures
and options contract under the full set of risk scenarios, constitutes the risk array for that
contract.
In the risk array, losses are represented as positive values, and gains as negative values. Risk
array values are represented in Indian Rupees, the currency in which the futures or options
contract is denominated.
Risk scenarios
The specific set of market conditions evaluated by SPAN, are called the risk scenarios, and
these are defined in terms of:
1.

How much the price of the underlying instrument is expected to change over one trading
day, and

2.

How much the volatility of that underlying price is expected to change over one trading
day.
SPAN further uses a standardized definition of the risk scenarios, defined in terms of:

1.
2.

The underlying price scan range or probable price change over a one day period, and
The underlying price volatility scan range or probable volatility change of the underlying
over a one day period.
Table gives the sixteen risk scenarios. +1 refers to increase in volatility and -1 refers to
decrease in volatility.
Worst scenario loss
Risk scenario
number

Price move in
multiples of

Volatility move
multiples of

Fraction of loss
considered (%)

price scan range

volatility range

+1

100

-1

100

+1/3

+1

100

+1/3

-1

100

-1/3

+1

100

-1/3

-1

100

+2/3

+1

100

+2/3

-1

100

-2/3

+1

100

10

-2/3

-1

100

11

+1

+1

100

12

+1

-1

100

13

-1

+1

100

14

-1

-1

100

15

+2

35

16

-2

35

Method of computation of volatility


The exponential moving average method is used to obtain the volatility estimate every day.
The estimate at the end of day t, s t is estimated using the previous days volatility estimate s t
1 (as at the end of day t-1), and the return rt observed in the futures market on day t.

whereis l a parameter which determines how rapidly volatility estimates change. A value of
0.94 is used for l
SPAN uses the risk arrays to scan probable underlying market price changes and probable
volatility changes for all contracts in a portfolio, in order to determine value gains and
losses at the portfolio level. This is the single most important calculation executed by the
system.
Scanning risk charge
As shown in the table giving the sixteen standard risk scenarios, SPAN starts at the last
underlying market settlement price and scans up and down three even intervals of price
changes (price scan range). At each price scan point, the program also scans up and down a
range of probable volatility from the underlying markets current volatility (volatility scan
range). SPAN calculates the probable premium value at each price scan point for volatility
up and volatility down scenario. It then compares this probable premium value to the
theoretical premium value (based on last closing value of the underlying) to determine profit
or loss.
Deep-out-of-the-money short options positions pose a special risk identification problem. As
they move towards expiration, they may not be significantly exposed to normal price
moves in the underlying. However, unusually large underlying price changes may cause
these options to move into-the-money, thus creating large losses to the holders of short
option positions. In order to account for this possibility, two of the standard risk scenarios in
the risk array, Number 15 and 16, reflect an extreme underlying price movement,
currently defined as double the maximum price scan range for a given underlying. However,
because price changes of these magnitudes are rare, the system only covers 35% of the
resulting losses.
After SPAN has scanned the 16 different scenarios of underlying market price and volatility
changes, it selects the largest loss from among these 16 observations. This largest
reasonable loss is the scanning risk charge for the portfolio.
Calendar spread margin
A calendar spread is a position in an underlying with one maturity which is hedged by an
offsetting position in the same underlying with a different maturity: for example, a short
position in a July futures contract on Reliance and a long position in the August futures
contract on Reliance is a calendar spread. Calendar spreads attract lower margins because
they are not exposed to market risk of the underlying. If the underlying rises, the July

contract would make a loss while the August contract would make a profit.
As SPAN scans futures prices within a single underlying instrument, it assumes that price
moves correlate perfectly across contract months. Since price moves across contract months
do not generally exhibit perfect correlation, SPAN adds an calendar spread charge (also
called the inter-month spread charge) to the scanning risk charge associated with each
futures and options contract. To put it in a different way, the calendar spread charge covers
the calendar basis risk that may exist for portfolios containing futures and options with
different expirations.
For each futures and options contract, SPAN identifies the delta associated each futures and
option position, for a contract month. It then forms spreads using these deltas across
contract months. For each spread formed, SPAN assesses a specific charge per spread which
constitutes the calendar spread charge.
The margin for calendar spread is calculated on the basis of delta of the portfolio in each
month. Thus a portfolio consisting of a near month option with a delta of 100 and a far
month option with a delta of 100 would bear a spread charge equivalent to the calendar
spread charge for a portfolio which is long 100 near month futures contract and short 100
far month futures contract. A calendar spread position on Exchange traded equity derivatives
may be granted calendar spread treatment till the expiry of the near month contract.
Margin on calendar spreads is levied at 0.5% per month of spread on the far month contract
of the spread subject to a minimum margin of 1% and a maximum margin of 3% on the far
month contract of the spread.
Short option minimum margin
Short options positions in extremely deep-out-of-the-money strikes may appear to have little
or no risk across the entire scanning range. However, in the event that underlying market
conditions change sufficiently, these options may move into-the-money, thereby generating
large losses for the short positions in these options. To cover the risks associated with deepout-of-the-money short options positions, SPAN assesses a minimum margin for each short
option position in the portfolio called the short option minimum charge, which is set by the
NSCCL. The short option minimum charge serves as a minimum charge towards margin
requirements for each short position in an option contract.
For example, suppose that the short option minimum charge is Rs.50 per short position. A
portfolio containing 20 short options will have a margin requirement of at least Rs. 1,000,
even if the scanning risk charge plus the calendar spread charge on the position is only Rs.
500.
The short option minimum margin equal to 3% of the notional value of all short index
options is charged if sum of the worst scenario loss and the calendar spread margin is lower
than the short option minimum margin. For stock options it is equal to 7.5% of the notional
value based on the previous days closing value of the underlying stock. Notional value of
option positions is calculated on the short option positions by applying the last closing price
of the relevant underlying.
Net option value

The net option value is calculated as the current market value of the option times the
number of option units (positive for long options and negative for short options) in the
portfolio.
Net option value is added to the liquid net worth of the clearing member. This means that
the current market value of short options are deducted from the liquid net worth and the
market value of long options are added thereto. Thus mark to market gains and losses on
option positions get adjusted against the available liquid net worth.
Net buy premium
To cover the one day risk on long option positions (for which premium shall be payable on
T+1 day), net buy premium to the extent of the net long options position value is deducted
from the Liquid Networth of the member on a real time basis. This would be applicable only
for trades done on a given day. The net buy premium margin shall be released towards the
Liquid Networth of the member on T+1 day after the completion of pay-in towards
premium settlement.
Overall portfolio margin requirement
The total margin requirements for a member for a portfolio of futures and options contract
would be computed by SPAN as follows:
1.

Adds up the scanning risk charges and the calendar spread charges.

2.

Compares this figure to the short option minimum charge and selects the larger of the
two. This is the SPAN risk requirement.

3.

Total SPAN margin requirement is equal to SPAN risk requirement less the net option
value, which is mark to market value of difference in long option positions and short option
positions.

4.

Initial margin requirement = Total SPAN margin requirement + Net Buy Premium.
Cross Margining
Cross margining benefit is provided for off-setting positions at an individual client level in
equity and equity derivatives segment. The cross margin benefit is provided on following
offsetting positions-

a.

Index Futures and constituent Stock Futures positions in F&O segment

b.

Index futures position in F&O segment and constituent stock positions in CM segment

c.

Stock futures position in F&O segment and stock positions in CM segment

1.

In order to extend the cross margining benefit as per (a) and (b) above, the basket of
constituent stock futures/ stock positions needs to be a complete replica of the index futures.

2.

The positions in F&O segment for stock futures and index futures of the same expiry
month are eligible for cross margining benefit.

3.

The position in a security is considered only once for providing cross margining benefit.
E.g. Positions in Stock Futures of security A used to set-off against index futures positions is
not considered again if there is a off-setting positions.

4.

Positions in option contracts are not considered for cross margining benefit. The positions
which are eligible for offset are subjected to spread margins. The spread margins shall be
25% of the applicable upfront margins on the offsetting positions.

5.

Securities shall not include any unit linked insurance policy or scrips or any
such
instrument or unit, by what-ever name called, which provides a combined benefit risk on the
life of the persons and investments by such persons and issued by an insurer referred to in
clause (9) of section 2 of the insurance Act, 1938 (4 of 1938)

Prior to the implementation of a cross margining mechanism positions in the


equity and equity derivatives segment were been treated separately, despite being traded on
the common underlying securities in both the segments. For example, Mr. X bought 100
shares of a security A in the capital market segment and sold 100 shares of the same security
in single stock futures of the F&O segment. Margins were payable in the capital market and
F&O segments separately. If the margins payable in the capital market segment is Rs.100
and in the F&O segment is Rs. 140, the total margin payable by MR. X is Rs.240. The risk
arising out of the open position of Mr. X in the capital market segment is significantly
mitigated by the corresponding off-setting position in the F&O segment. Cross margining
mechanism reduces the margin for Mr. X from Rs. 240 to only Rs. 60.

Regulatory Framework
The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI
Act, the rules and regulations framed under that and the rules and byelaws of the stock
exchanges. This Chapter takes a look at the legal and regulatory framework for derivatives
trading in India. It also, discusses in detail the recommendation of the LC Gupta Committee
for trading of derivatives in India.
Securities Contracts (Regulation) Act, 1956

SC(R)A regulates transactions in securities markets along with derivatives markets. The
original act was introduced in 1956. It was subsequently amended in 1996, 1999, 2004,
2007 and 2010. It now governs the trading of securities in India. The term securities has
been defined in the amended SC(R)A under the Section 2(h) to include:

Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities
of a like nature in or of any incorporated company or other body corporate.
Derivative.
Units or any other instrument issued by any collective investment scheme to the investors
in such schemes.
Security receipt as defined in clause (zg) of section 2 of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002

Units or any other such instrument issued to the investor under any mutual fund scheme5.
Any certificate or instrument (by whatever name called), issued to an investor by an
issuer being a special purpose distinct entity which possesses any debt or receivable,
including mortgage debt, assigned to such entity, and acknowledging beneficial interest of
such investor in such debt or receivable, including mortgage debt as the case may be.

Government securities

Such other instruments as may be declared by the Central Government to be securities.

Rights or interests in securities.

Derivative is defined to include:


(a)

A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.

(b)

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

Section 18A of the SC(R)A provides that notwithstanding anything contained in any other
law for the time being in force, contracts in derivative shall be legal and valid if such
contracts are:

Traded on a recognized stock exchange


Settled on the clearing house of the recognized stock exchange, in accordance with the
rules and byelaws of such stock exchanges.

Securities and Exchange Board of India Act, 1992


SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India
(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b)
promoting the development of the securities market and (c) regulating the securities market.
Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of
securities, in addition to all intermediaries and persons associated with securities market.
SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit.
In particular, it has powers for:

regulating the business in stock exchanges and any other securities markets.

registering and regulating the working of stock brokers, subbrokers etc.

promoting and regulating self-regulatory organizations.

prohibiting fraudulent and unfair trade practices relating to securities markets.

calling for information from, undertaking inspection, conducting inquiries and audits of
the stock exchanges, mutual funds and other persons associated with the securities market
and other intermediaries and selfregulatory organizations in the securities market.

performing such functions and exercising according to Securities Contracts


(Regulation) Act, 1956, as may be delegated to it by the Central Government.
Regulation for Derivatives Trading
SEBI set up a 24-member committee under the Chairmanship of Dr. L. C. Gupta to develop
the appropriate regulatory framework for derivatives trading in India. On May 11, 1998
SEBI accepted the recommendations of the committee and approved the phased introduction
of derivatives trading in India beginning with stock index futures.
87 According to this framework:

Any Exchange fulfilling the eligibility criteria can apply to SEBI for grant of recognition
under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives
exchange/segment should have a separate governing council and representation of
trading/clearing members shall be limited to maximum of 40% of the total members of the
governing council. The exchange would have to regulate the sales practices of its members
and would have to obtain prior approval of SEBI before start of trading in any derivative
contract.
The Exchange should have minimum 50 members.
The members of an existing segment of the exchange would not automatically become the
members of derivative segment. The members seeking admission in the derivative segment
of the exchange would need to fulfill the eligibility conditions.

The clearing and settlement of derivatives trades would be through a SEBI approved
clearing corporation/house. Clearing corporations/houses complying with the eligibility
conditions as laid down by the committee have to apply to SEBI for approval.

Derivative brokers/dealers and clearing members are required to seek registration from
SEBI. This is in addition to their registration as brokers of existing stock exchanges. The
minimum networth for clearing members of the derivatives clearing corporation/ house shall
be Rs.300 Lakh. The networth of the member shall be computed as follows:

Capital + Free reserves

Less non-allowable assets viz.,

(a) Fixed assets


(b) Pledged securities
(c) Members card
(d) Non-allowable securities (unlisted securities)

(e) Bad deliveries


(f) Doubtful debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30% marketable securities

The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit
details of the futures contract they propose to introduce.

The initial margin requirement, exposure limits linked to capital adequacy and margin
demands related to the risk of loss on the position will be prescribed by SEBI/Exchange
from time to time.

There will be strict enforcement of Know your customer rule and requires that every
client shall be registered with the derivatives broker. The members of the derivatives
segment are also required to make their clients aware of the risks involved in derivatives
trading by issuing to the client the Risk Disclosure Document and obtain a copy of the
same duly signed by the client.

The trading members are required to have qualified approved user and sales person who
should have passed a certification programme approved by SEBI.
Forms of collaterals acceptable at NSCCL
Members and authorized dealers have to fulfill certain requirements and provide collateral
deposits to become members of the F&O segment. All collateral deposits are segregated
into cash component and non-cash component. Cash component means cash, bank
guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash
component mean all other forms of collateral deposits like deposit of approved demat
securities.
Requirements to become F&O segment member
The eligibility criteria for membership on the F&O segment is as given in table 9.1.
Requirements for professional clearing membership are provided in table 9.2. Anybody
interested in taking membership of F&O segment is required to take membership of CM
and F&O segment or CM, WDM and F&O segment. An existing member of CM
segment can also take membership of F&O segment. A trading member can also be a
clearing member by meeting additional requirements. There can also be only clearing
members.
Eligibility criteria for membership on F&O segment (corporates)
Particulars (all values in

CM and F&O segment

CM, WDM and F&O

Rs. Lakh)

Segment

Minimum Paid Up Capital

30

30

Net worth1

100 (Membership in CM
segment and Trading/
Trading and self-clearing

200 (Membership in WDM


segment, CM segment and
trading/trading and self
clearing membership in
F&O
segment)

membership in F&O
segment)
300 (Membership in CM
segment and trading and
clearing membership in
F&O
Segment)

300 (Membership in WDM


segment, CM segment
and Trading and clearing
membership in F&O
segment)

Interest free
security
deposit (IFSD) with
NSEIL

110

260

Interest free security


deposit (IFSD) with
NSCCL

15*

15*

25**
1

25**
2

Collateral security
deposit (CSD)3
Annual subscription

Notes for Table


1 No additional networth is required for self clearing members. However, a networth of Rs.
300 Lakh is required for TM-CM and PCM.
*

Additional IFSD of 25 lakhs with NSCCL is required for Trading and Clearing (TM-CM)
and for Trading and Self clearing member (TM/SCM).

Additional Collateral Security Deposit (CSD) of 25 lakhs with NSCCL is required for
Trading and Clearing (TM-CM) and for Trading and Self clearing member (TM/SCM).

In addition, a member clearing for others is required to bring in IFSD of Rs. 2 lakh and CSD
of Rs. 8 lakh per trading member he undertakes to clear in the F&O segment.

Table Requirements for Professional Clearing Membership


(Amount in Rs. lakh)
Particulars
Eligibility

CM Segment

F&O Segment

Trading Member of NSE/SEBI Registered


Custodians/Recognised Banks

Net Worth

300

300

Interest Free Security Deposit


(IFSD)*

25

25

Collateral Security Deposit (CSD)

25

25

Annual Subscription

2.5

Nil

*The Professional Clearing Member (PCM) is required to bring in IFSD of Rs. 2 lakh and
CSD of Rs. 8 lakh per trading member whose trades he undertakes to clear in the F&O
segment and IFSD of Rs. 6 lakh and CSD of Rs. 17.5 lakh (Rs. 9 lakh and Rs. 25 lakh
respectively for corporate Members) per trading member in the CM segment.
Requirements to become authorized / approved user
Trading members and participants are allowed to appoint, with the approval of the F&O
segment of the exchange, authorized persons and approved users to operate the trading
workstation(s). These authorized users can be individuals, registered partnership firms or
corporate bodies as defined under the Companies Act, 1956.
Authorized persons cannot collect any commission or any amount directly from the clients
he introduces to the trading member who appointed him. However he can receive a
commission or any such amount from the trading member who appointed him as provided
under regulation.
Approved users on the F&O segment have to pass a certification program which has been
approved by SEBI. Each approved user is given a unique identification number through
which he will have access to the NEAT system. The approved user can access the NEAT
system through a password and can change such password from time to time.
Position limits
Position limits have been specified by SEBI at trading member, client, market and FII levels
respectively.
Trading member position limits

Trading member position limits are specified as given below:


1.

Trading member position limits in equity index option contracts: The trading member
position limits in equity index option contracts is higher of Rs.500 crore or 15% of the total
open interest in the market in equity index option contracts. This limit is applicable on open
positions in all option contracts on a particular underlying index.

2.

Trading member position limits in equity index futures contracts: The trading member
position limits in equity index futures contracts is higher of Rs.500 crore or 15% of the total
open interest in the market in equity index futures contracts. This limit is applicable on open
positions in all futures contracts on a particular underlying index.

3.

Trading member position limits for combined futures and options position:

For stocks having applicable market-wise position limit (MWPL) of Rs.500 crores or more,
the combined futures and options position limit is 20% of applicable MWPL or Rs.300
crores, whichever is lower and within which stock futures position cannot exceed 10% of
applicable MWPL or Rs.150 crores, whichever is lower.

For stocks having applicable market-wise position limit (MWPL) less than Rs.500 crores,
the combined futures and options position limit is 20% of applicable MWPL and futures
position cannot exceed 20% of applicable MWPL or Rs.50 crore which ever is lower. The
Clearing Corporation shall specify the trading member-wise position limits on the last
trading day month which shall be reckoned for the purpose during the next month.

Client level position limits


The gross open position for each client, across all the derivative contracts on an underlying,
should not exceed 1% of the free float market capitalization (in terms of number of shares)
or 5% of the open interest in all derivative contracts in the same underlying stock (in terms
of number of shares) whichever is higher.
Market wide position limits
The market wide limit of open position (in terms of the number of underlying stock) on
futures and option contracts on a particular underlying stock is 20% of the number of shares
held by non-promoters in the relevant underlying security i.e. 20% of the freefloat in terms
of no. of shares of a company. This limit is applicable on all open positions in all futures and
option contracts on a particular underlying stock. The enforcement of the market wide limits
is done in the following manner:

At end of the day the exchange tests whether the market wide open interest for any scrip
exceeds 95% of the market wide position limit for that scrip. In case it does so, the exchange
takes note of open position of all client/TMs as at end of that day for that scrip and from
next day onwards they can trade only to decrease their positions through offsetting
positions.

At the end of each day during which the ban on fresh positions is in force for any scrip,
the exchange tests whether any member or client has increased his existing positions or has
created a new position in that scrip. If so, that client is subject to a penalty equal to a
specified percentage (or basis points) of the increase in the position (in terms of notional
value). The penalty is recovered before trading begins next day. The exchange specifies the
percentage or basis points, which is set high enough to deter violations of the ban on
increasing positions.

The normal trading in the scrip is resumed after the open outstanding position comes
down to 80% or below of the market wide position limit. Further, the exchange also checks
on a monthly basis, whether a stock has remained subject to the ban on new position for a
significant part of the month consistently for three months. If so, then the exchange phases
out derivative contracts on that underlying.
FII / MFs position limits
FII and MFs position limits are specified as given below:

1.

The FII and MF position limits in all index options contracts on a particular underlying
index are Rs. 500 crores or 15% of the total open interest of the market in index options,
whichever is higher, per exchange. This limit is applicable on open positions in all option
contracts on a particular underlying index.

2.

FII and MF position limits in all index futures contracts on a particular underlying index
is the same as mentioned above for FII and MF position limits in index option contracts.
This limit is applicable on open positions in all futures contracts on a particular underlying
index.
In addition to the above, FIIs and MFs can take exposure in equity index derivatives subject
to the following limits:

a.

Short positions in index derivatives (short futures, short calls and long puts) not
exceeding (in notional value) the FIIs/MFs holding of stocks.

b.

Long positions in index derivatives (long futures, long calls and short puts) not exceeding
(in notional value) the FIIs/MFs holding of cash, government securities, T-bills and similar
instruments.

In this regards, if the open positions of the FII/MF exceeds the limits as stated in point no.
(a) and (b) above, such surplus is deemed to comprise of short and long positions in the
same proportion of the total open positions individually. Such short and long positions in
excess of the said limits are compared with the FIIs/MFs holding in stocks, cash etc in a
specified format.
3.

For stocks having applicable market-wide position limit (MWPL) of Rs. 500 crores or
more, the combined futures and options position limit is 20% of applicable MWPL or Rs.
300 crores, whichever is lower and within which stock futures position cannot exceed 10%
of applicable MWPL or Rs. 150 crores, whichever is lower.
For stocks having applicable market-wide position limit of less than Rs. 500 crores, the
combined futures and options position limit is 20% of applicable MWPL and futures
position cannot exceed 20% of the applicable MWPL or Rs. 50 crore whichever is lower.
The FIIs should report to the clearing member (custodian) the extent of the FIIs holding of
stocks, cash, government securities, T-bills and similar instruments before the end of the
day. The clearing member (custodian) in turn should report the same to the exchange. The
exchange monitors the FII position limits. The position limit for sub-account is same as that
of client level position limits.
At the level of the FII sub-account /MF scheme
Mutual Funds are allowed to participate in the derivatives market at par with Foreign
Institutional Investors (FII). Accordingly, mutual funds shall be treated at par with a
registered FII in respect of position limits in index futures, index options, stock options and
stock futures contracts. Mutual funds will be considered as trading members like registered
FIIs and the schemes of mutual funds will be treated as clients like sub-accounts of FIIs.
The position limits for Mutual Funds and its schemes shall be as under:

1.

Position limit for MFs in index futures and options contracts

A disclosure is required from any person or persons acting in concert who together own
15% or more of the open interest of all futures and options contracts on particular
underlying index on the Exchange. Failing to do so, is a violation of the rules and
regulations and attracts penalty and disciplinary action.

2.

Position limit for MFs in stock futures and options


The gross open position across all futures and options contracts on a particular underlying
security, of a sub-account of an FII, / MF scheme should not exceed the higher of:

1% of the free float market capitalisation (in terms of number of shares), OR

5% of the open interest in the derivative contracts on a particular underlying stock (in terms
of number of contracts). These position limits are applicable on the combined position in all
futures and options contracts on an underlying security on the Exchange.
Reporting of client margin
Clearing Members (CMs) and Trading Members (TMs) are required to collect upfront initial
margins from all their Trading Members/ Constituents.
CMs are required to compulsorily report, on a daily basis, details in respect of such margin
amount due and collected, from the TMs/ Constituents clearing and settling through them,
with respect to the trades executed/ open positions of the TMs/ Constituents, which the CMs
have paid to NSCCL, for the purpose of meeting margin requirements.
Similarly, TMs are required to report on a daily basis details in respect of such margin
amount due and collected from the constituents clearing and settling through them, with
respect to the trades executed/ open positions of the constituents, which the trading
members have paid to the CMs, and on which the CMs have allowed initial margin limit to
the TMs.
Penalties, as specified by the stock exchange, is levied on trading members for shortcollection / non-collection of margins from clients.

Adjustments for Corporate Actions

Adjustments for corporate actions for stock options would be as follows:

The basis for any adjustment for corporate action shall be such that the value of the
position of the market participants on cum and ex-date for corporate action shall continue to

remain the same as far as possible. This will facilitate in retaining the relative status of
positions namely in-the-money, at-the-money and out-of-money. This will also address
issues related to exercise and assignments.

Adjustment for corporate actions shall be carried out on the last day on which a security
is traded on a cum basis in the underlying cash market.

Adjustments shall mean modifications to positions and/or contract specifications namely


strike price, position, market lot, multiplier. These adjustments shall be carried out on all
open, exercised as well as assigned positions.

INDUSTRY PROFILE

HISTORY OF STOCK EXCHANGE:The only stock exchanges operating in the 19th century were those of Bombay set up in
1875 and Ahmadabad set up in 1894. These were organized as voluntary non profitmaking association of brokers to regulate and protect their interests. Before the control
on securities trading became central subject under the constitution in 1950, it was a state
subject and the Bombay securities contracts (control) Act of 1925 used to regulate
trading in securities. Under this act, the Bombay stock exchange was recognized in 1927
and Ahmadabad in 1937.
During the war boom, a number of stock exchanges were organized in Bombay,
Ahmadabad and other centers, but they were not recognized. Soon after it became a
central subject, central legislation was proposed and a committee headed by A.D.
Gorwala went into the bill for securities regulation. On the basis of the committees
recommendations and public discussion, the securities contracts (regulation) Act became
law in 1956.
DEFINITION OF STOCK EXCHANGE:Stock exchange means anybody or individuals whether incorporated or not, constituted
for the purpose of assisting, regulating or controlling the business of buying, selling or
dealing in securities.
It is an association of member brokers for the purpose of self-regulation and protecting
the interests of its members.
It can operate only if it is recognized by the Government under the securities contracts
(regulation) Act, 1956. The recognition is granted under section 3 of the Act by the
central government, Ministry of Finance.
BY LAWS:Besides the above act, the securities contracts (regulation) rules were also made in 1975
to regulative certain matters of trading on the stock exchanges. There are also bylaws of
the exchanges, which are concerned with the following subjects.
Opening / closing of the stock exchanges, timing of trading, regulation of blank
transfers, regulation of Badla or carryover business, control of the settlement and other

72

activities of the stock exchange, fixating of margin, fixation of market prices or making
up prices, regulation of taravani business (jobbing), etc., regulation of brokers trading,
brokerage chargers, trading rules on the exchange, arbitrage and settlement of disputes,
settlement and clearing of the trading etc.
REGULATION OF STOCK EXCHANGES:The securities contracts (regulation) act is the basis for operations of the stock exchanges
in India. No exchange can operate legally without the government permission or
recognition. Stock exchanges are given monopoly in certain areas under section 19 of the
above Act to ensure that the control and regulation are facilitated. Recognition can be
granted to a stock exchange provided certain conditions are satisfied and the necessary
information is supplied to the government. Recognition can also be withdrawn, if
necessary. Where there are no stock exchanges, the government licenses some of the
brokers to perform the functions of a stock exchange in its absence.
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI):SEBI was set up as an autonomous regulatory authority by the government of India in
1988 to protect the interests of investors in securities and to promote the development
of, and to regulate the securities market and for matter connected therewith or incidental
thereto. It is empowered by two acts namely the SEBI Act, 1992 and the securities
contract (regulation) Act, 1956 to perform the function of protecting investors rights and
regulating the capital markets.
BOMBAY STOCK EXCHANGE:This stock exchange, Mumbai, popularly known as BSE was established in
1875 as The Native share and stock brokers association, as a voluntary non-profit
making association. It has an evolved over the years into its present status as the
premiere stock exchange in the country. It may be noted that the stock exchanges the
oldest one in Asia, even older than the Tokyo stock exchange, which was founded in
1878.
The exchange, while providing an efficient and transparent market for
trading in securities, upholds the interests of the investors and ensures redressed of their
grievances, whether against the companies or its own member brokers. It also strives to
educate and enlighten the investors by making available necessary informative inputs
and conducting investor education programs.
A governing board comprising of 9 elected directors, 2 SEBI nominees, 7 public
representatives and an executive director is the apex body, which decides is the apex
body, which decides the policies and regulates the affairs of the exchange.
The Exchange director as the chief executive offices is responsible for the daily today
administration of the exchange.

73

BSE INDICES:In order to enable the market participants, analysts etc., to track the various ups and
downs in the Indian stock market, the Exchange has introduced in 1986 an equity stock
index called BSE-SENSEX that subsequently became the barometer of the moments of
the share prices in the Indian stock market. It is a Market capitalization weighted index
of 30 component stocks representing a sample of large, well-established and leading
companies. The base year of Sensex is 1978-79. The Sensex is widely reported in both
domestic and international markets through print as well as electronic media.
Sensex is calculated using a market capitalization weighted method. As per this
methodology the level of the index reflects the total market value of all 30-component
stocks from different industries related to particular base period. The total market value
of a company is determined by multiplying the price of its stock by the nu7mber of
shared outstanding. Statisticians call index of a set of combined variables (such as price
and number of shares) a composite Index. An indexed number is used to represent the
results of this allocution in order to make the value easier to go work with and track over
a time. It is much easier to graph a chart based on Indexed values than on based on
actual valued world over majority of the well-known Indices are constructed using
Market capitalization weighted method.
In practice, the daily calculation of SENSEX is done by dividing the
aggregate market value of the 30 companies in the index by a number called the Index
Divisor. The divisor is the only link to the original base period value of the SENSEX.
The Devisor keeps the Index comparable over a period value of time and if the
references point for the entire Index maintenance adjustments. SENSEX Is widely used
to describe the mood in the Indian stock markets. Base year average is changed as per
the formula new base year average = old base year average*(new market value / old
market value).
NATIONAL STOCK EXCHANGE:The NSE was incorporated in Nov, 1992 with an equity capital of Rs.25 crs. The
international securities consultancy (ISC) of Hong Kong has helped in setting up NSE.
ISC has prepared the detailed business plans and initialization of hardware and software
systems. The promotions for NSE were financial institutions, insurances, companies,
banks and SEBI capital market ltd, Infrastructure leasing and financial services ltd and
stock holding corporations ltd.
It has been set up to strengthen the move towards professionalization of the capital
market as well as provide nationwide securities trading facilities to investors.
NSE is not an exchange in the traditional sense where brokers own and manage the
exchange. A two tier administrative set up involving a company board and a governing
aboard of the exchange is envisaged.
NSE is a national market for shares PSU bonds, debentures and government securities
since infrastructure and trading facilities are provided.

74

NSE-NIFTY:The NSE on Apr22, 1996 launched a new equity Index. The NSE-50. The new Index
which replaces the existing NSE-100 Index is expected to serve as an appropriate Index
for the new segment of future and option.
NIFTY mean National Index for fifty stocks. The NSE-50 comprises fifty companies
that represent 20 board industry groups with an aggregate market capitalization of
around Rs 1, 70,000 crs. All companies included in the Index have a market
capitalization in excess of Rs. 500 crs each and should have trade for 85% of trading
days at an impact cost of less than 1.5%.
The base period for the index is the close of price on Nov 3 1995, which makes one year
of completion of operation of NSEs capital market segment. The base value of the index
has been set at 1000.
NSE-MIDCAP INDEX:The NSE madcap index or the junior nifty comprises 50 stocks that represent 21 board
industry groups and will provide proper representation of the midcap segment of the
Indian capital market. All stocks in the Index should have market capitalization of more
than Rs.200 crs and should have traded 85% of the trading days at an impact cost of less
than 2.5%.
The base period for the index is Nov 4 1996, which signifies 2 years for
completion of operations of the capital market segment of the operations. The base value
of the Index has been set at 1000.
Average daily turnover of the present scenario is 258212 (Laces) and number of average
daily trades 2160(Laces).
At present there are 24 stock exchanges recognized under the securities contract
(regulation Act, 1956).

RESEARCH METHODOLOGY
Objectives of the Research
The main objectives of the project are as follows: To study the current scenario of derivatives market in India.
To study the role of derivatives in India financial market
To analyze whether the purpose for which derivatives are used has actually been
achieved.
To study in detail the role of futures and options
To study the concept of derivatives and the purpose for which financial institutions
adopt derivatives.

75

NEED FOR STUDY:


In recent times the Derivative markets have gained importance in terms of their vital
role in the economy. The increasing investments in derivatives (domestic as well as
overseas) have attracted my interest in this area. Through the use of derivative products,
it is possible to partially or fully transfer price risks by locking-in asset prices. As the
volume of trading is tremendously increasing in derivatives market, this analysis will be
of immense help to the investors.
TYPE OF RESEARCH:The type of research is selected on the basis of problems identified. Here the research
type used is descriptive research. Descriptive research includes fact-findings and
enquiries of different kinds. The major purpose of descriptive research is a description
of the state of affairs, as it exists in the present system. In this dissertation an attempt
has been made to discover various issues related to derivatives in the Indian market and
how they help the hedge the risk.

Limitations of the study

The study is conducted in Delhi only.


Since the study covers the overview of derivatives market, it cannot be generalized.
Data collected is only from secondary sources
The study is confined to only one week trading of 4 month contract
The study does not take any Nifty Index Futures and Options and International Markets
into the consideration.
This is a study conducted within a period of 45 days.
During this limited period of study, the study may not be a detailed, Full fledged and
utilitarian one in all aspects.
The study contains some assumptions based on the demands of the analysis.
The study does not provide any predictions or forecast of the selected scripts.
The study is done as per the syllabus prescribed by the University for the Award of the
MBA.

ACTUAL COLLECTION OF DATA: Data Collection from secondary Sources

Secondary data were gathered from numerous sources. While preparation


of this project report, the secondary data have been collected through:

76

Data was generated from general library research sources, textbooks, trade
journals, articles from newspaper, treasury management, brochures, interviews with
different brokers of Bangalore stock Exchange and Internet web site
www.nseindia.com
www.sherkhan.com
www.icfai.org
www.google.com
www.commodityindia.com

DATA ANALYSIS AND INTERPRETATION


Derivatives in India: A chronology

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 setup L.C. Gupta Committee to draft a policy framework for
index futures.

1 May 1998 a Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreement (FRAs) and
interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty Index Futures commenced at NSE.

25 September 2000 Nifty Futures trading commenced at SGX.

In July 2001 Trading of Nifty index Options and Stock Options commenced at NSE.

In Nov 2001 trading of stock Futures commenced at NSE.

77

TABLE 1: THE GLOBAL DERIVATIVES INDUSTRY: CHRONOLOGY OF


INSTRUMENTS
1874
Commodity futures
1972
Foreign currency futures
1973
Equity options
1975
T-bond futures
1981
Currency swaps
1982
Interest rate swaps; T-note futures; Eurodollar futures; Equity index
futures; Options on T-bond futures; Exchange listed currency options
1983
Options on equity index; Options on T-note futures; Options on currency
futures; Options on equity index Futures; Interest rates caps and floors
1985
Eurodollar options; Swaption
1987
OTC compound options; OTC average options
1989
Futures on interest rate swaps; Quanto options
1990
Equity index swaps
1991
Differential swaps
1993
Captions; Exchange-listed FLEX options
1994
Credit default options

Table 2: DERIVATIVES TRADING VOLUME AT NSE FROM OCT-12 TO


MARCH-13
Particulars
Stock
futures

Oct-12 Nov-12 Dec-12


214398 216526 280283

Index
Futures

170100 135478

183293

166127

Stock
Options

13575

12777

17244

17893

Index
Options

35586

31073

42987

Jan-13
Feb-13
Mar-13
265042 288715
473251

38521

156359

192035

15268

22466

32331

47097

Graph 1:- Showing the Derivatives trading volume at NSE from Oct 2012 to

78

Mar 2013

Derivatives Trading Volume


350000
300000

280283

250000

288715

265042

216526

214398
Stock
200000 Futures
170100

Index Futures
135478

150000

Stock Options
Index Options
183293
166127
156359

100000
50000
0

35586
13575
1

31073
12777
2

42987
17244
3

38521
17893
4

32331
15268
5

41183

41214

41244

41275

41306

Data

Interpretation:
Derivatives trading volume table clearly shows that there is consistent rise in the trading
volume of stock futures. Whereas index futures remains almost constant during these
six months. Stock options and index options tends to be lower as usual
Table 2:- Showing trading Contracts from Oct 2012 to Mar 2013.
Parti.

Oct-12

Stock

6526919

Nov-12

Dec-12

6252736 757137

Jan-13

Feb-13

7134199 7443178

79

Mar-13
10844400

Futures
Index
6844732 5238175
Futures

6613032 5760999 5186835

5952206

Stock
Options

456529

537261

389254

364188

Index
1410519 1200557
Options

456055

401973

1540180 1330466

1066396

1456351

Graph 2:- Showing the Derivatives trading Contracts at NSE from Oct 2012 to
Mar 2013.

Derivatives Contracts
12000000

10844400

10000000
7571377
8000000 6844732
7134199 7443178
6613032
Stock6526919
Future
Index
Future
Stock Option
Index Option
6252736
5952206
5760999
6000000
5238175
5186835
4000000
2000000

1410519 1200557 1540180 1330466 1066396 1456351


537261
456529
456055
401973
389254
364188

0
41183

41214

41244

41275

41306

41334

Data Interpretation:
Derivatives trading volume table clearly shows that there is consistent rise in the trading
volume of stock futures during six months of the study. Whereas index futures remains
almost constant. Stock options and index options tends to be lower than the stock nd
index futures .
Table 3:- Showing the Derivatives trading volume at NSE of Oct 2012.
Particulars

Oct 12

80

Stock Futures
Index Futures
Stock Options
Index Options

214398
170100
13575
3558

Graph 3:- Showing the Derivatives trading volume at NSE of Oct 2012.

Derivatives trading volume at NSE of oct 2012


250000
214398
200000
170100
150000
Oct-12
100000
50000

35586
13575

0
Stock Futures Index Futures Stock Options Index Options

Derivatives

Data Interpretation:
The trading volume table clearly shows that there is consistent rise in the trading
volume of stock futures but index futures remains almost constant during these six
months. Stock options and index options tends to be lower as usual in the last six
months of the study.

Table 4:- Showing the Derivatives trading volume at NSE of Nov 2012
Particulars
Nov-12
Stock Futures
216526
Index Futures
135478

81

Stock Options
Index Options

12777
3107

Graph 4. Showing the Derivatives trading volume at NSE of Nov 2012

Derivatives trading volume at NSE of Nov 2012


250000
216526
200000

150000

135478

Nov-12

100000

50000

31073
12777

0
Stock Futures Index Futures Stock Options Index Options

Data Interpretation:
Table clearly shows that there is consistent rise in the trading volume of stock futures
Whereas index futures remains almost constant during these six months. Stock options
and index options tends to be lower than stock and index futures as always.

Table 5:- Showing the Derivatives trading volume at NSE of Dec 2012.
Particulars

Dec-12

82

Stock Futures
Index Futures
Stock Options
Index Options

280283
183293
17244
42987

Graph 5:- Showing the Derivatives trading volume at NSE of Dec 2012.

Derivatives trading volume at NSE of Dec 2012


300000
250000
200000
150000
100000
50000
0

280283
183293

17244

42987

Derivatives

Data Interpretation:
Derivatives trading volume table shows that there is rise in the trading volume of stock
futures and index futures remains almost lower than stock futures during these six
months. Stock options is also lower than index options and both of the options are as
usual lower than the futures.

Table 6:- Showing the Derivatives trading volume at NSE of Jan 2013

83

Particulars
Stock Futures
Index Futures
Stock Options
Index Options

Jan-13
265042
166127
17893
38521

Graph 6:- Showing the Derivatives trading volume at NSE of Jan 2013.

Derivatives trading volume at NSE of Jan 2013


300000
265042
250000
200000
Jan-13

150000

166127

100000
38521

50000
1

Stock Futures

Index Futures

17893

Stock Options

Index Options

Data Interpretation:
Derivatives trading volume table clearly shows that there is consistent rise in the trading
volume of stock futures. Whereas index futures remains almost constant during these
six month and we cannot see any change in trading of Stock options and index options
which tends to be lower than the former one in last six months.

Table 7:- Showing the Derivatives trading volume at NSE of Feb 2013.
Particulars
Stock Futures
Index Futures

Feb-13
265042
166127

84

Stock Options
Index Options

17893
38521

Graph 7:- Showing the Derivatives trading volume at NSE of Feb 2013

Derivatives trading volume at NSE of Feb 2013


300000
265042
250000
200000
Feb-13

150000

166127

100000
38521

50000
1

Stock Futures

Index Futures

17893

Stock Options

Index Options

Data Interpretation:
The above table of NSE in the month of feb 2013 indicates the trading volume table
which clearly shows that there is consistent rise in the trading volume of stock futures.
Whereas index futures follows the same trend as stock futures where as in trading of
Stock options and index options tends to be lower as usual.
Table 8:- Showing the Derivatives trading volume at NSE of March 2013.
Particulars
Stock Futures
Index Futures

Mar-13
265042
166127

85

Stock Options
Index Options

17893
38521

Graph 8:- Showing the Derivatives trading volume at NSE of Mar-2013.

Derivatives trading volume at NSE of Mar-2013


300000
265042
250000
200000
150000

Mar-13

166127

100000
38521

50000
0

Stock Futures

Index Futures

17893

Stock Options

Index Options

Data Interpretation:
Derivatives trading volume table clearly shows that there is consistent rise in the trading
volume of stock futures. Whereas index futures are relative lower than stock futures and
both Stock options and index options tends to be lower than stock futures and index
future in the month of March 2013.
Growth of Derivative Market in India
Table. Showing the Turnover of various derivatives in Indian market.

86

Particulars
Index
Futures
Stock
Futures
Index
Options
Stock
Options

2008-09
21482
51516
2466
18780

2009-10

2010-11

2011-12

43952

554446

772147

286533

1305939

5669

31794

69371

167967

132054

69643

1484056

Growth of Derivative Market in India


1600000
1400000
1200000
Index Futures

1000000

Stock Futures
Index Options

800000

Stock Options
600000
400000
200000
0
2008-09

2009-10

2010-11

2011-12

ROLE OF DERIVATIVES IN INDIAN ECONOMY


Benefits that acquire to the Indian capital markets and the Indian economy from
derivatives are discussed here.
Derivatives will make possible hedging which otherwise is infeasible this
is illustrated by the dollar-rupee forward market. Imports and exports used to take place
in the country under the presumption that importer and exporters have to bear currency

87

risk. To the extent that importers and exporters are risk averse, the existence of this risk
would lead them to do international trade in smaller quantities than they have liked to.
Once the dollar-rupee forward market came about, importers and exporters could hedge
themselves against currency risk. Today the use of such hedging is extremely common
amongst companies that are exposed to currency risk. This hedging facility has
definitely helped importers and exporters do international trade in larger quantities than
before. The RBIs permission for the dollar-rupee forward market is therefore part of the
explanation for the enormous growth in imports and exports that has taken place in the
last five years.
Similarly, on the equity market, many retail investors who are uncomfortable
about the equity market would enter if they were given the alternative of buying
insurance, which controls their downside risk. This would enhance the action of the
savings of the country, which are routed through the equity market. The same would be
the case with international investors, who would place limit orders. These
improvements in the quality of the underlying market have been observed across a
variety of research studies done on foreign markets, which have compared
market quality before introduction of derivatives as compared with after.
a) Development of Indias financial industry
Today, derivatives are a major part of the global financial system. If India is able to
swiftly develop competence in the derivatives area, then there is an enormous
opportunity for India as a center of international finance. One of the largest futures
market on Japans Nikkei 225 index, today, is in Singapore. In that same sense, it is
quite possible for Indian markets to be trading derivatives on underlying price, which
are not from India. This would bring revenues into Indias financial industry and help
enhance Indias integration into the world economy.
Conversely, if India does not develop such markets locally, the derivatives
market in the Indian instruments might develop outside India that will undermine the
regulatory framework under which other Indian markets work. In addition, Indian
investors who cannot access such off-shore markets will be denied the benefits
of advance risk hedging mechanism putting them at disadvantage be able to enhance
the fraction of their portfolio that they allocate to India once hedging instruments
become available.

Derivatives will enable a clear separation between speculators who wish to


bear risks versus hedgers who wish to buy insurance services. Today
speculators act on the cash market, which generates its own difficulties. With
derivatives market it will be possible for risk to be transferred to the people
who are most apt to bear it, and to do all these activities away from the basic
cash market.
Derivatives will lead to an improvement in the quality of the cash market.
The liquidity and market efficiency of the underlying cash market will
improve once derivatives come about the causality underlying this
transformation of the quality of the underlying market is as follows: Derivatives markets will move some of the noise traders in the present
speculation securities away from the cash market. Due to this shift, it is expected that
the volatility of the cash market instrument will reduce. It is generally believed that
derivatives will improve the quality of information production and analysis, by giving

88

higher profit rates to people who successfully understand valuation. Similarly, it is


expected that derivatives will lead to multi-crore arbitrage markets with arbitrageurs
who constantly close small miss-pricings between the derivatives and the cash market.
Due to the very nature of arbitrage business to attain risk free position, such arbitrage
will be liquidity demanding. This irreversibility arises because once a market is well
established; it is difficult to get it to move. For example, Japanese regulators know more
about financial economies today, but the Nikkei 225 market is still in Singapore.
That could easily happen to Indias derivatives market also. Market prices for
Indias market are available worldwide through information vendor feeds such as
Reuters, knight-redder etc. and there is nothing preventing an exchange in other country
from having options and futures on any Indian underlying. If the derivatives markets on
Indian underlying move offshore, it would be unfair to Indian citizens who would be
unable to access these markets under the present regime of barriers to international
flows of funds.
b) Challenges
The challenges in todays context for starting the derivatives market is to foster the
development of strong, healthy and vibrant derivatives industry, which
complements the securities, market existing in the country. The pressure for an early
development of Indias derivatives is twofold:
To the extent that Indias economy lives for one more year without
derivatives, it hinders the economic progress of the country. For example, if the dollarrupee forward market had come about sooner, then Indias imports and exports might
have seen higher growth much before.
If Indian markets do not develop derivatives quickly, the markets for
derivatives of Indian instrument will move offshore. In derivatives, competition
amongst markets from all over the world to obtain trading volume from innovations in
contract design is fierce.
BENEFITS AND RISK ASSOCIATED WITH DERIVATIVES
Economic function of derivatives
Derivatives play the following important roles in every economy where
they are traded.
Price discovery and planning
Prices of an organized derivatives market reflect the combined
views and perception of buyers and sellers, not only of the current demand and supply,
but also of their expiration. At the time of expiration the prices of derivatives converge
with the price of the underlying assets. This process of price discovery is applicable to
both futures and options. Information generated by futures trading through price

89

discovery process helps in planning of all users at every stage. To the extent that these
markets improve planning and efficiency as well as reduce operating costs, benefits will
accrue to consumers in the economy.
Risk shifting
The derivative market allows and facilitates risks to be transferred from those who have
them but may not want them. The risk in case of derivatives is primarily price risk. This
risk represent a cost, which must be borne by someone if the dealer, lender,
borrower, merchant or middlemen has to assume risk, then they will pay the opposite
party less or charge them more or a combination of the two. If the risk is assumed
directly by the dealer or merchant they are compensated for bearing the risk.

Numerous general economic benefits flow from the risk shifting of


hedging function. These include reduced finance charges in carrying inventory of
all kinds including portfolio of investments. The larger banks that finance producers,
distributors and processors give their best terms for the value of the inventory that is
fully protected by an adequate hedge
Enhance liquidity in the underlying markets
Derivatives due to their inherent nature are linked to the underlying cash markets.
It has been observed the world over that introduction of derivatives increases the trading
volume in the underlying. Markets players reluctant to participate due to the absence of
risk shifting mechanism can now participate in the cash market. Interplay between the
underlying derivatives market generates additional activity in the underlying market
increasing liquidity in the underlying.
Shifts the speculative trading to a more controlled environment
In the absence of an organized derivatives market, speculators operate in the
underlying cash markets. This acts as an establishing factor for the underlying marker
since the underlying market act also as proxy futures and options market. Margining,
monitoring and surveillance of the activities of the various participants is difficult in
these kind of mixed markets. Derivatives market provides a mechanism for the
speculators to be identified separately and surveillance of these participants and their
positions can be done in a better manner. This reduce imbalance in the underlying
markets. Thus the derivatives markets will help in controlling the activities of
speculators and reduce the risks now prevalent in the underlying securities market in
India.

FINDINGS AND RECOMMENDATIONS


Some of the few suggestions are as follows: -

90

Regulations should be transparent and subject the same disclosure standards as those
applying to other participants in the financial markets. Tough after the commencement
of the commodity market in India it has become transparent to some extent, more
transparency is required.
Increase the limits on trading of derivatives by foreign institutional investors.
Increase the number of stocks on which options and futures are traded.
Contact size at NSE is 100 decided by SEBI
SEBI should promote the use of the derivatives and educate the investors on how
derivatives can reduce risk if used widely.
Availability of futures on all agricultural commodities would boost private sector
participation in sourcing agricultural produce from villages and transport them across
the country as also store them to transport across the time or period. This in turn helps
mitigate the crisis emanating from the vagaries of monsoon.
Indian currency derivatives market is basically an Over The Counter (OTC)
market. It suffers from poor participation from corporate, and fewer market makers. It
therefore, calls for increased product familiarization, market participation and
development of supporting regulation, legal and tax framework.
There is a need to establish research wings in all major banks for predicting intraday
and short-term movements in the exchange rate so that traders can initiate deals
with confidence.

CONCLUSION
The basic function of a financial system is to "facilitate the allocation and
development of economic resources, both inter temporarily and across time, in an
uncertain environment". Risk is therefore an inherent feature of every financial
decision. In that context, derivative products offer a means to transfer the risk inherent
to financial decisions. Derivatives trading also add to the market completeness. Trading
in derivatives also facilitates price discovery of the underlying cash securities via
information dissemination. Besides these economic benefits, derivatives, like any other
financial instruments, contain certain risks such as market risk, credit risk etc.
Therefore, the consensus is that if used properly, derivatives can be a valuable risk
management tool but strict monitoring is needed to prevent (as far as possible) their
perceived `misuse' for speculative purposes.
While the very core of derivative products is to manage risk, it is important to
appreciate that all derivatives are highly geared, or leveraged, transactions.
Traders/investors are able to assume large positions - with similar sized risks - with very
little up-front outlay and the risk to the investor is high. A thorough grasp of product

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technicalities is only one aspect of the knowledge and skills that traders require. Every
trader has a view of the market and their end objective is, of course, profit from that
view. And the most effective route to achieving this is to form a view that proves to be
correct; having positioned one's self to obtain the maximum profit from it. If a trader
has a bullish he could go long in the futures market or choose to purchase a call option.
Since derivatives also suffer from risk, as do the underlying securities,
derivatives need to be handled cautiously on account of sheer size. These
characteristics make derivatives double-edged
swords. This drives home the
importance of adequate regulation that care of the concerns associated with derivatives
trading.
Increase in companies listed on stock exchanged emergence of securities and
exchange board of India (SEBI) as truly national level securities regulator, free pricing
of public issues, screen based trading system, more than six times increases in turnover
the stock exchanges, emergence of self regulatory organization in the fields of merchant
banking, mutual funds, emergence of investor associations, implementation of
trade guarantees besides others.
SEBIS consistent efforts at improving the market infrastructure,
providing level playing field and ensuring transparent, fair and efficient trading at stock
exchanges have started to yield beneficial results. Depository legislation has also been
approved by the parliament and depository operations have commenced. In the four
years. SEBI has consistently tried to bring in international practices approval
granted for setting up derivatives market is a big step to bring Indian capital markets.
Increased sophistication of capital market participants and the need of market
participants for risk hedging instruments are strong factors in favor of derivatives
market in India.
To summarize the role of regulation is the cushion and help other market
monitoring mechanism such as competition or reputation to maintain a fair and orderly
financial markets in which innovation is encouraged. Its objective is thus to support and
encourage all the necessary structural changes in the products or institutions architecture
that allows market participants to increase the benefits extract from the economic
functions of derivatives at controlled risk levels. Thus, one could view the role of
regulation as that of a player of last resort that guarantees that the economic benefits
associated to the derivative trading activity remains on the efficient risk/return frontier.

BIBLOGRAPHY
Books: Derivatives Dealers Module Work Book - NCFM
Financial Febket and Services - GORDAN & NATRAJAN
Financial Management - PRASANNA CHANDRA

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KHAN M Y:-Financial Febket and Services (tata mc graw hill 1998)


I M PANDEY-Financial Management (VIKAS PUBLICATIONS 10th edition)
BERI G.C MARKETING RESEARCH (tata Mc Graw hill;4th edition)
News Papers: THE FINANCIAL EXPRESS
BUSINESSWORLD
ECONOMIC TIMES
Web sites:

WWW.nseindia.com
WWW.bseindia.Com
WWW.derivatives.com

Terminologies
OTC

: Over the counter

SEBI

: Securities Exchange Board of India

CBOT : Chicago Board of Trade


CBOE : Chicago Board Option Exchange
NSCC

: National securities clearing Corporation

TM

: Trading members

CM

: Clearing members

NEAT

: National Exchange for Automated Trading

F& O

: Futures & Option

FUTINX

: Futures Index

FUTSTK

: Futures Stock

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OPTIDX

: Option Index

OPTSTK

: Option Stock

FUTINT: Future Interest


NSE

: National Stock Exchange

BSE

: Bombay stock Exchange

NYSE

: New York Stock Exchange

COFEI : Coffee Futures Exchange of India


NCDEX : National Commodity & Derivatives Exchange of India
MCX

: Multi Commodity Exchange Of India Limited

NMCEIL

: National Multi Commodity Exchange Of India Limited

FMC

: Forward market Commission

NABARD

: National Bank for Agriculture & Rural Development

NPA

: Non-Performing Assets

FRA

: Forward rate agreements

RTGS

: Real time Gross Settlements

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