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PROJECT REPORT

INDIAN DERIVATIVE MARKET

SUBMITTED BY: SIMRANJEET SINGH ANAND


ENROLLMENT NO: 1132

SUBMITTED TO:
DR. YP SINGH
(Faculty)

INTERNATIONAL INSTITUTE FOR SPECIAL EDUCATION


KANCHANA BIHARI MARG, KALYANPUR, LUCKNOW, PIN-226022
DECLARATION

I hereby declare that this project work entitled is PROJECT ON INDIAN


DERIVATIVE MARKET is my work, this report neither full nor in part
has ever been submitted for award of any other degree of either this
university or any other university.

SIMRANJEET SINGH ANAND

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CONTENTS
1.1 Early toothpastes
1.2 Tooth powder
S.NO PARTICULARS PAGE
NO.
1 ACKNOWLEDGEMENT 5
2 NEED OF THE STUDY 6
3 OBJECTIVE 7
4 SCOPE 8
5 RESEARCH METHODOLOGY 9
6 LIMITATIONS OF THE STUDY 10
7 LITERATURE REVIEW 11
8 EXECUTIVE SUMMARY 13
9 INTRODUCTION-INDIAN INVESTMENT 22
INDUSTRY
10 OVERVIEW:INDIAN SECURITIES MARKET 26
11 INDIAN DERIVATIVE MARKET 35
12 DERIVATIVE MARKET AND ITS INSTRUMENTS 44
13 MARKET TRENDS IN FUTURE AND OPTION 56
14 COMPARISION OF NEW SYSTEM WITH THE 68
EXISTING ONE
15 DEVELOPMENT OF DERIVATIVE MARKET IN 77
INDIA

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1.2 Tooth powder
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NO.
16 MAJOR APPLICATIONS OF FINANCIAL 85
DERIVATIVES
17 FINANCIAL DERIVATIVES-INSTRUMENTS 89
IN STRATEGIC RISK MANAGEMENT
18 HEDGING 96

19 SPECULATION 111

20 FINDINGS AND CONCLUSION 112

21 RECOMMENDATIONS AND SUGGESTIONS 114

22 BIBLIOGRAPHY 116

ACKNOWLEDGEMENT

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I am extremely grateful to all those who have shared their views, opinions,
ideas and experiences which have significantly improved this Project Report.
I would like to express my sincere thanks to, Mr.YP SINGH International
Institute for Special Education, Lucknow for his guidance and sincere efforts
towards bringing in years of his vast industrial experience into this project. I
am very thankful to all the respondents and the employees for their
cooperation in the course of my study.
A special thanks to my friends and family for their encouragement and help
in the successful completion of the study.

SIMRANJEET SINGH ANAND

NEED OF THE STUDY

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The study has been conducted to know about the derivative market of
India as well as the instruments used in strategic risk management. This
study also covers the recent developments in the derivative market taking
into account the trading in past years.
Through this study I came to know the trading done in derivatives and
their use in the stock markets as well as the recent trends in the field of
hedging and speculation.

OBJECTIVES OF THE STUDY

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 To understand the concept of the Derivatives and Derivative Trading.
 To know different types of Financial Derivatives
 To know the role of derivatives trading in India.
 To analyse the performance of Derivatives Trading since 2001with
special reference to Futures & Options
 To understand the concepts of hedging and speculation in Indian
derivative market

SCOPE OF THE PROJECT

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The project covers the derivatives market and its instruments. For better
understanding various strategies with different situations and actions have
been given. It includes the data collected in the recent years and also the
market in the derivatives in the recent years. This study extends to the
trading of derivatives done in the National Stock Markets.

RESEARCH METHODOLOGY

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Method of data collection:-

Secondary sources:-
It is the data which has already been collected by some one or an
organization for some other purpose or research study .The data for study
has been collected from various sources:
 Books
 Journals
 Magazines
 Internet sources
Time:
2 months
Statistical Tools Used:
Simple tools like bar graphs, tabulation, line diagrams have been used.

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LIMITATIONS OF STUDY

1. VOLATALITY:
Share market is so much volatile and it is difficult to forecast any thing
about it whether you trade through online or offline

2. LIMITED TIME:
The time available to conduct the study was only 2 months. It being a
wide topic had a limited time.

3. LIMITED RESOURCES:
Limited resources are available to collect the information about the
commodity trading.

4. ASPECTS COVERAGE:
Some of the aspects may not be covered in my study.

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LITERATURE REVIEW

Derivative products initially emerged, as hedging devices against


fluctuations in commodity prices and commodity-linked derivatives
remained the sole form of such products for almost three hundred years. The
financial derivatives came into spotlight in post-1970 period due to growing
instability in the financial markets. However, since their emergence, these
products have become very popular and by 1990s, they accounted for about
two-thirds of total transactions in derivative products. In recent years, the
market for financial derivatives has grown tremendously both in terms of
variety of instruments available, their complexity and also turnover. In the
class of equity derivatives, futures and options on stock indices have gained
more popularity than on individual stocks, especially among institutional
investors, who are major users of index-linked derivatives.
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.

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Even small investors find these useful due to high correlation of the popular
indices with various portfolios and ease of use. The lower costs associated
with index derivatives vis-vis derivative products based on individual
securities is another reason for their growing use.
As in the present scenario, Derivative Trading is fast gaining
momentum, I have chosen this topic.

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EXECUTIVE SUMMARY
My project is all about THE INDIAN DERIVATIVE MARKET and its
instruments.a thorogh study has been conducted to know the recent trends
and factual aspects of Indian derivative market and its intruments

WEALTH CREATION

Starting the process of Investment of money is the first cornerstone to wealth


creation especially when we know that India is on a fast track growth. In in
the pre-independence era (before 1947) India was mainly characterized by
people who saves and saves-heavily. It was the country of savers. But post-
independence the growth has picked its pace and also is the rate of inflation.
Prices of essential commodities like food, housing, gas, electricity, education
etc has been increasing at a dramatic pace of more than 9%. This is one of
the biggest disadvantages of a growing economy; inflation rate seems to fly
like a limitless bull. Investment is required to fight inflation and in addition
make your money grow.

CHANGE OF SHIFT FROM SAVER TO AN INVESTOR

The transition form a "nation that only saves" to a "nation of investors" is


evident. Taking the statistics of last 35years, the number of retail as well as
institutional investors in India has multiplied several folds. Not only Indian
investors but international investors is eying India as an Investment heaven.
Only next to China, India has been rates as the fastest growing economies in
recent times. India has learned to differentiate between saving and
investment. If earning money is a need then savings and investment should
be a habit. Savings in isolation is not of much help because inflation is eating

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our money. Inflation makes our money less powerful each day. This is the
reason why we need to fight inflation (to protect our money) by a great tool
called investment. India is growing and a person who is investing is actually
contributing to the growth of the nation; in return he/she will get the desired
returns. Important is to identify a suitable "asset class" for oneself and start
investing in it. Like retired people would like to invest in bonds, deposits;
middle aged men would like to invest in mutual funds, real estate but people
who are young and dynamic would like to invest in direct equity like stocks.

CONFIDENCE OF INVESTORS AND GDP GROWTH

Why we have seen this transition and change of shift form savings to
investment? The answer clearly lies in the confidence of Indian Investors in
the future growth prospects of India. This confidence is fueled by a
consistent GDP growth of around 8%. Average performance of various asset
classes is as listed below:

• Savings account (3% to 3.5%)


• Bonds (6% to 7%)
• Bank or Companies Deposits (6% to 7%)
• Gold (8% to 10%)
• Real Estate (10% to 12%)
• Stocks (12% to 15%)
• Art (15% to 20%)

Talking about short term investment horizon and GDP growth almost
assured at 7% to 8%, the focus on investors in Indian market shall be more
on selecting a suitable asset class for investment rather then debating of
growth and risks of investment. India will grow and top brains are convinced

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and assures average retail investors of this growth scene. People who are
already in the boat (investing) might have realized the power of investment
in Indian economy, but for people who have not started yet for them its not
late. In long run India is certain to make big money for its investors but
consistent GDP growth rate proves very encouraging even for short-term
investors.

But India is India and volatility is only the other name for this dynamic
country. Changes in political scenario, inflation, drought, flood, rise of
interest rates, market demands all in totality effect the performance of the
market. People should realize that India is a growing economy and such
volatility is expected. The price of stocks may fall and rise but investors
must not loose faith; it is important to keep the focus and attention of the
bigger picture of India's growth.

With over 25 million shareholders, India has the third largest investor base in
the world after USA and Japan. Over 7500 companies are listed on the
Indian stock exchanges (more than the number of companies listed in
developed markets of Japan, UK, Germany, France, Australia, Switzerland,
Canada and Hong Kong.). The Indian capital market is significant in terms
of the degree of development, volume of trading, transparency and its
tremendous growth potential.
India’s market capitalization was the highest among the emerging markets.
Total market capitalization of The Bombay Stock Exchange (BSE), which,
as on July 31, 1997, was US$ 175 billion has grown by 37.5% percent every
twelve months and was over US$ 834 billion as of January, 2007. Bombay
Stock Exchanges (BSE), one of the oldest in the world, accounts for the

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largest number of listed companies transacting their shares on a nationwide
online trading system. The two major exchanges namely the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5
in the world, calculated by the number of daily transactions done on the
exchanges.
The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in
2006 – An increase of 82% from US $ 1237 billion in 2004 in a short span of
2 years only. Turnover in the Spot and Derivatives segment both in NSE &
BSE was higher by 45% into 2006 as compared to 2005. With daily average
volume of US $ 9.4 billion, the Sensex has posted excellent returns in the
recent years. Currently the market cap of the Sensex as on July 4th, 2009
was Rs 48.4 Lakh Crore with a P/E of more than 20.

Derivatives trading in the stock market have been a subject of enthusiasm of


research in the field of finance the most desired instruments that allow
market participants to manage risk in the modern securities trading are
known as derivatives. The derivatives are defined as the future contracts
whose value depends upon the underlying assets. If derivatives are
introduced in the stock market, the underlying asset may be anything as
component of stock market like, stock prices or market indices, interest rates,
etc. The main logic behind derivatives trading is that derivatives reduce the
risk by providing an additional channel to invest with lower trading cost and
it facilitates the investors to extend their settlement through the future
contracts. It provides extra liquidity in the stock market.

Derivatives are assets, which derive their values from an underlying asset.
These underlying assets are of various categories like

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• Commodities including grains, coffee beans, etc.
• Precious metals like gold and silver.
• Foreign exchange rate.
•Bonds of different types, including medium to long-term negotiable debt
securities issued by governments, companies, etc.
• Short-term debt securities such as T-bills.
• Over-The-Counter (OTC) money market products such as loans or
deposits.
• Equities
For example, a dollar forward is a derivative contract, which gives the buyer
a right & an obligation to buy dollars at some future date. The prices of the
derivatives are driven by the spot prices of these underlying assets.
However, the most important use of derivatives is in transferring market risk,
called Hedging, which is a protection against losses resulting from
unforeseen price or volatility changes. Thus, derivatives are a very important
tool of risk management.
Hedging risk has been an integral part of the financial markets for many
years. In the 1800s, commodity producers and merchants began using
forward contracts for protection against unfavorable price changes. This
system is still very active today.

The term "hedge fund" dates back to only 1949. In 1949, almost all
investment strategies took only long positions. A reporter for Fortune
magazine, named Alfred Winslow Jones, published an article pointing out
that investors could achieve higher returns if hedging were implemented into
an investment strategy. This was the beginning of the Jones model of
investing.

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To prove his hypothesis, Jones launched an investment partnership
incorporating two investment tools into his strategy: short selling and
leverage. The purpose of these two strategies was to limit risk and enhance
returns simultaneously.

In addition, Jones established two important characteristics that are still part
of the industry today. He used an incentive fee of 20% of profits and he kept
most of his own personal money in the fund. This ensured that his personal
goals and the goals of his investors were in alignment.

Exceptional results were obtained through this hedged approach. During the
period from 1962 to 1966, Jones outperformed the top mutual fund by more
than 85%, net of fees. The success of Jones stimulated the interest of high
net worth individuals in hedge funds.

Not only did Jones attract the interest of high net worth individuals to hedge
funds, but also many top money managers were drawn to hedge fund
because of the unique fee structure. A 20% incentive fee made it possible
for managers to earn 10 to 20 times as much in compensation when
compared to long-only money management services.

Between 1966 and 1968, nearly 140 new hedge funds were launched as a
consequence of the new dynamics of investing and managing money. Many
of these funds, however, did not follow the Jones model of hedging risk.
Instead of hedging, only leverage was used to enhance returns, ignoring the
short-selling aspect that Jones employed. Using a leveraged, long-only

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strategy made these funds highly susceptible to the market downturn that
began in late 1968. Some hedge funds dropped in value by more than 70%
within two years.

Large hedge fund losses due to the 1973-1974 bear market caused many
investors to turn away from hedge funds. For the next ten years, few
managers could attract the necessary capital to launch new partnerships. By
1984, there were only 68 funds in existence.

In the late 1980s, a small group of extremely talented hedge fund managers,
including George Soros, Michael Steinhart, and Julian Robertson, gave
hedge funds a restored credibility. Despite difficult market conditions, these
managers produced annual returns of greater than 50%.

Many of the world¡s best money managers left the traditional institutional
and retail investment firms because of potentially higher fees and great
flexibility with managing hedge fund products. By 1990, there were over
500 hedge funds worldwide with assets of about $38 billion.

Hedge funds now represent one of the largest segments of the investment
management industry. Currently, it is estimated that there are over 6,000
hedge funds in existence with total money under management in excess of
$1 trillion.

There are various derivative products traded. They are;

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1. Forwards
2. Futures
3. Options
4. Swaps

“A Forward Contract is a transaction in which the buyer and the seller


agree upon a delivery of a specific quality and quantity of asset usually a
commodity at a specified future date. The price may be agreed on in
advance or in future.”

“A Future contract is a firm contractual agreement between a buyer and


seller for a specified as on a fixed date in future. The contract price will vary
according to the market place but it is fixed when the trade is made. The
contract also has a standard specification so both parties know exactly what
is being done”.

“An Options contract confers the right but not the obligation to buy (call
option) or sell (put option) a specified underlying instrument or asset at a
specified price – the Strike or Exercised price up until or an specified future
date – the Expiry date. The Price is called Premium and is paid by buyer of
the option to the seller or writer of the option.”

A call option gives the holder the right to buy an underlying asset by a
certain date for a certain price. The seller is under an obligation to fulfill the
contract and is paid a price of this, which is called "the call option premium
or call option price".

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A put option, on the other hand gives the holder the right to sell an
underlying asset by a certain date for a certain price. The buyer is under an
obligation to fulfill the contract and is paid a price for this, which is called
"the put option premium or put option price".

“Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a ‘SWAP’. In case of swap, only
the payment flows are exchanged and not the principle amount”

I had conducted this research to find out whether investing in the


derivative market is beneficial or not? You will be glad to know that
derivative market in India is the most booming now days.
So the person who is ready to take risk and want to gain more should
invest in the derivative market.
On the other hand RBI has to play an important role in derivative
market. Also SEBI must encourage investment in derivative market so
that the investors get the benefit out of it. Sorry to say that today even
educated persons are not willing to invest in derivative market because
they have the fear of high risk.

INDIAN INVESTMENT INDUSTRY


INVESTMENT-MEANING

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Investment is referred to as the concept of deferred consumption, which
might comprise of purchasing an asset, rendering a loan, keeping the saved
funds in a bank account such that it might generate lucrative returns in the
future. The options of investments are huge; all of them having different
risk-reward trade off. This concludes that the investment industry is really
broad and that is why understanding the core concepts of investments and
accordingly analyzing them is essential. After thorough understanding of the
investment industry, can an investor create and manage his own investment
portfolio such that the returns are maximized with the least risk exposure.

TYPES OF INVESTMENTS IN INDIA


As stated earlier, the investment industry is huge; therefore the types of
investments are also varied. Different types of investments are:

CASH INVESTMENTS: Cash investments comprise of savings bank


accounts, certificates of deposit (CDs) and treasury bills (TBs). All these
types of investments render a low interest rate and prove to be quite risky
during times of inflation.

DEBT SECURITIES: This type of investment gives returns in the form of


fixed periodic payments and the fixed capital appreciate at maturity. This is
safe bait for the investors in the investment industry and has always proved
to be the risk free investment tool. Though, it is generally low in risks, the
returns are also lower than the other peer securities.

STOCKS: Investors can also buy stocks (equities) from the secondary
markets and be a part of any business corporates that are listed in the

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bourses. By this way, one can become the part of the profits that the
company generates. But one should remember that stocks are generally more
volatile and carries more risk than bonds.

MUTUAL FUNDS: They are usually a collection of stocks and bonds that a
fund manager selects for an investor such that the returns are maximum. The
investor does not have to track the investment, be it a bond, stock- or index-
based mutual funds.

DERIVATIVES: Derivatives are financial contracts, whose value is derived


from the value of the underlying assets like equities, commodities and bonds.
They can take the form of futures, options and swaps. Investors choose
derivatives as they are used to minimize the risk of loss that result from
variations in the underlying asset values.

COMMODITIES: The items that are traded on the commodities market are
agricultural and industrial commodities and they need to be standardized.
Commodities trading have always been giving high returns and thus they are
the riskiest of all investment options. One, who trades in commodities,
requires specialize knowledge and analytical abilities

REAL ESTATE: Investing in real estate has to be a long term affair. Funds
get hooked into the real estate sector for a considerable time period.

THE INVESTMENT INDUSTRY IN INDIA

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India's equity market has doubled since March 2009, with ADRs like Dr.
Reddy's Laboratories and Tata Motors only getting doubled and tripled. So,
do we say that the Indian investment industry is overheated at the moment or
may we infer that the stocks are fairly valued?

Warren Buffett has always mentioned that investment in India should always
be a long-term story - as the industry has been growing from an emerging
market to a developed one. The next 10 years in India will surely give good
returns.

India's GDP growth would be around 6.5% to 7% in 2010. The sustainable


growth rate of India would however hover around 7%. Before becoming a
mature economy, India has another 20 to 40 years to spare.

CHALLENGES OF INDIAN INVESTMENT


INDUSTRY
The investing story in India has not been always that smooth. Pitfalls are
sure to co-exist. The main restraint on India's growth now happens to be its
infrastructure. On the other hand, infrastructure is India's biggest opportunity
as well. The fiscal deficit of India also poses a big threat to the investment
industry in India. For an emerging economy like India, it is recommended
that an investor always balances the unique risks against the potential for
high long-term growth. Accordingly the decision for investment should be
made.

Of late, the Indian economy is turning out to be extremely conducive in


terms of domestic and foreign investments. India Investments has been the

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major propelling force towards India's attainment of self-sustained growth by
way of rapid industrialization. The pioneers of the investment industry has
been Foreign Direct Investment (FDI) and Investments made by NRIs.

Foreign Direct Investments in India has been gearing up momentum every


passing day. So, to view an economy which is entirely open to the global
markets, the investment industry in India should be groomed in a manner
that the maximum returns are achieved. It is advisable that the investment
industry's potential should neither be overestimated nor underestimated. We
should know how to deal with the complexities of the investment industry
and grow along with it.

OVERVIEW OF THE INDIAN SECURITIES


MARKET
INTRODUCTION
The Indian securities market, considered one of the most promising
emerging markets, is among the top eight markets of the world. The Stock
Exchange, Mumbai, which was established in 1875 as “The Native Share
and Stockbrokers Association” (a voluntary non-profit making association),
has evolved over the years into its present status as the premier Stock

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Exchange in the country. At present 24 stock exchanges operate all over
India. These stock exchanges provide facilities for trading securities,
Securities markets provide a common platform for transfer of funds from the
person who has excess funds to those who need them. Securities market is
regulated by the Securities& Exchange Board of India (SEBI).

COMPONENTS OF SECURITY MARKET


1. The major components of the securities market are listed below:

2. Securities-Shares, Bonds, Debentures, Futures, Options, Mutual Fund

Units
3. Intermediaries-Brokers, Sub brokers, Custodians, Share transfer

agents,
4. Merchant Bankers

5. Issuers of securities-Companies, Bodies corporate, Government,

Financial
6. Institutions, Mutual funds, Banks

7. Investors-Individuals, Companies, Mutual funds, Financial

Institutions, Foreign
8. Institutional Investors

9. Market Regulators-SEBI, RBI, Department of Company Affairs

TYPES OF SECURITIES MARKETS


In the contest of equity products, which this publication seeks to cover in
depth, the following markets could be defined:

• Primary Market

• Secondary Market

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• Derivatives market

MARKETS CAN ALSO BE BROADLY CLASSIFIED INTO EQUITY


AND DEBT MARKETS.

Debt markets are characterized currently by a large institutional presence,


though an attempt is being made to attract retail participation in recent times.
Debt markets trade in Government securities, Treasury Bills, Corporate
Bonds and other debt instruments while Equity markets deal mainly in
equity shares and to a limited extent in preference shares and company
debentures. Futures and Options in indices and equity shares are of a
relatively recent origin and form part of equity markets.

INTERMEDIARIES
Intermediaries provide various services to investors and issuers and have
grown to become among both powerful and knowledgeable due to due to
substantial growth of securities markets over the last century. A large variety
and number of intermediaries provide intermediation services in the Indian
securities market.

ISSUERS OF SECURITIES
Every organisation, whether if be a company, institution or a Government
body needs funds for various operations. Organisations issue securities in the
primary market depending on their needs. The Securities market in India is
an important source for corporate and government. The corporate sector does
depend significantly on equity and debt markets for meeting its funding
requirements though the share of equity markets has been decreasing over
the recent years in view of the rather dull primary market. During the year
2001-02 total funds raised through capital issues were Rs. 43,700 crores

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approx. The share of the Public Sector was Rs. 33,300 crores and Private
Sector Rs. 10,400 crores. Equity component of the Capital Issues was 5,400
crores and whereas Debt component was the major one at Rs 38,300 crores.

Investors are those who have excess funds with them and want to employ it
for returns. Indian securities market has more than 20 million investors,
comprising Individuals, Companies, Mutual funds,Financial Institutions,
Foreign Institutional Investors. A review of shareholding pattern of all BSE
Companies shows that, more than 50% of the shares are heldby the
promoters of companies, whereas 15% by Institutional Investors.

After liberalization of the economy investments by foreign institutional


investors have shown a steadyincrease. Foreign direct investment has
increased from Rs. 174 crores in 1990-91 to Rs. 10,686 crores in 2000-01.
Portfolio Investment has shown a faster growth. It is increased from Rs 11
crores in 1990-91 to Rs. 12,609 crores in 2000-2001.

MARKET REGULATORS
Securities market is regulated by following governing bodies:

1. Securities and Exchange Board of India (SEBI)

2. Department of Economic Affairs (DEA)

3. Department of Company Affairs (DCA)

4. Reserve Bank of India

5. Stock exchanges

Significant among the legislations for the securities market are the following:

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1. The SEBI Act, 1992, which establishes SEBI to protect investors and
development and regulate securities market. All the powers under this act are
exercised by SEBI.

2. The Companies Act, 1956 which set out the code of conduct for the
corporate sector in relation to issue, allotment and transfer of securities,
disclosures to be made in public issues and nonpayment of dividend. Powers
under this Act are exercised by SEBI in case of listed public companies and
public companies proposing to get their securities listed.

3. The Securities Contract (Regulation) Act, 1956, which provide for


regulation of transaction in securities through control over stock exchanges,
Most of lthe powers under this act are exercised by Department of Economic
Affairs (DEA), some are concurrently exercised by DEA and SEBI and a
few powers by SEBI. 4. The Depository Act, 1996, which provides for
electronic maintenance and transfer of ownership of demateralised securities,
SEBI administers the rules and regulation under this Act.

The Securities and Exchange Board of India was established in 1988 to


regulate and develop the growth of the capital market. SEBI regulates the
working of stock exchanges and intermediaries such as stock brokers and
merchant bankers, accords approval for mutual funds, and registers

Foreign Institutional Investors who wish to trade in Indian scrips. Section


11(1) of the Sebi Act provides that it shall be the duty of the Board to protect
the interests of investor’s securities and to promote the development of, and
to regulate the securities market, by such measures as it thinks fit.

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SEBI regulates the business in stock exchanges and any other securities
markets and the working of collective investment schemes, including mutual
funds, registered by it. SEBI promotes investor’s education and training of
intermediaries of securities market. It prohibits fraudulent and unfair trade
practices relating to securities markets, and insider trading in securities, with
the imposition of monetary penalties, on erring market intermediaries, It also
regulates substantial acquisition of shares and takeover of companies and can
call for information from, carry out inspection, conduct inquiries and audits
of the stock exchanges and intermediaries and self regulatory organizations
in the securities market.

PRIMARY MARKET
Fresh issues of shares and other securities are effected though the Primary
market. It provides issuers opportunity to issue securities, to raise resources
to meet their requirements of business. Equity issues can be effected at face
value or at discount/premium. Issues at discounts are rare and almost
unheard of. Issuers can issue the securities in domestic market and/or
international market through ADR/GDR/ECB route.

SECONDARY MARKET

Investors can buy and sell securities in secondary market from/to other
investors. The securities are traded, cleared and settled through

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intermediaries as per prescribed regulatory framework under the supervision
of the Exchanges and oversight of SEBI. The regulatory framework has
prohibited trading of securities outside the exchanges. There are 24
exchanges (The Capital Stock Exchanges, the latest in the list, is yet to
commence trading) today recognised over a period of time to enable
investors across the length and breadth of the country to access the market.

DERIVATIVES MARKET

Derivatives are contracts that are based on or derived from some underlying
asset, reference rate, or index. Most common financial derivatives are:
forwards, futures, options and swaps.

Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2000 for trading in index futures,
Currently, the Indian markets provide equity derivatives of the following
types:

• Index Futures-Two Indices

• Stock Futures-Twenty Nine stocks

• Index Options-Two Indices

• Stock Options-Twenty Nine Stocks

Derivatives help to improve market efficiencies because risks can be isolated


and sold to those who are willing to accept them at the least cost. Using
derivatives breaks risk into pieces that can be managed independently.
Corporations can keep the risks they are most comfortable managing and

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transfer those they do not want to other companies that are more willing to
accept them. From a market-oriented perspective, derivatives offer the free
trading of financial risks.

Financial derivatives have changed the face of finance by creating new ways
to understand, measure, and manage financial risks. Ultimately, derivatives
offer organizations the opportunity to break financial risks into smaller
components and then to buy and sell those components to best meet specific
risk-management objectives. Moreover, under a market-oriented philosophy,
derivatives allow for the free trading of individual risk components, thereby
improving market efficiency. Using financial derivatives should be
considered a part of any business’s riskmanagement strategy to ensure that
value-enhancing investment opportunity can be pursued.

The derivatives markets are the financial markets for derivatives, financial
instruments like futures contracts or options, which are derived from other
forms of assets.
The market can be divided into two, that for exchange traded derivatives and
that for over-the-counter derivatives. The legal nature of these products is
very different as well as the way they are traded, though many market
participants are active in both
what are derivatives:-

In most cases derivatives are contracts to buy or sell the underlying asset at a
future time, with the price, quantity and other specifications defined today.
The contract may bind both parties, and just one party with the other party
reserving the option to exercise or not. The underlying asset either has to be

32
traded or some kind of cash settlement has to transpire. Derivatives are
traded either in organized exchanges or over the counter. Examples of
derivatives include forwards, futures, options, caps, floors, swaps, collars,
and many others.

ADVANTAGES OF TRADING IN DERIVATIVES


Derivative contracts are effective tool for hedging and thereby reducing the
potential of future risk. They also allow investors to take a leveraged
position in the market and hereby increase the possibilities of earning higher
returns.

DISADVANTAGES OF TRADING IN DERIVATIVES


Because of their ability to provide leveraging, derivative disasters are pretty
common in international markets. Just as there is huge potential of earning
higher returns, it also exposes individuals and corporations alike to lose
money in case the market moves against the positions held by them.

EQUITY MARKET

Publicly traded equities form a significant source of capital for firms, and
equity markets are a key part of the process of allocating capital among
competing uses in our economy, Through issuance of equities, companies
enable a broad set of investors to share in the risk and reward of economic
activities.

33
MEANING – EQUITY MARKET

The market in which shares are issued and traded, either through exchanges
or over-thecounter markets. Also known as the stock market, it is one of the
most vital areas of a market economy because it gives companies access to
capital and investors a slice of ownership in a company with the potential to
realize gains based on its future performance.

INDIAN DERIVATIVE MARKET


HISTORY

The history of derivatives is quite colourful and surprisingly a lot longer than
most people think. Forward delivery contracts, stating what is to be delivered
for a fixed price at a specified place on a specified date, existed in ancient
Greece and Rome. Roman emperors entered forward contracts to provide the
masses with their supply of Egyptian grain. These contracts were also
undertaken between farmers and merchants to eliminate risk arising out of
uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.
The first organized commodity exchange came into
existence in the early 1700’s in Japan. The first formal commodities
exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the
US to deal with the problem of ‘credit risk’ and to provide centralised

34
location to negotiate forward contracts. From ‘forward’ trading in
commodities emerged the commodity ‘futures’. The first type of futures
contract was called ‘to arrive at’. Trading in futures began on the CBOT in
the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives
contract, known as the futures contracts. Futures trading grew out of the need
for hedging the price risk involved in many commercial operations. The
Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in
1919, though it did exist before in 1874 under the names of ‘Chicago
Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB).
The first financial futures to emerge were the currency in 1972 in the US.
The first foreign currency futures were traded on May 16, 1972, on
International Monetary Market (IMM), a division of CME. The currency
futures traded on the IMM are the British Pound, the Canadian Dollar, the
Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and
the Euro dollar. Currency futures were followed soon by interest rate futures.
Interest rate futures contracts were traded for the first time on the CBOT on
October 20, 1975. Stock index futures and options emerged in 1982. The
first stock index futures contracts were traded on Kansas City Board of
Trade on February 24, 1982.The first of the several networks, which offered
a trading link between two exchanges, was formed between the Singapore
International Monetary Exchange (SIMEX) and the CME on September 7,
1984.

Options are as old as futures. Their history also dates back to ancient Greece
and Rome. Options are very popular with speculators in the tulip craze of
seventeenth century Holland. Tulips, the brightly coloured flowers, were a
symbol of affluence; owing to a high demand, tulip bulb prices shot up.

35
Dutch growers and dealers traded in tulip bulb options. There was so much
speculation that people even mortgaged their homes and businesses. These
speculators were wiped out when the tulip craze collapsed in 1637 as there
was no mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an
American financier, Russell Sage, in 1872. These options were traded over
the counter. Agricultural commodities options were traded in the nineteenth
century in England and the US. Options on shares were available in the US
on the over the counter (OTC) market only until 1973 without much
knowledge of valuation. A group of firms known as Put and Call brokers and
Dealer’s Association was set up in early 1900’s to provide a mechanism for
bringing buyers and sellers together.
On April 26, 1973, the Chicago Board options Exchange
(CBOE) was set up at CBOT for the purpose of trading stock options. It was
in 1973 again that black, Merton, and Scholes invented the famous Black-
Scholes Option Formula. This model helped in assessing the fair price of an
option which led to an increased interest in trading of options. With the
options markets becoming increasingly popular, the American Stock
Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began
trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and
nineties. The collapse of the Bretton Woods regime of fixed parties and the
introduction of floating rates for currencies in the international financial
markets paved the way for development of a number of financial derivatives
which served as effective risk management tools to cope with market
uncertainties.

36
The CBOT and the CME are two largest financial exchanges in the world on
which futures contracts are traded. The CBOT now offers 48 futures and
option contracts (with the annual volume at more than 211 million in
2001).The CBOE is the largest exchange for trading stock options. The
CBOE trades options on the S&P 100 and the S&P 500 stock indices. The
Philadelphia Stock Exchange is the premier exchange for trading foreign
options.
The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and
the Nikkei 225 trade almost round the clock. The N225 is also traded on the
Chicago Mercantile Exchange.

In less than three decades of their coming into vogue, derivatives


markets have become the most important markets in the world.
Today, derivatives have become part and parcel of the day-to-day life
for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to
the latest trading methods and was using traditional out-dated
methods of trading. There was a huge gap between the investors'
aspirations of the markets and the available means of trading. The
opening of Indian economy has precipitated the process of
integration of India's financial markets with the international
financial markets. Introduction of risk management instruments in
India has gained momentum in last few years thanks to Reserve

37
Bank of India's efforts in allowing forward contracts, cross currency
options etc. which have developed into a very large market.

TYPES OF DERIVATIVE MARKET IN INDIA

DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

38
National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange

Index Future Index option Stock option Stock future

CHRONOLOGY OF INSTRUMENTS

1991 Liberalisation process initiated


14 December NSE asked SEBI for permission to trade index

39
1995 futures.
18 November SEBI setup L.C.Gupta Committee to draft a
1996 policy framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate
agreements (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 futures commenced at NSE.
25 September Nifty futures trading commenced at SGX.
2000
2 June 2001 Individual Stock Options & Derivatives

ABOUT DERIVATIVES
Derivatives are nothing but a kind of security whose price or value is
determined by the value of the underlying variables. It is more like a contract
of future date in which two or more parties are involved to alleviate future
risk. Usually, derivatives enjoy high leverage. Its value is affected by the
volatility in the rates of the underlying asset. Some of the widely known
underlying assets are:

40
• Indexes (consumer price index (CPI), stock market index, weather
conditions or inflation)
• Bonds
• Currencies
• Interest rates
• Exchange rates
• Commodities
• Stocks (equities)

TYPES OF DERIVATIVES
The range of derivatives is really wide. But some of the most commonly known
derivatives are:

FORWARDS-This is a tailor-made contract between two parties. In case of


this contract, a settlement is done on a scheduled future date at today's pre-
decided rate.

FUTURES-When two entities decide to purchase or sell an asset at a given


time in the future at a given price, it is called futures contract. Futures
contracts can be said to be a special kind of forward contracts, as they are
customized exchange-traded agreements.

OPTIONS-It is of two different kinds such as calls and puts. Those who
take calls option, they are not obligated to purchase given quantity of the
underlying variable, at a mentioned price on or prior to a scheduled future
date. On the other hand, buyers in case of puts option may not necessarily
sell a mentioned quantity of the underlying variable at a mentioned price on

41
or prior to a given date.

SWAPS-These are private contracts between two entities to deal in cash


flows in the future following a pre-decided formula. They are somewhat like
forward contracts' portfolios. Swaps are also of two types such as interest
rate swaps and currency swaps.

INTEREST RATE SWAPS-in this case, only interest related cash flows
can be exchanged between the entities in one currency.

CURRENCY SWAPS-in this case of swapping, principal and interest can


be exchanged in one currency for the same in other form of currency.

IMPORTANCE OF DERIVATIVES
Financial transactions are fraught with several risk factors. Derivatives are
instrumental in alienating those risk factors from traditional instruments and
shifting risks to those entities that are ready to take them. Some of the basic
risk components in derivatives business are:

• CREDIT RISK: When one of the two parties fails to perform its
role as per the agreement, this is called the credit risk. It can also be

42
referred to as default or counterparty risk. It varies with different
sources.
• MARKET RISK: This is a kind of financial loss that takes place
due to the adverse price movements of the underlying variable or
instrument.
• LIQUIDITY RISK: When a firm is unable to devise a transaction
at current market rates, it can be referred to as liquidity risk. There are
two kinds of liquidity risks involved in the scenario. First is concerned
with the liquidity of separate items and second is related to supporting
the activities of the organization with funds comprising derivatives.
• LEGAL RISK: Legal issues related with the agreement need to be
scrutinized well, as one can deal in derivatives across the different
judicial boundaries.

DERIVATIVE MARKETS IN INDIA


India had started with a controlled economic system and from there it moved
on to become a destination that witnesses constant fluctuation in prices on a
daily basis now. Persistent efforts of Reserve Bank of India (RBI) in
building currency forward market and liberalization process provided the
risk management agencies their much needed momentum. Derivatives are
the indispensable components of liberalization process to handle risk. With
National Stock Exchange (NSE) measuring the market demands, the process

43
of launching derivative markets in India got started. In the year 1999,
derivatives trading took place in India.

Indian derivatives markets can be divided into two types including 1) the
transaction which depends on the exchange, and 2) the transaction which
takes place 'over the counter' in one-to-one scenario. They can thus be
referred to as:

• Exchange Traded Derivatives


• Over the Counter (OTC) Derivatives
• Over the Counter (OTC) Equity Derivatives
• Operators in the Derivatives Market

There are different kinds of traders in the derivatives market. These include:

• HEDGERS-traders who are interested in transferring a risk


element of their portfolio.
• SPECULATORS-traders who deliberately go for risk components
from hedgers in look out for profit.
• ARBITRATORS-traders who work in various markets at the same
time in order to gain profit and do away with mis-pricing.

DERIVATIVE MARKETS AND


INSTRUMENTS
FORWARD CONTRACTS

44
A forward contract is an agreement to buy or sell an asset on a specified
date for a specified price. One of the parties to the contract assumes a
long position and agrees to buy the underlying asset on a certain
specified future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same date
for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are n o r m a l l y traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

• They are bilateral contracts and hence exposed to counter-party risk.


• Each contract is custom designed, and hence is unique in terms of
contract size, expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the
asset.
• If the party wishes to reverse the contract, it has to compulsorily go to
the same counter-party, which often results in high prices being
charged.

However forward contracts in certain markets have become very


standardized, as in the case of foreign exchange, thereby reducing
transaction costs and increasing transactions volume. This process of
standardization reaches its limit in the organized futures market. Forward
contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic
functions of allocating risk in the presence of future price uncertainty.

45
However futures are a significant improvement over the forward
contracts as they eliminate counterparty risk and offer more
liquidity.

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures


exchange, to buy or sell a certain underlying instrument at a certain date in
the future, at a pre-set price. The future date is called the delivery date or
final settlement date. The pre-set price is called the futures price. The price
of the underlying asset on the delivery date is called the settlement price. The
settlement price, normally, converges towards the futures price on the
delivery date.

A futures contract gives the holder the right and the obligation to buy or sell,
which differs from an options contract, which gives the buyer the right, but
not the obligation, and the option writer (seller) the obligation, but not the
right. To exit the commitment, the holder of a futures position has to sell his
long position or buy back his short position, effectively closing out the
futures position and its contract obligations. Futures contracts are exchange
traded derivatives. The exchange acts as counterparty on all contracts, sets
margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. STANDARDIZATION:
Futures contracts ensure their liquidity by being highly standardized, usually
by specifying:

46
• The underlying. This can be anything from a barrel of sweet crude oil
to a short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be
the notional amount of bonds, a fixed number of barrels of oil, units of
foreign currency, the notional amount of the deposit over which the
short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In case of bonds, this specifies which
bonds can be delivered. In case of physical commodities, this specifies
not only the quality of the underlying goods but also the manner and
location of delivery. The delivery month.
• The last trading date.
• Other details such as the tick, the minimum permissible price
fluctuation.

2. MARGIN:
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in
value, and creates a credit risk to the exchange, who always acts as
counterparty. To minimize this risk, the exchange demands that contract
owners post a form of collateral, commonly known as Margin requirements
are waived or reduced in some cases for hedgers who have physical

47
ownership of the covered commodity or spread traders who have offsetting
contracts balancing the position.

• Initial Margin: is paid by both buyer and seller. It represents the loss
on that contract, as determined by historical price changes, which is
not likely to be exceeded on a usual day's trading. It may be 5% or
10% of total contract price.

• Mark to market Margin: Because a series of adverse price changes


may exhaust the initial margin, a further margin, usually called
variation or maintenance margin, is required by the exchange. This is
calculated by the futures contract, i.e. agreeing on a price at the end of
each day, called the "settlement" or mark-to-market price of the
contract.
To understand the original practice, consider that a futures trader, when
taking a position, deposits money with the exchange, called a "margin". This
is intended to protect the exchange against loss. At the end of every trading
day, the contract is marked to its present market value. If the trader is on the
winning side of a deal, his contract has increased in value that day, and the
exchange pays this profit into his account. On the other hand, if he is on the
losing side, the exchange will debit his account. If he cannot pay, then the
margin is used as the collateral from which the loss is paid.

3. SETTLEMENT
Settlement is the act of consummating the contract, and can be done in one
of two ways, as specified per type of futures contract:

48
• Physical delivery - the amount specified of the underlying asset of the
contract is delivered by the seller of the contract to the exchange, and by
the exchange to the buyers of the contract. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering
position - that is, buying a contract to cancel out an earlier sale (covering
a short), or selling a contract to liquidate an earlier purchase (covering a
long).
• Cash settlement - a cash payment is made based on the underlying
reference rate, such as a short term interest rate index such as Euribor, or
the closing value of a stock market index. A futures contract might also
opt to settle against an index based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For
many equity index and interest rate futures contracts, this happens on the
Last Thursday of certain trading month. On this day the t+2 futures contract
becomes the t forward contract.

PRICING OF FUTURE CONTRACT


In a futures contract, for no arbitrage to be possible, the price paid on
delivery (the forward price) must be the same as the cost (including interest)
of buying and storing the asset. In other words, the rational forward price
represents the expected future value of the underlying discounted at the risk
free rate. Thus, for a simple, non-dividend paying asset, the value of the

future/forward, , will be found by discounting the present value at


time to maturity by the rate of risk-free return .

49
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying

today (on the spot market) with borrowed money.


2. On the delivery date, the arbitrageur hands over the underlying, and
receives the agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:


1. The arbitrageur buys the futures contract and sells the underlying
today (on the spot market); he invests the proceeds.
2. On the delivery date, he cashes in the matured investment, which has
appreciated at the risk free rate.
3. He then receives the underlying and pays the agreed forward price

using the matured investment. [If he was short the underlying, he


returns it now.]
4. The difference between the two amounts is the arbitrage profit.

50
51
DISTINCTION BETWEEN FUTURES AND
FORWARDS CONTRACTS
FEATURE FORWARD FUTURE CONTRACT
CONTRACT
Operational Traded directly between Traded on the exchanges.
Mechanism two parties (not traded on
the exchanges).

Contract Differ from trade to trade. Contracts are standardized


Specifications contracts.
Counter-party Exists. Exists. However, assumed by the
risk clearing corp., which becomes
the counter party to all the trades
or unconditionally guarantees
their settlement.

Liquidation Low, as contracts are High, as contracts are


Profile tailor made contracts standardized exchange traded
catering to the needs of contracts.
the needs of the parties.

Price Not efficient, as markets Efficient, as markets are


discovery are scattered. centralized and all buyers and
sellers come to a common
platform to discover the price.
Examples Currency market in India. Commodities, futures, Index
Futures and Individual stock
Futures in India.

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OPTIONS -

A derivative transaction that gives the option holder the right but not the
obligation to buy or sell the underlying asset at a price, called the strike
price, during a period or on a specific date in exchange for payment of a
premium is known as ‘option’. Underlying asset refers to any asset that is
traded. The price at which the underlying is traded is called the ‘strike price’.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an
underlying asset-stock or any financial asset, at a specified price on or before
a specified date is known as a ‘Call option’. The owner makes a profit
provided he sells at a higher current price and buys at a lower future price.

53
54
PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an
underlying asset-stock or any financial asset, at a specified price on or before
a specified date is known as a ‘Put option’. The owner makes a profit
provided he buys at a lower current price and sells at a higher future price.
Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally
preference shares, bonds and warrants become the subject of options.

55
MARKET TRENDS IN FUTURES AND OPTIONS

Recent Market Volatility has impacted the Use of Derivatives

Volatility in the markets has affected both structured derivatives along with
futures and options

Research from the consulting firm Greenwich Associates indicates that while
the use of over-the-counter, dealer traded, structured derivatives has seen a
marked decline in recent months, the use of exchange traded standard futures
and option contracts has seen the opposite, a rise in their use by institutional
investors for a variety of reasons. Perhaps some of the strategies employed
by these institutions can help the average retail investor.

PRODUCT USAGE OVERALL

According to that same research, many institutions in North America use


futures and options as a means to take a position, whether long or short, in
the underlying issue or index. Given that, roughly two-thirds use equity
derivatives as a functional adjunct to their fundamental investment strategy
or philosophy.

Slightly less than two-thirds of institutions use futures and options to execute
their opinion on the general direction of the market, sector or individual
issues and just under half use exchange traded derivatives to establish more
complex strategies.

56
PRODUCT SECTOR USAGE

Just over half of North American institutions use index futures with hedge
funds participating in this sector at just under half. The opposite is true in
usage of Exchange Traded Funds (ETF) with just over a half of institutions
using ETF’s and not quite two-thirds hedge funds.

To a lesser extent, institutions use futures and option contracts for index or
sector swaps and swaps on a particular portfolio or basket of stocks while
usage for access to the underlying sector or issue is a distant last.

POPULAR STRATEGIES

There are some slight differences between institutional investors overall and
hedge funds, but on balance the most popular strategy is single-stock listed
options with roughly three-quarters using them. The next most popular with
60% to 70% participation is listed index options and the third most popular
strategy with roughly half of institutions using them is options on sector
Exchange Traded Funds.

Much less popular were the more exotic type of uses such as futures and
options on volatility, dispersion and correlation type trades and variance
swaps on indexes and single stocks.

CONSIDERATIONS

There are a number of considerations any investor should make about their
broker. Being penny wise and pound foolish about commissions is a major
point. Institutional investors use a "high-touch" sales professional over half
the time for futures and three-quarters of he time for options. Electronic

57
execution accounts for the reciprocal, whether to the broker’s desk or
directly to an exchange.

Consider what institutional investors consider important factors in their


choice of brokers: Certainly pricing is important but so is the expertise of the
sales professional, their understanding of the client’s investment strategy,
their market judgment and sense of timing and willingness to commit capital
to facilitate trades.

Remember to consult your own investment professional to determine if


employing futures and options is an appropriate and suitable vehicle for you
to use.

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SWAPS -
Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a ‘SWAP’. In case of swap, only
the payment flows are exchanged and not the principle amount. The two
commonly used swaps are:

INTEREST RATE SWAPS:


Interest rate swaps is an arrangement by which one party agrees to exchange
his series of fixed rate interest payments to a party in exchange for his
variable rate interest payments. The fixed rate payer takes a short position in
the forward contract whereas the floating rate payer takes a long position in
the forward contract.

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

59
FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to
access one market and then exchange the liability for another type of
liability. It also allows the investors to exchange one type of asset for another
type of asset with a preferred income stream.

THE NO-ARBITRAGE PRINCIPLE


To discuss the no-arbitrage principle we first need to develop a basic
understanding of arbitrage. An arbitrage opportunity is a chance to
make riskless profit with no investment. An arbitrageur is a person who
engages in arbitrage.

Illustrative Example

Shares of IBM trade on both the New York Stock Exchange and the Pacific
Stock Exchange. Suppose the shares of IBM trade for $65 on the New
York market and for $60 on the Pacific Exchange. A trader could make
the following two transactions simultaneously: Buy 1 share of IBM on

60
the Pacific Exchange for $60Sell 1 share of IBM on the New York
Exchange for $65 The two transactions generate a riskless profit of $5.
Because both trades are assumed to occur simultaneously, there is no
investment.

Thus this opportunity qualifies as an arbitrage opportunity.

The no-arbitrage principle states that any rational price for a financial
instrument must exclude arbitrage opportunities. This is one of the
minimal requirements for a feasible or rational price for any financial
instrument.

FINANCIAL DERIVATIVES AND THE MARKET


A derivative is a kind of financial instrument which is derived from some
other underlying assets. Trading using derivatives has been emerging and
many countries follow this method. Here, instead of trading or exchanging
the asset involved, traders can have agreement among themselves for
exchanging either cash or assets.

A good example of this kind is a future contract. Here the traders will
involve in an agreement that in a future date they both agree to exchange the
underlying asset. Derivatives usually have high leverage because even a
small change in the asset value can cause high difference in the derivative.
Derivatives are used by investors mainly for speculating and making profit
in the financial market. But, this will work only if the value of the asset
follows the trend in the financial market as expected. If the asset price moves
in a downward direction in the financial market then it could prove risky. In

61
such cases where traders are uncertain of the assert price trend they can use
hedge or can enter into agreement for which the opposite derivative moves in
opposite direction.

In the financial market, derivatives classified based on the following:

1. The link between the derivative and the underlying asset.


2. The kind of the underlying asset. This can be equity derivatives, interest
rate derivatives foreign exchange derivatives and credit derivatives.
3. The type of market where the trade happens. It can be traded over the
counter or using exchanges.

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INDIAN DERIVATIVES MARKET
Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments
in India gained momentum in the last few years due to liberalisation process
and Reserve Bank of India’s (RBI) efforts in creating currency forward
market. Derivatives are an integral part of liberalisation process to manage
risk. NSE gauging the market requirements initiated the process of setting up
derivative markets in India. In July 1999, derivatives trading commenced in
India.

Need for derivatives in India today


In less than three decades of their coming into vogue, derivatives markets
have become the most important markets in the world. Today, derivatives
have become part and parcel of the day-to-day life for ordinary people in
major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest
trading methods and was using traditional out-dated methods of trading.
There was a huge gap between the investors’ aspirations of the markets and
the available means of trading. The opening of Indian economy has
precipitated the process of integration of India’s financial markets with the
international financial markets. Introduction of risk management instruments
in India has gained momentum in last few years thanks to Reserve Bank of
India’s efforts in allowing forward contracts, cross currency options etc.
which have developed into a very large market.

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MYTHS AND REALITIES ABOUT DERIVATIVES

In less than three decades of their coming into vogue, derivatives markets
have become the most important markets in the world. Financial derivatives
came into the spotlight along with the rise in uncertainty of post-1970, when
US announced an end to the Bretton Woods System of fixed exchange rates
leading to introduction of currency derivatives followed by other innovations
including stock index futures. Today, derivatives have become part and
parcel of the day-to-day life for ordinary people in major parts of the world.
While this is true for many countries, there are still apprehensions about the
introduction of derivatives. There are many myths about derivatives but the
realities that are different especially for Exchange traded derivatives, which
are well regulated with all the safety mechanisms in place.
What are these myths behind derivatives?
• Derivatives increase speculation and do not serve any economic
purpose
• Indian Market is not ready for derivative trading
• Disasters prove that derivatives are very risky and highly leveraged
instruments.
• Derivatives are complex and exotic instruments that Indian investors
will find difficulty in understanding
• Is the existing capital market safer than Derivatives?
Derivatives increase speculation and do not serve any economicpurpose:
Numerous studies of derivatives activity have led to a broad consensus, both
in the private and public sectors that derivatives provide numerous and

64
substantial benefits to the users. Derivatives are a low-cost, effective method
for users to hedge and manage their exposures to interest rates, commodity
prices or exchange rates. The need for derivatives as hedging tool was felt
first in the commodities market. Agricultural futures and options helped
farmers and processors hedge against commodity price risk. After the fallout
of Bretton wood agreement, the financial markets in the world started
undergoing radical changes. This period is marked by remarkable
innovations in the financial markets such as introduction of floating rates for
the currencies, increased trading in variety of derivatives instruments, on-
line trading in the capital markets, etc. As the complexity of instruments
increased many folds, the accompanying risk factors grew in gigantic
proportions. This situation led to development derivatives as effective risk
management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional


investors to effectively manage their portfolios of assets and liabilities
through instruments like stock index futures and options. An equity fund, for
example, can reduce its exposure to the stock market quickly and at a
relatively low cost without selling off part of its equity assets by using stock
index futures or index options.

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By providing investors and issuers with a wider array of tools for
managing risks and raising capital, derivatives improve the allocation of
credit and the sharing of risk in the global economy, lowering the cost of
capital formation and stimulating economic growth. Now that world markets
for trade and finance have become more integrated, derivatives have
strengthened these important linkages between global markets, increasing
market liquidity and efficiency and facilitating the flow of trade and finance

(ii) Indian Market is not ready for derivative trading


Often the argument put forth against derivatives trading is that the Indian
capital market is not ready for derivatives trading. Here, we look into the
pre-requisites, which are needed for the introduction of derivatives, and how
Indian market fares:

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PRE-REQUISITES INDIAN SCENARIO
Large market India is one of the largest market-capitalised
Capitalisation countries in Asia with a market capitalisation of
more than Rs.765000 crores.

High Liquidity in the The daily average traded volume in Indian


underlying capital market today is around 7500 crores.
Which means on an average every month 14%
of the country’s Market capitalisation gets
traded. These are clear indicators of high
liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing


trades has become fully functional from July
1996 in the form of National Securities Clearing
Corporation (NSCCL). NSCCL is responsible
for guaranteeing all open positions on the
National Stock Exchange (NSE) for which it
does the clearing.

A Strong Depository National Securities Depositories Limited


(NSDL) which started functioning in the year
1997 has revolutionalised the security settlement
in our country.

A Good legal guardian In the Institution of SEBI (Securities and


Exchange Board of India) today the Indian
capital market enjoys a strong, independent, and
innovative legal guardian who is helping the
market to evolve to a healthier place for trade
practices.

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COMPARISON OF NEW SYSTEM WITH EXISTING
SYSTEM
Many people and brokers in India think that the new system of Futures &
Options and banning of Badla is disadvantageous and introduced early, but I
feel that this new system is very useful especially to retail investors. It
increases the no of options investors for investment. In fact it should have
been introduced much before and NSE had approved it but was not active
because of politicization in SEBI.

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize


1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum
Trading, margin loss to extent of on delivery basis loss possible
trading & carry price change. 2) Buy Call &Put to premium
forward transactions. by paying paid
2) Buy Index Futures premium
hold till expiry.

Advantages

• Greater Leverage as to pay only the premium.


• Greater variety of strike price options at a given time.

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Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free


one and selling in whichever way promising as still game.
another exchange. the Market moves. in weekly settlement
forward transactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
more or less than Fair price

• Fair Price = Cash Price + Cost of Carry.

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional


offload holding available risk latter by paying premium. cost is only
during adverse reward dependant 2)For Long, buy ATM Put premium.
market conditions on market prices Option. If market goes up,
as circuit filters long position benefit else
limit to curtail losses. exercise the option.
3)Sell deep OTM call option
with underlying shares, earn
premium + profit with increase prcie

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Advantages
• Availability of Leverage

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downside


stocks else sell it. implies unlimited based on market outlook remains
profit/loss. 2) Hedge position if protected &
holding underlying upside
stock unlimited.
Advantages
• Losses Protected.

EXCHANGE-TRADED VS. OTC DERIVATIVES MARKETS


The OTC derivatives markets have witnessed rather sharp growth over the
last few years, which has accompanied the modernization of commercial and
investment banking and globalisation of financial activities. The recent
developments in information technology have contributed to a great extent to
these developments. While both exchange-traded and OTC derivative
contracts offer many benefits, the former have rigid structures compared to
the latter. It has been widely discussed that the highly leveraged institutions
and their OTC derivative positions were the main cause of turbulence in
financial markets in 1998. These episodes of turbulence revealed the risks
posed to market stability originating in features of OTC derivative
instruments and markets.

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The OTC derivatives markets have the following features compared to
exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralized and
located within individual institutions,
2. There are no formal centralized limits on individual positions,
leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability
and integrity, and for safeguarding the collective interests of market
participants, and
5. The OTC contracts are generally not regulated by a regulatory
authority and the exchange’s self-regulatory organization, although
they are affected indirectly by national legal systems, banking
supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial


market stability.

The following features of OTC derivatives markets can give rise to


instability in institutions, markets, and the international financial system: (i)
the dynamic nature of gross credit exposures; (ii) information asymmetries;
(iii) the effects of OTC derivative activities on available aggregate credit;
(iv) the high concentration of OTC derivative activities in major institutions;
and (v) the central role of OTC derivatives markets in the global financial
system. Instability arises when shocks, such as counter-party credit events
and sharp movements in asset prices that underlie derivative contracts, occur
which significantly alter the perceptions of current and potential future credit

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exposures. When asset prices change rapidly, the size and configuration of
counter-party exposures can become unsustainably large and provoke a rapid
unwinding of positions.

There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk
management, including counter-party, liquidity and operational risks, and
OTC derivatives markets continue to pose a threat to international financial
stability. The problem is more acute as heavy reliance on OTC derivatives
creates the possibility of systemic financial events, which fall outside the
more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through the use of exchange traded
derivatives. In view of the inherent risks associated with OTC derivatives,
and their dependence on exchange traded derivatives, Indian law considers
them illegal.

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FACTORS CONTRIBUTING TO THE GROWTH OF
DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price


volatility, globalizations of the markets, technological developments and
advances in the financial theories.

A.} PRICE VOLATILITY –


A price is what one pays to acquire or use something of value. The objects
having value maybe commodities, local currency or foreign currencies. The
concept of price is clear to almost everybody when we discuss commodities.
There is a price to be paid for the purchase of food grain, oil, petrol, metal,
etc. the price one pays for use of a unit of another persons money is called
interest rate. And the price one pays in one’s own currency for a unit of
another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers


have ‘demand’ and producers or suppliers have ‘supply’, and the collective
interaction of demand and supply in the market determines the price. These
factors are constantly interacting in the market causing changes in the price
over a short period of time. Such changes in the price are known as ‘price
volatility’. This has three factors: the speed of price changes, the frequency
of price changes and the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market


adjustments through price changes. These price changes expose individuals,
producing firms and governments to significant risks. The break down of the

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BRETTON WOODS agreement brought and end to the stabilising role of
fixed exchange rates and the gold convertibility of the dollars. The
globalisation of the markets and rapid industrialisation of many
underdeveloped countries brought a new scale and dimension to the markets.
Nations that were poor suddenly became a major source of supply of goods.
The Mexican crisis in the south east-Asian currency crisis of 1990’s has also
brought the price volatility factor on the surface. The advent of
telecommunication and data processing bought information very quickly to
the markets. Information which would have taken months to impact the
market earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates
rapidly.
These price volatility risks pushed the use of derivatives like futures and
options increasingly as these instruments can be used as hedge to protect
against adverse price changes in commodity, foreign exchange, equity shares
and bonds.

B.} GLOBALISATION OF MARKETS –


Earlier, managers had to deal with domestic economic concerns; what
happened in other part of the world was mostly irrelevant. Now globalisation
has increased the size of markets and as greatly enhanced competition .it has
benefited consumers who cannot obtain better quality goods at a lower cost.
It has also exposed the modern business to significant risks and, in many
cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis-à-vis depreciated currencies. Export of

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certain goods from India declined because of this crisis. Steel industry in
1998 suffered its worst set back due to cheap import of steel from south East
Asian countries. Suddenly blue chip companies had turned in to red. The fear
of china devaluing its currency created instability in Indian exports. Thus, it
is evident that globalisation of industrial and financial activities necessitates
use of derivatives to guard against future losses. This factor alone has
contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –


A significant growth of derivative instruments has been driven by
technological breakthrough. Advances in this area include the development
of high speed processors, network systems and enhanced method of data
entry. Closely related to advances in computer technology are advances in
telecommunications. Improvement in communications allow for
instantaneous worldwide conferencing, Data transmission by satellite. At the
same time there were significant advances in software programmes without
which computer and telecommunication advances would be meaningless.
These facilitated the more rapid movement of information and consequently
its instantaneous impact on market price.
Although price sensitivity to market forces is beneficial to the economy as a
whole resources are rapidly relocated to more productive use and better
rationed overtime the greater price volatility exposes producers and
consumers to greater price risk. The effect of this risk can easily destroy a
business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy. To the extent the

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technological developments increase volatility, derivatives and risk
management products become that much more important.

D.} ADVANCES IN FINANCIAL THEORIES –


Advances in financial theories gave birth to derivatives. Initially forward
contracts in its traditional form, was the only hedging tool available. Option
pricing models developed by Black and Scholes in 1973 were used to
determine prices of call and put options. In late 1970’s, work of Lewis
Edeington extended the early work of Johnson and started the hedging of
financial price risks with financial futures. The work of economic theorists
gave rise to new products for risk management which led to the growth of
derivatives in financial markets.
The above factors in combination of lot many factors led to growth of
derivatives instruments

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DEVELOPMENT OF DERIVATIVES MARKET IN
INDIA

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

77
commenced in India in June 2000 after SEBI granted the final approval to
this effect in May 2001. SEBI permitted the derivative segments of two
stock exchanges, NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivatives contracts. To
begin with, SEBI approved trading in index futures contracts based on S&P
CNX Nifty and BSE–30 (Sense) index. This was followed by approval for
trading in options based on these two indexes and options on individual
securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001. The
derivatives trading on NSE commenced with S&P CNX Nifty Index futures
on June 12, 2000. The trading in index options commenced on June 4, 2001
and trading in options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futures
and options contract on NSE are based on S&P CNX Trading and settlement
in derivative contracts is done in accordance with the rules, byelaws, and
regulations of the respective exchanges and their clearing house/corporation
duly approved by SEBI and notified in the official gazette. Foreign
Institutional Investors (FIIs) are permitted to trade in all Exchange traded
derivative products.

The following are some observations based on the trading statistics provided
in the NSE report on the futures and options (F&O):

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• Single-stock futures continue to account for a sizable proportion of the
F&O segment. It constituted 70 per cent of the total turnover during June
2002. A primary reason attributed to this phenomenon is that traders are
comfortable with single-stock futures than equity options, as the former
closely resembles the erstwhile badla system.

• On relative terms, volumes in the index options segment continue to


remain poor. This may be due to the low volatility of the spot index.
Typically, options are considered more valuable when the volatility of the
underlying (in this case, the index) is high. A related issue is that brokers do
not earn high commissions by recommending index options to their clients,
because low volatility leads to higher waiting time for round-trips.

• Put volumes in the index options and equity options segment have
increased since January 2002. The call-put volumes in index options have
decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put
volumes ratio suggests that the traders are increasingly becoming pessimistic
on the market.

• Farther month futures contracts are still not actively traded. Trading in
equity options on most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O segment
as a less risky alternative (read substitute) to generate profits from the stock
price movements. The fact that the option premiums tail intra-day stock
prices is evidence to this. If calls and puts are not looked as just substitutes

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for spot trading, the intra-day stock price variations should not have a one-
to-one impact on the option premiums.

• The spot foreign exchange market remains the most important


segment but the derivative segment has also grown. In the
derivative market foreign exchange swaps account for the largest
share of the total turnover of derivatives in India followed by
forwards and options. Significant milestones in the development
of derivatives market have been (i) permission to banks to
undertake cross currency derivative transactions subject to certain
conditions (1996) (ii) allowing corporates to undertake long term
foreign currency swaps that contributed to the development of
the term currency swap market (1997) (iii) allowing dollar rupee
options (2003) and (iv) introduction of currency futures (2008). I
would like to emphasise that currency swaps allowed companies
with ECBs to swap their foreign currency liabilities into rupees.
However, since banks could not carry open positions the risk was
allowed to be transferred to any other resident corporate. Normally
such risks should be taken by corporates who have natural hedge or
have potential foreign exchange earnings. But often corporate
assume these risks due to interest rate differentials and views on
currencies.

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This period has also witnessed several relaxations in regulations relating
to forex markets and also greater liberalisation in capital account
regulations leading to greater integration with the global economy.

• Cash settled exchange traded currency futures have made foreign


currency a separate asset class that can be traded without any
underlying need or exposure a n d on a leveraged basis on the
recognized stock exchanges with credit risks being assumed by the
central counterparty
Since the commencement of trading of currency futures in all the three
exchanges, the value of the trades has gone up steadily from Rs 17, 429
crores in October 2008 to Rs 45, 803 crores in December 2008. The
average daily turnover in all the exchanges has also increased from
Rs871 crores to Rs 2,181 crores during the same period. The turnover in
the currency futures market is in line with the international scenario,
where I understand the share of futures market ranges between 2 – 3 per
cent.

April’05- April’06- April’07- April’08-


Mar’06 Mar’07 Mar’08 Dec’08
Total turnover (USD billion) 4,404 6,571 12,304 9,621
Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1
Spot/Total Turnover (%) 50.5 51.9 49.7 45.9
Forward/Total Turnover (%) 19.0 17.9 19.3 21.5
Swap/Total Turnover (%) 30.5 30.1 31.1 32.7
Source: RBI

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BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT –


Futures and options contract can be used for altering the risk of investing in
spot market. For instance, consider an investor who owns an asset. He will
always be worried that the price may fall before he can sell the asset. He can
protect himself by selling a futures contract, or by buying a Put option. If the
spot price falls, the short hedgers will gain in the futures market, as you will
see later. This will help offset their losses in the spot market. Similarly, if the
spot price falls below the exercise price, the put option can always be
exercised.

2.] PRICE DISCOVERY –


Price discovery refers to the markets ability to determine true equilibrium
prices. Futures prices are believed to contain information about future spot
prices and help in disseminating such information. As we have seen, futures
markets provide a low cost trading mechanism. Thus information pertaining
to supply and demand easily percolates into such markets. Accurate prices
are essential for ensuring the correct allocation of resources in a free market
economy. Options markets provide information about the volatility or risk of
the underlying asset.

3.] OPERATIONAL ADVANTAGES –

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As opposed to spot markets, derivatives markets involve lower transaction
costs. Secondly, they offer greater liquidity. Large spot transactions can
often lead to significant price changes. However, futures markets tend to be
more liquid than spot markets, because herein you can take large positions
by depositing relatively small margins. Consequently, a large position in
derivatives markets is relatively easier to take and has less of a price impact
as opposed to a transaction of the same magnitude in the spot market.
Finally, it is easier to take a short position in derivatives markets than it is to
sell short in spot markets.

4.] MARKET EFFICIENCY –


The availability of derivatives makes markets more efficient; spot, futures
and options markets are inextricably linked. Since it is easier and cheaper to
trade in derivatives, it is possible to exploit arbitrage opportunities quickly
and to keep prices in alignment. Hence these markets help to ensure that
prices reflect true values.

5.] EASE OF SPECULATION –


Derivative markets provide speculators with a cheaper alternative to
engaging in spot transactions. Also, the amount of capital required to take a
comparable position is less in this case. This is important because facilitation
of speculation is critical for ensuring free and fair markets. Speculators
always take calculated risks. A speculator will accept a level of risk only if
he is convinced that the associated expected return is commensurate with the
risk that he is taking.

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The derivative market performs a number of economic functions.
• The prices of derivatives converge with the prices of the underlying at
the expiration of derivative contract. Thus derivatives help in
discovery of future as well as current prices.
• An important incidental benefit that flows from derivatives trading is
that it acts as a catalyst for new entrepreneurial activity.
• Derivatives markets help increase savings and investment in the long
run. Transfer of risk enables market participants to expand their
volume of activity.

CONTRIBUTION OF DERIVATIVE MARKET IN


MARKET COMPLETENESS
Complete market: A complete market is a market in which any and all
identifiable payoffs can be obtained by trading the securities available in
the market. For example in order to have a complete market a trader
must be able to purchase a set of securities in order to obtain any payoff
he can think of.

From this definition we see that a complete market is an idealization that is


most likely always unobtainable in practice. Nonetheless, completeness
is a desirable characteristic of a financial market, because it can be
shown that access to a complete market increases the welfare of the
agents in the economy. Even if an actual market can never be truly
complete, the more closely the market approaches completeness, the

84
better off the economic agents are in the economy. Financial derivatives
play a valuable role in financial markets because they help to move the
market closer to completeness.

If we consider two financial markets that are the same, except that one
includes financial derivatives, the market with financial derivatives will
allow traders to shape the risk and return characteristics of their
portfolios more exactly, thereby increasing the welfare of traders and
the economy in general.

THE MAJOR APPLICATIONS OF FINANCIAL


DERIVATIVES
The major applications of financial derivatives are:

MARKET COMPLETENESS

• A complete market is a market in which any and all identifiable payoffs can
be obtained by trading the securities available in the market.

SPECULATION

• Financial derivatives allow traders the ability to expose themselves to


calculated and well understood risks in the pursuit of profits.

• For example traders can speculate on a rise or fall in interest rates, change
in currencies against each other or on a host of other specific
propositions.

RISK MANAGEMENT

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• Financial derivatives are a powerful tool for limiting risks.

• For example a corporation that is planning to issue bonds faces


considerable interest rate risk.

• If interest rates rise before the bond is issued, the firm will have to pay
considerably more over the life of the bond.

• This firm can use interest rate futures to control its exposure to this risk.

TRADING EFFICIENCY

• Traders can use one or more financial derivatives as a substitute for a


position in the more fundamental underlying instruments.

• For example an option position can mimic the profit or loss performance of
an underlying stock index.

• In many instances traders find financial derivatives to be a more attractive


instrument than the underlying security owing to substantially lower
transaction costs and higher liquidity in the financial derivatives market.

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SUMMARY
1) A derivative instrument is one whose value depends on the value of
something else.

2) A forward contract is a type of a contract initiated at the start with


performance in accordance with the terms of the contract occurring at a
later time. There is an exchange of assets and the price at which the
exchange occurs is set at the time of the initial contracting. The actual
payment and delivery of the asset occur at the later time.

3) A futures contract is a type of a forward contract with highly standardized


and closely specified contract terms. A futures contract has the
following characteristics:

a) Futures contracts always trade on an organized exchange.

b) Futures contracts are always highly standardized with a specified quantity


of a good, with a specific delivery date and delivery mechanism.

c) Performance on futures contracts is guaranteed by a clearinghouse.

d) All futures contracts require that traders post margin in order to trade.

e) Futures markets are regulated by an identifiable government agency.

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4) A clearinghouse is a financial institution associated with the futures
exchange that guarantees the financial integrity of the market to all
traders.

5) A margin is a good faith deposit made by the prospective futures trader to


indicate his or her willingness and ability to fulfill all financial
obligations that may arise from trading futures.

6) Call option – The owner of a call has the right to purchase an underlying
good at a specific price, and this right lasts until a specific date

7) Put option – The owner of a put option has the right to sell the underlying
well at a specific price, and this right lasts until a specific date.

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FINANCIAL DERIVATIVES – INSTRUMENT
IN STRATEGIC RISK MANAGEMENT

The financial derivatives aren’t new at all; they have been there since years.
You will find a description of initial known options contract in the
Aristotle’s writings. The financial derivatives are vital instruments for
assisting the organizations to reach the risk management objectives.
Basically, it’s with all instruments that the user needs to understand the
function of the instrument and then the safety precautions should be taken to
make use of the instrument.

As the builder makes use of the power saw for constructing houses for
effectiveness as well as efficiency, the financial derivatives could be a useful
instrument for helping the corporations as well as banks to become more
effective and efficient in meeting the risk management goals. But, the power
saw can also get dangerous when used improperly or blindly.

Therefore, if the users of the power saws are not careful, it will cause serious
harm and ruin the entire project. Similarly, if the financial derivatives aren’t
used properly, they can cause serious damage leading to losses impelling the
organization in a wrong direction damaging the future.

Financial derivatives have to be used properly and will surely help the
organization to fulfill the risk management goals so that the funds are handy

89
for making the best investments. Also, the company’s decision to utilize the
financial derivatives should have the risk management strategy based on
wider corporate targets.

The most basic form of questions regarding the strategies in the risk
management needs to be addressed. For example, which kind of risk needs to
be hedged and further which ones should remain unhedged ? Which type of
trading strategies and derivatives are the most appropriate? How is the
performance of these instruments going to be in case of decrease or increase
in the rate of interest? What will be the impact of these instruments if there
are terrific fluctuations in the exchange rates?

Therefore, if you do not have a defined strategy of risk management, it


should be very dangerous to use the financial derivatives. The same can put
the firm’s accomplishment in danger and can hamper the long term
objectives resulting in unsound and unsafe practices which can result in
insolvency of the firm. But, if the same thing is used wisely, the financial
derivative can increase the value of the shareholder by providing means to
control the risks and cash flow better.

In short, the financial derivatives are just not a latest fad of the risk
management. The financial derivatives are going to stay. We are right on the
track to the true world financial market that will go on continuing with new
innovations for improving the risk management practices. They are surely
not a fad but are vital tools for helping the organizations for better
management of the risk exposures.

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In the end, the financial derivatives need to be considered as a part of any of
the company’s strategy of risk management for ensuring that the value
enhancing opportunities in investment are achieved.

RISK-
Risk is a characteristic feature of most commodity and capital markets.
Variations in the prices of agricultural and non-agricultural commodities are
induced, over time, by demand-supply dynamics. The last two decades have
witnessed many-fold increase in the volume of international trade and
business due to the wave of globalization and liberalization sweeping across
the world. This has led to rapid and unpredictable variations in financial
assets prices, interest rates and exchange rates, and subsequently, to
exposing the corporate world to an unwieldy financial risk. In the present
highly uncertain business scenario, the importance of risk management is
much greater than ever before. The emergence of derivatives market is an
ingenious feat of financial engineering that provides an effective and less
costly solution to the problem of risk that is embedded in the price
unpredictability of the underlying asset. In India, the emergence and growth
of derivatives market is relatively a recent phenomenon. Since its inception
in June 2000, derivatives market has exhibited exponential growth both in
terms of volume and number of traded contracts. The market turn-over has
grown from Rs.2365 crore in 2000-2001 to Rs. 11010482.20 crore in 2008-
2009. Within a short span of eight years, derivatives trading in India has
surpassed cash segment in terms of turnover and number of traded contracts.
The present study encompasses in its scope an analysis of historical roots of
derivative trading, types of derivative products, regulation and policy

91
developments, trend and growth, future prospects and challenges of
derivative market in India. Some space is devoted also to a brief discussion
of the status of global derivatives markets vis-a–vis the Indian derivatives
market.

Risk is a characteristic feature of all commodity and capital markets. Over


time, variations in the prices of agricultural and non-agricultural
commodities occur as a result of interaction of demand and supply forces.
The last two decades have witnessed a many-fold increase in the volume of
international trade and business due to the ever growing wave of
globalization and liberalization sweeping across the world. As a result,
financial markets have experienced rapid variations in interest and exchange
rates, stock market prices thus exposing the corporate world to a state of
growing financial risk.

STRATEGIC RISK MANAGEMENT


Why would risk-averse individuals and entities ever expose
themselvesintentionally to risk and increase that exposure over time? One
reason is that they believethat they can exploit these risks to advantage and
generate value. How else can youexplain why companies embark into
emerging markets that have substantial political andeconomic risk or into
technologies where the ground rules change on a day-to-day basis?

By the same token, the most successful companies in every sector and in
each generation – General Motors in the 1920s, IBM in the 1950s and
1960s, Microsoft and Intel in the1980s and 1990s and Google in this
decade- share a common characteristic. They achieved their success not by
avoiding risk but by seeking it out.There are some who would attribute the

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success of these companies and otherslike them to luck, but that can explain
businesses that are one-time wonders – a singlesuccessful product or service.
Successful companies are able to go back to the well againand again,
replicating their success on new products and in new markets. To do so,
theymust have a template for dealing with risk that gives them an
advantage over thecompetition. In this chapter, we consider how best to
organize the process of risk takingto maximize the odds of success. In the
process, we will have to weave through manydifferent functional areas of
business, from corporate strategy to finance to operationsmanagement, that
have traditionally not been on talking terms.

Increased financial risk causes losses to an otherwise profitable


organisation. This underlines the importance of risk management to hedge
against uncertainty. Derivatives provide an effective solution to the problem
of risk caused by uncertainty and volatility in underlying asset. Derivatives
are risk management tools that help an organisation to effectively transfer
risk. Derivatives are instruments which have no independent value. Their
value depends upon the underlying asset. The underlying asset may be
financial or non-financial. The present study attempts to discuss the genesis
of derivatives trading by tracing its historical development, types of traded
derivatives products, regulation and policy developments, trend and growth,
future prospects and challenges of derivative market in India. The study is
organised into four sections

Financial transactions are fraught with several risk factors. Derivatives are
instrumental in alienating those risk factors from traditional instruments and
shifting risks to those entities that are ready to take them. Some of the basic
risk components in derivatives business are:

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• Credit Risk: When one of the two parties fails to perform its role
as per the agreement, this is called the credit risk. It can also be referred
to as default or counterparty risk. It varies with different sources.
• Market Risk: This is a kind of financial loss that takes place due to
the adverse price movements of the underlying variable or instrument.
• Liquidity Risk: When a firm is unable to devise a transaction at
current market rates, it can be referred to as liquidity risk. There are
two kinds of liquidity risks involved in the scenario. First is concerned
with the liquidity of separate items and second is related to supporting
the activities of the organization with funds comprising derivatives.
• Legal Risk: Legal issues related with the agreement need to be
scrutinized well, as one can deal in derivatives across the different
judicial boundaries.

DERIVATIVE MARKET AND FINANCIAL RISK


Derivatives play a vital role in risk management of both financial and non-
financial institutions. But, in the present world, it has become a rising
concern that derivative market operations may destabilize the efficiency of
financial markets. In today’s’ world the companies the financial and non-
financial firms are using forward contracts, future contracts, options, swaps
and other various combinations of derivatives to manage risk and to increase
returns. It is true that growth of derivatives market reveal the increasing
market demand for risk managing instruments in the economy. But, the
major concern is that, the main components of Over the Counter (OTC)
derivatives are interest rates and currency swaps. So, the economy will suffer
surely if the derivative instruments are misused and if a major fault takes
place in derivatives market.

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Share markets across the world are flooded with different types of financial
instruments. Instruments because they directly do not give us money, but
acts as a channel to gain money. Today let us discuss in detail about
financial derivatives.

In chemistry, the definition of derivatives states that these are substances


which are created from another substance. Similarly in the financial markets
derivatives are financial instruments which are based on an already existing
act and which allow value exchange.

In this, the stock holder enters into a deal with a person, who is ready to buy
the stock at a recognized price or at a different price in the near future.
However; amongst both the latter part is the most popular one.

There are specific roles that are a part of financial derivatives

SPECULATION AND HEDGING

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HEDGING INSTRUMENT IN DERIVATIVE
MARKET

THE HEDGE FUNDS- BRIEF HISTORY

THE FATHER OF THE HEDGE FUND

Alfred Jones was born in Melbourne, Australiain 1901 to American parents.


He moved to the United States as a young child, graduated from Harvard in
1923 and became a U.S. diplomat in the early 1930s, working
in Berlin, Germany. He earned a PhD in sociology
from ColumbiaUniversity and joined the editorial staff atFortune magazine
in the early 1940s.

It was while writing an article about current investment trends for Fortune in
1948 that Jones was inspired to try his hand at managing money. He raised
$100,000 (including $40,000 out of his own pocket) and set forth to try to
minimize the risk in holding long-term stock positions by short selling other
stocks. This investing innovation is now referred to as the classic long/short
equities model. Jones also employed leverage in an effort to enhance
returns.

In 1952, Jones altered the structure of his investment vehicle, converting it


from a general partnership to a limited partnership and adding a 20%
incentive fee as compensation for the managing partner. As the first money
manager to combine short selling, the use of leverage, shared risk through a

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partnership with other investors and a compensation system based on
investment performance, Jones earned his place in investing history as the
father of the hedge fund.

THE RISE OF THE INDUSTRY


When a 1966 article in Fortune magazine highlighted an obscure investment
that outperformed every mutual fund on the market by double-digit figures
over the past year and by high double-digits over the last five years, the
hedge fund industry was born. By 1968, there were some 140 hedge funds in
operation.

In an effort to maximize returns, many funds turned away from Jones'


strategy, which focused on stock picking coupled with hedging, and chose
instead to engage in riskier strategies based on long-term leverage. These
tactics led to heavy losses in 1969-70, followed by a number of hedge fund
closures during the bear market of 1973-74.

The industry was relatively quiet for more than two decades, until a 1986
article inInstitutional Investor touted the double-digit performance of Julian
Robertson's Tiger Fund. With a high-flying hedge fund once again capturing
the public's attention with its stellar performance, investors flocked to an
industry that now offered thousands of funds and an ever-increasing array of
exotic strategies, including currency trading and derivatives such
as futures and options.

High-profile money managers deserted the traditional mutual fund industry


in droves in the early 1990s, seeking fame and fortune as hedge fund

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managers. Unfortunately, history repeated itself in the late 1990s and into the
early 2000s as a number of high-profile hedge funds, including Robertson's,
failed in spectacular fashion.

THE HEDGE FUND TODAY


With media attention still focused on the recent failure of some hedge funds,
there has been an increasing move towards their regulation. In 2004, the
Securities and Exchange Commission adopted changes that require hedge
fund managers and sponsors to register as investment advisors under
the Investment Advisor's Act of 1940. This greatly increased the number of
requirements placed on hedge funds, including keeping up-to-date
performance records, hiring a compliance officer and creating a code of
ethics. This was seen as an important move in protecting investors. (For
more information, see the SEC website.)

Despite troubles in the last few years, the hedge fund industry continues to
thrive. The development of the "fund of funds", which is simplistically
defined as a mutual fund that invests in multiple hedge funds, provided
greater diversification for investors' portfolios and reduced the minimum
investment requirement to as low as $25,000. The introduction of the fund of
funds not only took some of the risk out of hedge fund investing, but also
made the product more accessible to the average investor.

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CONCLUSION
Hedge funds have evolved significantly since 1949. Modern hedge funds
offer a variety of strategies, including many that do not involve traditional
hedging techniques. The industry has also rapidly grown, with recent
estimations pegging its size at $1 trillion - quite the leap from the $100,000
used to start the first fund half a century ago.

With a fascinating past that has twice seen media-fostered publicity push the
industry to stratospheric highs and vilify it when it fell from grace, it seems
highly probable that the cycle will repeat itself at some point in the future.
While it is easy to get sucked in by the hype or repelled by the negative
press, it's always advisable to take a step back and conduct some due
diligence, just as you would prior to making any investment.
Before you put your hard-earned money at risk, you have to make sure you
are choosing the right investment for the right reason. Don't blindly chase
performance, and remember that past performance is not an indicator of
future performance.

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HEDGING:
This technique reduces the risk involved in financial market. In this method,
the risk involved in the derivative can be transferred from one trader to the
other. For example consider a derivative agreement between a wheat farmer
and a miller. They can sign for an agreement so that the wheat farmer can
hand over a certain amount of wheat to the miller and the miller in turn gives
a certain amount of cash..

In Hedging, financial derivatives act as a financial instrument to transfer risk.


However; the transfer of risk is only possible if there is stock or underlying
asset already existing, else in no ways can you transfer the risk. Let’s take an
example, in case of an electricity manufacturer; he is assured of hedging
process as he will receive money from the electricity supplier. And the
electricity supplier is also sure that electricity will be available to him
through the help financial derivative.

So the thing that has cleared happened for both the parties is that risk has
been minimized. Derivatives play a pivotal role in hedging because they are
uncomplicated and don’t require any form of balance sheet calculations. The
products in derivatives can be put up, without regarding the fact that these
products actually cease to exist in reality.

THE BENEFITS OF HEDGING ARE:


1)It is uncomplicated to handle.
2) The risk is minimized for both the parties.
3) The traders can take the risk, without actually buying the future stock.

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RISK HEDGING AND RISK MANAGEMENT

Risk Hedging Risk Management


View of risk Risk is a danger Risk is a danger & an
opportunity
Objective Protect against the Exploit the upside
downside
Approach Financial, Product Strategy/ cross
oriented functional process
oriented

Measure of success Reduce volatility in Higher value


earnings, cash flows,
value

Type of real option Put Call

Primary impact on Lower discount rate Higher & sustainable


value excess returns

Ideal situation Closely held, private Volatile businesses


firms, publicly traded with significant
firms with high potential for excess
financial leverage or returns
distress costs

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Many a times when you think of derivatives, the first thing that strikes your
mind is the reduction of risk involvement, the simple ways of tracking it, the
volatility of the market affecting your financial instrument, the speculations
and the hedging involved in it. But a derivative market is much more than
that. If you have researched about it you will come to know about it.
We have all heard how derivatives have an impact on the economy, we will
today learn more about the derivatives which are very lucrative and
valuable in nature.
Let’s take couple of examples to understand what exactly derivatives
are.

Two farmers, one of them growing wheat and the other growing corn, come
together and decide to trade three sacks of wheat for three sack of corn. In
this way, they are just trying to steady the value of both the crop, regardless
of what may the actual cost in the market. It also does not consider the
supply and the demand of the products.

Let’s take an example of a nation producing oil and a firm into oil brokering,
here in this case – when they come to trade, they do not base it on exchange.
Here, the contract is just based on the trading of oil and no exchange of
anything else. However; one barrel of oil will be traded against dollar.

In this case, as the cost of oil kept increasing the brokering company would
have noticed the trend and must have fixed a value to buy oil. For example,
if they decided to pay $60 throughout the year, and the barrel prices increase
to $100 the oil brokering company would still pay $60 thereby gaining
profit, but it can also affect them badly if the prices turn towards a

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downward trend. This is what we call a forward contract in the financial
markets.

Another derivative type, which has caused a lot of issues in the current
economy, is the credit swap. Let’s take an example, everyone must have
heard of sub prime crisis. The credit started getting swapped from sub prime
loaners to investment brokers and eventually to different investment firms.
What happened because of this, the paper worth of the mortgaged houses
reduced and in the meanwhile, a lot of home buyers started defaulting on
their loans. This particular phenomenon grew out of proportion and
attributed to the fall of big and old financial institutions.

So if you ask me what is a derivative, in simple terms it can be said as a


contractual agreement between two different parties, where the worth of
commodity or the services offered, will be given to you by the other person.
The best help of this is the risk gets minimized and transferred to both the
parties. However, as we have seen the crisis of US economy unfolds, it is
essential to think and invest. Derivatives are good option, but we need to be
precarious while using this form of financial investments as on a given day it
can prove really beneficial to us, however; if you do not make a good
decision, it can also be the cause for a lot of troubles.

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HEDGING RISK
Hedging risk has been an integral part of the financial markets for many
years. In the 1800s, commodity producers and merchants began using
forward contracts for protection against unfavorable price changes. This
system is still very active today.

The term "hedge fund" dates back to only 1949. In 1949, almost all
investment strategies took only long positions. A reporter for Fortune
magazine, named Alfred Winslow Jones, published an article pointing out
that investors could achieve higher returns if hedging were implemented into
an investment strategy. This was the beginning of the Jones model of
investing.

To prove his hypothesis, Jones launched an investment partnership


incorporating two investment tools into his strategy: short selling and
leverage. The purpose of these two strategies was to limit risk and enhance
returns simultaneously.

In addition, Jones established two important characteristics that are still part
of the industry today. He used an incentive fee of 20% of profits and he kept
most of his own personal money in the fund. This ensured that his personal
goals and the goals of his investors were in alignment.

Exceptional results were obtained through this hedged approach. During the
period from 1962 to 1966, Jones outperformed the top mutual fund by more
than 85%, net of fees. The success of Jones stimulated the interest of high
net worth individuals in hedge funds.

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Not only did Jones attract the interest of high net worth individuals to hedge
funds, but also many top money managers were drawn to hedge fund
because of the unique fee structure. A 20% incentive fee made it possible
for managers to earn 10 to 20 times as much in compensation when
compared to long-only money management services.

Between 1966 and 1968, nearly 140 new hedge funds were launched as a
consequence of the new dynamics of investing and managing money. Many
of these funds, however, did not follow the Jones model of hedging risk.
Instead of hedging, only leverage was used to enhance returns, ignoring the
short-selling aspect that Jones employed. Using a leveraged, long-only
strategy made these funds highly susceptible to the market downturn that
began in late 1968. Some hedge funds dropped in value by more than 70%
within two years.

Large hedge fund losses due to the 1973-1974 bear market caused many
investors to turn away from hedge funds. For the next ten years, few
managers could attract the necessary capital to launch new partnerships. By
1984, there were only 68 funds in existence.

In the late 1980s, a small group of extremely talented hedge fund managers,
including George Soros, Michael Steinhart, and Julian Robertson, gave
hedge funds a restored credibility. Despite difficult market conditions, these
managers produced annual returns of greater than 50%.

Many of the world¡s best money managers left the traditional institutional

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and retail investment firms because of potentially higher fees and great
flexibility with managing hedge fund products. By 1990, there were over
500 hedge funds worldwide with assets of about $38 billion.

Hedge funds now represent one of the largest segments of the investment
management industry. Currently, it is estimated that there are over 6,000
hedge funds in existence with total money under management in excess of
$1 trillion.

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THE LONG-TERM FUTURE FOR THE HEDGE FUND

During the recent economic downturn, the reputation of the hedge fund has
been exposed to a battering which many believe will leave a permanent
marker in the reputation of this business structure. The belief in rampant
capitalism is no longer taken to mean gospel truth. Rather people are
insisting that capitalism is always tempered by common sense approaches to
economic policy to ensure that there is no exploitation of weak economic
structures.

The people who used to own and run hedge funds still have that burning
desire to make profits and they will always look for ways to resurrect their
ambitions. This is in spite of the widespread condemnation that has been
leveled at the system.

As for the various economies, they have to get over the initial shock of the
economic downturn and think of new ways to improve the lives of their
people. Of course they will be far more cautious about the presence of hedge
funds but at some point they will have to invite them back to do business. In
fact some bold governments have already set up initiatives to ensure that

107
they can attract the hedge fund once again before other rival governments get
in on the act.

LESSONS LEARNED
One would like to think that the hedge fund managers have learn a good
lesson and will not go back to the practices of making unmitigated risky
investments. That they will learn the value of building good community
relationships and ensuring that the people in the countries in which they
invest get a reasonable benefit from their presence. This is not to say that
they will all over sudden abandon their business instinct and start giving all
their profits to charity. It merely means that they will balance their ambitions
with recognition that they operate within a community and that they will feel
the obligation to give back to that community.

However experience tells me that none of this is going to happen. The hedge
fund will continue to be an instrumentof exploitation to the maximum. They
might make some half hearted attempts to appear to be socially responsible
especially given the new obsession with environmental matters. However
their core purpose can never move away from making maximum profits at
minimum profits. It would be unthinkable to believe that a successful hedge
fund will suddenly put the interests of the community above that of the
people who give them money.

As for the communities themselves, they will continue to question the fund
within their communities and will demand to understand why they are not
receiving the full benefit of such a lucrative business opportunities. The
excuses will probably run out and eventually the hedge find might acquire a

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socialist twist in as much as it might increase the access to ordinary people
who want to invest their savings.

Many people have been hearing the term derivatives over and over because
of their role in the 2008 financial crisis. Some have called derivatives the
'nuclear weapons' of the financial world. Indeed, derivatives are far more
complicated financial instruments than stocks or bonds, but the danger they
pose to the investor - or the greater economy - ultimately depends on
whether they are used to hedge or to bet.

HEDGING WITH DERIVATIVES

Most people look to derivatives as hedging instruments - that is, they use
them to reduce the risk of doing business in a particular market. A farmer,
for example, may purchase a corn futures contract to make sure he can sell
his corn at a good price. A wholesaler of corn may purchase the other end of
the same futures contract to make sure he can buy corn at a good price.

Between the time the parties purchase the futures contract and the time the
contract settles, the price of corn may go up or down. If the price of corn is
higher at the time the contract settles, the farmer will have to sell his corn at
a lower price than he could get in the market at that time, but he still benefits
from the contract because he has avoided the risk of having to sell his corn at
a price that was lower than he had hoped.

On the other end of the contract, the wholesaler has benefited from buying
the futures contract because he can now purchase the corn below the current
market price. Even if the market had gone the other way and he had to pay

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more than the current market price, he would still benefit from having
reduced his exposure to price increases.

When parties use derivatives as a hedge, they usually have some business
risk or exposure to the value of the underlying asset of the derivative (in our
example, the corn). In a hedge, a derivative works like insurance and protects
the parties from losses.

In fact, insurance in general can be considered to be a derivative. The value


of having health insurance, for example, increases as your health deteriorates
and decreases if you remain healthy. That is, its value fluctuates with the
value of an underlying asset - your health.

SPECULATIONS:
In short, speculation is nothing but plain speculative trading, where in you
just speculates what could be the possible cost of share or an asset. There are

110
many financial institutions who firmly believe that they can speculate the
trend of a particular stock or financial instruments. Directional playing is
how they understand this term as. Apart from this speculation can be done
based on the volatility of the security.

Many of the firms have been found making use of financial derivatives as a
source to reduce the risk involved. Because of the minimizing risk factor
derivatives are probably one of the most popular financial instruments
available in the financial market today. Apart from reducing the risk, some
firm also uses financial derivatives to reduce the tax liability of the firm. But
it has its own consequences, there are certain times it may do well for you,
but the other time it can fall flat on your face.

So you need to some kind of research before using it as source of using it as


instrument to reduce tax liability. A word of caution before investing learn
and read about financial derivatives as an instrument of money as it will be
beneficial to you for your own profits and losses.

FINDINGS & CONCLUSION


From the above analysis it can be concluded that:

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1. Most people look to derivatives as hedging instruments - that is, they
use them to reduce the risk of doing business in a particular market. A
farmer, for example, may purchase a corn futures contract to make
sure he can sell his corn at a good price. A wholesaler of corn may
purchase the other end of the same futures contract to make sure he
can buy corn at a good price.

2. After analyzing data it is clear that the main factors that are driving the
growth of Derivative Market are Market improvement in
communication facilities as well as long term saving & investment is
also possible through entering into Derivative Contract. So these
factors encourage the Derivative Market in India.

3. Derivative market is growing very fast in the Indian Economy. The


turnover of Derivative Market is increasing year by year in the India’s
largest stock exchange NSE. In the case of index future there is a
phenomenal increase in the number of contracts. But whereas the
turnover is declined considerably. In the case of stock future there was
a slow increase observed in the number of contracts whereas a decline
was also observed in its turnover. In the case of index option there was
a huge increase observed both in the number of contracts and turnover.

4. It encourages entrepreneurship in India. It encourages the investor to

take more risk & earn more return. So in this way it helps the Indian
Economy by developing entrepreneurship. Derivative Market is more
regulated & standardized so in this way it provides a more controlled

112
environment. In nutshell, we can say that the rule of High risk & High
return apply in Derivatives. If we are able to take more risk then we
can earn more profit under Derivatives.

Commodity derivatives have a crucial role to play in the price risk


management process for the commodities in which it deals. And it can be
extremely beneficial in agriculture-dominated economy, like India, as the
commodity market also involves agricultural produce. Derivatives like
forwards, futures, options, swaps etc are extensively used in the country.
However, the commodity derivatives have been utilized in a very limited
scale. Only forwards and futures trading are permitted in certain commodity
items.

RECOMMENDATIONS & SUGGESTIONS

BEST FIT ALTERNATIVES FOR SELECTED MARKET


CONDITIONS

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Along with the above recommendations, following are some more
suggestions that could be implemented for better opportunities in derivative
market:-

 SEBI should conduct seminars regarding the use of derivatives to


educate individual investors.

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 RBI should play a greater role in supporting derivatives.

 Derivatives market should be developed in order to keep it at par with


other derivative markets in the world.

 There must be more derivative instruments aimed at individual


investors.

 Speculation should be discouraged

 There is a need of more innovation in Derivative Market


because in today scenario even educated people also fear for
investing in Derivative Market Because of high risk involved in
Derivatives

 After study it is clear that Derivative influence our Indian Economy


up to much extent. So, SEBI should take necessary steps for
improvement in Derivative Market so that more investors can
invest in Derivative market.

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BIBLIOGRAPHY

BOOKS REFERRED:
 NSE’s Certification in Financial Markets: - Derivatives Core module

 Financial Markets & Services by Gordon & Natarajan


 Options Futures, and other Derivatives by John C Hull

 Derivatives FAQ by Ajay Shah

REPORTS:
 Report of the RBI-SEBI standard technical committee on exchange
traded Currency Futures
 Regulatory Framework for Financial Derivatives in India by
Dr.L.C.GUPTA

WEBSITES VISITED:
 www.derivativesindia.com

 www.nse-india.com

 www.bseindia.com

 www.sebi.gov.in

 www.ncdex.com

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