Tarun Jaju Summer Project

RESEARCH PROJECT REPORT
SUBMITTED TOWARDS THE PARTIAL FULFILLMENT OF

MASTER IN BUSINESS ADMINISTRATION
STUDY OF DERIVATIVES IN INDIAN CAPITAL

MARKET
SUBMITTED BY:
TARUN JAJU
MBA (2009-2011)
SUBMITTED TO
Mrs. SHWETA SIKKA
(FACULTY GUIDE)
DELHI INSTITUTE OF MANAGEMENT AND RESEARCH

NEW DELHI
(Affiliated to M. S. University)
STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 1

PREFACE
It is evident that work experience is an indispensable part of every professional
course. In the same manner practical training in any organization is a must for every
individual who is undergoing management course. Without practical experience, one
cannot consider oneself as a qualified, potential & capable manager.
The well planned, properly executed and evaluated industrial

training helps a lot in inoculating good work culture. It provides
linkage between the student and the industry in order to develop
the awareness of industrial approach to problem solving based on
broad understanding of plant, process, product and mode of
operations of industrial organization.
EDELWEISS is a broking company which deals in investment banking,

securities broking, and investment management. It is very big organization in
which the new technology is used.
I prepared myself for work in any condition during the training period and
understood the various processed used there. I worked under the department of demat
open at Edelweiss broking limited, New Delhi.

ACKNOWLEDGEMENT
First of all it is my privilege to acknowledge with gratitude to Edelweiss broking

limited, New Delhi for granting me to take practical training in this esteemed
organization.
I wish to thank the College Authority for giving me a golden opportunity to take practical
training on
STUDY OF DERIVATIVES IN INDIAN CAPITAL

MARKET
I am overwhelmed with rejoice to avail this rare opportunity to evince our profound
sense of reference and gratitude to Mr. Praveen kumar, Branch Manager
(Finance), Ms. Sachin arora & Mr. mujeeb ul hasan for providing facilities and
material to carry out this project and for constant encouragement throughout this
project.
I would like to express our sincere gratitude to Dr. Ashok Jeph, Director of
DELHI INSTITUTE OF Management & RESEARCH NEW DELHI, Ms.
NAVDEEP KAUR & SHWETA SIKKA for their support, precious guidance and
constructive encouragement.
No acknowledge would suffice for the support of my family members, my training

colleagues, classmates and friends.
TARUN JAJU

INDEX
PAGE
S.NO. TOPICS NO.
1. Introduction 05
2. Research Objective 11
3. Research Methodology 12
Indian Capital Market
4. 14
Overview
5. Derivative Market 24
6. Pros & Cons of Derivatives 48
7. Indian Derivative Market 59
8. Users of Derivatives 65
9. Conclusion 85
10. Recommendations 89
11. Limitations 91
12. Bibliography 92
13. Annexure 93

INTRODUCTION TO DERIVATIVES
The origin of derivative can be traced back to the need of formers to protect
themselves against fluctuation in the price of their crops. From th time it was sown to
the time it was ready for harvest, farmers would face price uncertainty. Through the
use of simple derivatives products, it was possible for the farmers to partially or fully
transfer price risk by locking – in assets prices. These were simple contracts
developed to meet the needs of farmers and basically a means of reducing risks.
A farmer who sowed his crops in June face uncertainty over the price of he
would receive for his harvest in September. In years of scarcity, he would probably
obtain attractive prices. However, during times of over supply, he would have to
dispose off his harvest at a very low price. Clearly this meant that the farmer and his
family were exposing to a high risk of uncertainty.
On the other hand, a merchant with an ongoing requirement of grain too would
face a price risk and that of having to pay exorbitant prices during dearth, although
favorable prices could be obtained during period of over supply. Under such
circumstances, it clearly made sense for the farmer and the merchant to come
together and enter in a contract whereby the price of the grain to be delivered in
September could be decided earlier. What they would then negotiate happened to be
a futures-type contract, which would enable both parties to eliminate the price risk.
In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and
merchant together. A group of traders got together and create the ‘to-arrive’ contract
that permitted farmers to lock in to price un front and deliver the grain later. These
to-arrive contracts proved useful as a device for hedging and speculation on price
changes. These were eventually standardized, and in 1925 the first futures clearing
house came into existence.

Today, derivative contract exist on a variety of commodities such as corn, pepper,
cotton, wheat, silver, etc. besides commodities, derivatives contracts also exist on a
lot of financial underlying like, interest rate, exchange rate etc.
Derivatives defined
Derivatives are financial contracts of pre-determined fixed duration, whose values
are derived from the value of an underlying primary financial instrument, commodity
or index, such as: interest rates, exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce
exposure to changes in foreign exchange rates, interest rates, or stock indexes or
commonly known as risk hedging. Hedging is the most important aspect of
derivatives and also its basic economic purpose. There has to be counter party to
hedgers and they are speculators. Speculators don’t look at derivatives as means of
reducing risk but it’s a business for them. Rather he accepts risks from the hedgers in
pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators
are essential.
Participants in Derivatives Markets
 Hedgers
These are market players who wish to protect an existing asset position from
future adverse price movements.
 Speculator
A speculator is a one who accepts the risk that hedgers wish to transfer.
Speculators have no position to protect and do not necessarily have the
physical resources to make delivery of the underlying asset nor do they

necessarily need to take delivery of the underlying asset. They take positions
on their expectations of futures price movements and in order to make a profit.
In general they buy futures contracts when they expect futures prices to rise
and sell futures contract when they expect futures prices to fall.
 Arbitrageurs
These are traders and market makers who deal in buying and selling futures
contracts hoping to profit from price differentials between markets and/or
exchanges.
Types of Derivatives
The common derivatives are futures, options, forward contracts, swaps etc. These are described
below.
Futures:
A Future represents the right to buy or sell a standard quantity and quality of
an asset or security at a specified date and price. Futures are similar to Forward
Contracts, but are standardized and traded on an exchange, and settlement of
financial obligation happens at the end of each trading day under the terms of future.
Unlike Forward Contracts, the counterparty to a Futures contract is the clearing
corporation on the appropriate exchange. Futures often are settled in cash or cash
equivalents, rather than requiring physical delivery of the underlying asset.
 Options: An Option gives holder the right (but not the obligation) to
buy or sell a security or other asset during a given time for a specified price

called the 'Strike' price. An Option to buy is known as a Call Option and an
Option to sell is called a Put Option. One can purchase Options (the right to
buy or sell the security) or sell (write) Options. As a seller, one would
become obligated to sell a security to or buy a security from the party that
purchased the Option. In order to acquire the right of option, the option
buyer pays to the option seller (known as "option writer") an Option
Premium. The buyer of an option can lose an amount no more than the
option premium paid but his possible gain in unlimited. On the other hand,
the option writer’s possible loss is unlimited but his maximum gain is
limited to the option premium charged by him to the holder. Option
premium is calculated using option pricing models like Black Scholes
Model etc.
 Forwards:
In a Forward Contract, the purchaser and its counter party are obligated to trade a
security or other asset at a specified date in the future. The price paid for the security
or asset is agreed upon at the time the contract is entered into, or may be determined
at delivery. Forward Contracts generally are traded OTC.
 Swaps: A Swap is a simultaneous buying and selling of the same

security or obligation. It can be an agreement in which two parties
exchange interest payments based on an identical principal amount, called
the notional principal amount. This is the most common type of Swap and
also known as plain vanilla swap.

 Warrants: options generally have the life of upto one year, the
majority of options traded on options exchange having a maximum
maturity of nine months. Longer-dated options are called warrants and are
generally traded over the counter.
 Leaps: the acronym LEAPS means long term Equity Anticipation

Securities. These are option having a maturity of up to thee years.
 Swaptions: Swaptions are options to buy or sell a swap that will

become operative at the expiry of the options thus a swaption is an option
on a forward swap. Rather than have calls and puts, the Swaptions market
has receiver swaption and payer Swaptions. A receiver swaption is an
opinion to receive fixed and pay floating. A payer swaption is an option to
pay fixed and received floating.
Factors driving the growth of financial derivatives

1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large number of financial assets leading to higher returns, reduced risk
as well as transactions costs as compared to individual financial assets.

RESEARCH OBJECTIVE
Research problem
“Study of Derivatives in the India capital market”
The main objective of the study is to do the detailed analysis of the trading of
derivatives in the capital market in Indian context and this is also includes the study
of:
 Meaning
 Type
 Trading
 Clearing & settlement
 Regulatory framework

RESEARCH METHODOLOGY
Research Design
A research design specifies the methods and procedure for conducting a
particular study. One has to specify the approach he intends to use with respect to the
proposed study. Broadly speaking, research design con be grouped into three
categories.
EXPLORATORY: Focuses on discovery on ideas and generally based on
secondary data.
DISCRIPTIVE: It is undertaken when the research wants to know the characteristics
of certain groups such as age, sex, educational level, income, occupation etc.
CAUSAL: It is undertaken when the researcher is interested in knowing the cause

and effect relationship between two or more variables.
The research design of my study is “Exploratory”

DATA SOURCES
Research is based on secondary data that has been collected from
various sources like internet, journals, magazines and books etc. (see
Bibliography also)
Data collection is the heart of all research work. It is an elaborate process

through which the researcher makes a planned search for all relevant data
and gathers the entire data required for the assignment.

INDIAN CAPITAL MARKET: AN OVERVIEW
Evolution
Indian Stock Markets are one of the oldest in Asia. Its history dates back to
nearly 200 years ago. The earliest records of security dealings in India are meagre
and obscure. The East India Company was the dominant institution in those days and
business in its loan securities used to be transacted towards the close of the
eighteenth century.
By 1830's business on corporate stocks and shares in Bank and Cotton presses took
place in Bombay. Thoh the trading list was broader in 1839, there were only half a
dozen brokers recognized by banks and merchants during 1840 and 1850.
The 1850's witnessed a rapid development of commercial enterprise and brokerage

business attracted many men into the field and by 1860 the number of brokers
increased into 60.
In 1860-61 the American Civil War broke out and cotton supply from United States
of Europe was stopped; thus, the 'Share Mania' in India begun. The number of
brokers increased to about 200 to 250. However, at the end of the American Civil
War, in 1865, a disastrous slump began (for example, Bank of Bombay Share which
had touched Rs 2850 could only be sold at Rs. 87).
At the end of the American Civil War, the brokers who thrived out of Civil War in
1874, found a place in a street (now appropriately called as Dalal Street) where they
would conveniently assemble and transact business. In 1887, they formally

established in Bombay, the "Native Share and Stock Brokers' Association" (which is
alternatively known as “The Stock Exchange "). In 1895, the Stock Exchange
acquired a premise in the same street and it was inaugurated in 1899. Thus, the Stock
Exchange at Bombay was consolidated.
Other leading cities in stock market operations
Ahmedabad gained importance next to Bombay with respect to cotton textile

industry. After 1880, many mills originated from Ahmedabad and rapidly forged
ahead. As new mills were floated, the need for a Stock Exchange at Ahmedabad was
realized and in 1894 the brokers formed "The Ahmedabad Share and Stock Brokers'
Association".
What the cotton textile industry was to Bombay and Ahmedabad, the jute industry
was to Calcutta. Also tea and coal industries were the other major industrial groups
in Calcutta. After the Share Mania in 1861-65, in the 1870's there was a sharp boom
in jute shares, which was followed by a boom in tea shares in the 1880's and 1890's;
and a coal boom between 1904 and 1908. On June 1908, some leading brokers
formed "The Calcutta Stock Exchange Association".
In the beginning of the twentieth century, the industrial revolution was on the way in
India with the Swadeshi Movement; and with the inauguration of the Tata Iron and
Steel Company Limited in 1907, an important stage in industrial advancement under
Indian enterprise was reached.
Indian cotton and jute textiles, steel, sugar, paper and flour mills and all companies
generally enjoyed phenomenal prosperity, due to the First World War.
In 1920, the then demure city of Madras had the maiden thrill of a stock exchange
functioning in its midst, under the name and style of "The Madras Stock Exchange"

with 100 members. However, when boom faded, the number of members stood
reduced from 100 to 3, by 1923, and so it went out of existence.
In 1935, the stock market activity improved, especially in South India where there
was a rapid increase in the number of textile mills and many plantation companies
were floated. In 1937, a stock exchange was once again organized in Madras -
Madras Stock Exchange Association (Pvt) Limited. (In 1957 the name was changed
to Madras Stock Exchange Limited).
Lahore Stock Exchange was formed in 1934 and it had a brief life. It was merged
with the Punjab Stock Exchange Limited, which was incorporated in 1936.
Indian Stock Exchanges - An Umbrella Growth
The Second World War broke out in 1939. It gave a sharp boom which was followed
by a slump. But, in 1943, the situation changed radically, when India was fully
mobilized as a supply base.
On account of the restrictive controls on cotton, bullion, seeds and other

commodities, those dealing in them found in the stock market as the only outlet for
their activities. They were anxious to join the trade and their number was swelled by
numerous others. Many new associations were constituted for the purpose and Stock
Exchanges in all parts of the country were floated.
The Uttar Pradesh Stock Exchange Limited (1940), Nagpur Stock Exchange Limited
(1940) and Hyderabad Stock Exchange Limited (1944) were incorporated.
In Delhi two stock exchanges - Delhi Stock and Share Brokers' Association Limited
and the Delhi Stocks and Shares Exchange Limited - were floated and later in June
1947, amalgamated into the Delhi Stock Exchange Association Limited.

Post-independence Scenario
Most of the exchanges suffered almost a total eclipse during depression. Lahore
Exchange was closed during partition of the country and later migrated to Delhi and
merged with Delhi Stock Exchange.
Bangalore Stock Exchange Limited was registered in 1957 and recognized in 1963.
Most of the other exchanges languished till 1957 when they applied to the Central
Government for recognition under the Securities Contracts (Regulation) Act, 1956.
Only Bombay, Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore, the well
established exchanges, were recognized under the Act. Some of the members of the
other Associations were required to be admitted by the recognized stock exchanges
on a concessional basis, but acting on the principle of unitary control, all these
pseudo stock exchanges were refused recognition by the Government of India and
they thereupon ceased to function.
Thus, during early sixties there were eight recognized stock exchanges in India
(mentioned above). The number virtually remained unchanged, for nearly two
decades. During eighties, however, many stock exchanges were established: Cochin
Stock Exchange (1980), Uttar Pradesh Stock Exchange Association Limited (at
Kanpur, 1982), and Pune Stock Exchange Limited (1982), Ludhiana Stock Exchange
Association Limited (1983), Gauhati Stock Exchange Limited (1984), Kanara Stock
Exchange Limited (at Mangalore, 1985), Magadh Stock Exchange Association (at
Patna, 1986), Jaipur Stock Exchange Limited (1989), Bhubaneswar Stock Exchange
Association Limited (1989), Saurashtra Kutch Stock Exchange Limited (at Rajkot,
1989), Vadodara Stock Exchange Limited (at Baroda, 1990) and recently established
exchanges - Coimbatore and Meerut. Thus, at present, there are totally twenty one

recognized stock exchanges in India excluding the Over The Counter Exchange of
India Limited (OTCEI) and the National Stock Exchange of India Limited (NSEIL).
The Table given below portrays the overall growth pattern of Indian stock markets
since independence. It is quite evident from the Table that Indian stock markets have
not only grown just in number of exchanges, but also in number of listed companies
and in capital of listed companies. The remarkable growth after 1985 can be clearly
seen from the Table, and this was due to the favouring government policies towards
security market industry.
Growth Pattern of the Indian Stock Market
As on 31st 1946 1961 1971 1975 1980 1985 1991 1995

Sl.No.
December
No. of 7 7 8 8 9 14 20 22
1
Stock Exchanges
No. of 1125 1203 1599 1552 2265 4344 6229 8593
2
Listed Cos.
No. of Stock 1506 2111 2838 3230 3697 6174 8967 11784
3 Issues of
Listed Cos.
Capital of Listed 270 753 1812 2614 3973 9723 32041 59583
4
Cos. (Cr. Rs.)
Market value of 971 1292 2675 3273 6750 25302 110279 478121
5 Capital of Listed
Cos. (Cr. Rs.)
Capital per 24 63 113 168 175 224 514 693
6 Listed Cos. (4/2)
(Lakh Rs.)
Market Value of 86 107 167 211 298 582 1770 5564
Capital per Listed
7
Cos. (Lakh Rs.)
(5/2)
Trading Pattern of the Indian Stock Market

Trading in Indian stock exchanges are limited to listed securities of public limited
companies. They are broadly divided into two categories, namely, specified
securities (forward list) and non-specified securities (cash list). Equity shares of
dividend paying, growth-oriented companies with a paid-up capital of atleast Rs.50
million and a market capitalization of atleast Rs.100 million and having more than
20,000 shareholders are, normally, put in the specified group and the balance in non-
specified group.
Two types of transactions can be carried out on the Indian stock exchanges: (a) spot
delivery transactions "for delivery and payment within the time or on the date
stipulated when entering into the contract which shall not be more than 14 days
following the date of the contract" : and (b) forward transactions "delivery and
payment can be extended by further period of 14 days each so that the overall period
does not exceed 90 days from the date of the contract". The latter is permitted only in
the case of specified shares. The brokers who carry over the outstandings pay carry
over charges (cantango or backwardation) which are usually determined by the rates
of interest prevailing.
A member broker in an Indian stock exchange can act as an agent, buy and sell
securities for his clients on a commission basis and also can act as a trader or dealer
as a principal, buy and sell securities on his own account and risk, in contrast with
the practice prevailing on New York and London Stock Exchanges, where a member
can act as a jobber or a broker only.
The nature of trading on Indian Stock Exchanges are that of age old conventional
style of face-to-face trading with bids and offers being made by open outcry.
However, there is a great amount of effort to modernize the Indian stock exchanges
in the very recent times.

National Stock Exchange (NSE)
With the liberalization of the Indian economy, it was found inevitable to lift the
Indian stock market trading system on par with the international standards. On the
basis of the recommendations of high powered Pherwani Committee, the National
Stock Exchange was incorporated in 1992 by Industrial Development Bank of India,
Industrial Credit and Investment Corporation of India, Industrial Finance
Corporation of India, all Insurance Corporations, selected commercial banks and
others.
Trading at NSE can be classified under two broad categories:
(a) Wholesale debt market and
(b) Capital market.
Wholesale debt market operations are similar to money market operations -

institutions and corporate bodies enter into high value transactions in financial
instruments such as government securities, treasury bills, public sector unit bonds,
commercial paper, certificate of deposit, etc.
There are two kinds of players in NSE:
(a) trading members and (b) participants.
Recognized members of NSE are called trading members who trade on behalf of
themselves and their clients. Participants include trading members and large players
like banks who take direct settlement responsibility.
Trading at NSE takes place through a fully automated screen-based trading

mechanism which adopts the principle of an order-driven market. Trading members

can stay at their offices and execute the trading, since they are linked through a
communication network. The prices at which the buyer and seller are willing to
transact will appear on the screen. When the prices match the transaction will be
completed and a confirmation slip will be printed at the office of the trading member.
NSE has several advantages over the traditional trading exchanges. They are as
follows:
• NSE brings an integrated stock market trading network across the nation.
• Investors can trade at the same price from anywhere in the country since inter-
market operations are streamlined coupled with the countrywide access to the
securities.
• Delays in communication, late payments and the malpractice’s prevailing in

the traditional trading mechanism can be done away with greater operational
efficiency and informational transparency in the stock market operations, with
the support of total computerized network.
Unless stock markets provide professionalised service, small investors and foreign
investors will not be interested in capital market operations. And capital market
being one of the major source of long-term finance for industrial projects, India
cannot afford to damage the capital market path. In this regard NSE gains vital
importance in the Indian capital market system.

INTRODUCTION TO “FUTURES & OPTIONS”
Forward Contracts
A forward contract is a simple derivative – It is an agreement to buy or sell an asset

at a certain future time for a certain price. The contract is usually between two
financial institutions or between a financial institution and its corporate client. A
forward contract is not normally traded on an exchange.
One of the parties in a forward contract assumes a long position i.e. agrees to buy the
underlying asset on a specified future date at a specified future price. The other party
assumes a short position i.e. agrees to sell the asset on the same date at the same
price. This specified price is referred to as the delivery price. This delivery price is
chosen so that the value of the forward contract is equal to zero for both transacting

parties. In other words, it costs nothing to the either party to hold the long or the
short position.
A forward contract is settled at maturity. The holder of the short position delivers the
asset to the holder of the long position in return for cash at the agreed upon rate.
Therefore, a key determinant of the value of the contract is the market price of the
underlying asset. A forward contract can therefore, assume a positive or negative
value depending on the movements of the price of the asset. For example, if the price
of the asset rises sharply after the two parties have entered into the contract, the party
holding the long position stands to benefit, i.e. the value of the contract is positive for
her. Conversely, the value of the contract becomes negative for the party holding the
short position.
The concept of Forward price is also important. The forward price for a certain
contract is defined as that delivery price which would make the value of the contract
zero. To explain further, the forward price and the delivery price are equal on the day
that the contract is entered into. Over the duration of the contract, the forward price is
liable to change while the delivery price remains the same. This is explained in the
following note on payoffs from forward contracts.
Options
A options agreement is a contract in which the writer of the option grants the buyer
of the option the right purchase from or sell to the writer a designated instrument for
a specified price within a specified period of time.
The writer grants this right to the buyer for a certain sum of money called the option
premium. An option that grants the buyer the right to buy some instrument is called a
call option. An options that grants the buyer the right to sell an instrument is called a

put option. The price at which the buyer an exercise his option is called the exercise
price, strike price or the striking price.
Options are available on a large variety of underlying assets like common stock,
currencies, debt instruments and commodities. Also traded are options on stock
indices and futures contracts – where the underlying is a futures contract and futures
style options.
Options have proved to be a versatile and flexible tool for risk management by
themselves as well as in combination with other instruments. Options also provide a
way for individual investors with limited capital to speculate on the movements of
stock prices, exchange rates, commodity prices etc. The biggest advantage in this
context is the limited loss feature of options.
Options Terminology
 Call Option
A call option gives the holder (buyer/ one who is long call), the right to buy specified
quantity of the underlying asset at the strike price on or before expiration date.
 Put Option
A Put option gives the holder (buyer/ one who is long Put), the right to sell specified
quantity of the underlying asset at the strike price on or before a expiry date.
 Strike Price (also called exercise price)
The price specified in the option contract at which the option buyer can purchase the
currency (call) or sell the currency (put) Y against X.

 Maturity Date
The date on which the option contract expires is the maturity date. Exchange traded
options have standardized maturity dates.
 American Option
An option, call or put, that can be exercised by the buyer on any business day from
initiation to maturity.
 European Option
A European option is an option that can be exercised only on maturity date.
 Premium (Option price, Option value)
The fee that the option buyer must pay the option writer at the time the contract is
initiated. If the buyer does not exercise the option, he stands to lose this amount.
 Intrinsic value of the option
The intrinsic value of an option is the gain to the holder on immediate exercise of the
option. In other words, for a call option, it is defined as Max [(S-X), 0], where s is
the current spot rate and X is the strike rate.
If S is greater than X, the intrinsic value is positive and is S is less than X, the
intrinsic value will be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In
the case of European options, the concept of intrinsic value is notional as these
options are exercised only on maturity.
 Time value of the option

The value of an American option, prior to expiration, must be at least equal to its
intrinsic value. Typically, it will be greater than the intrinsic value. This is because
there is some possibility that the spot price will move further in favor of the option
holder. The difference between the value of an option at any time "t" and its intrinsic
value is called the time value of the option.
 At-the-Money, In-the-Money and Out-of-the-Money Options
A call option is said to be at-the-money if S=X i.e. the spot price is equal to the
exercise price. It is in-the-money is S>X and out-of-the-money is S<X. Conversely, a
put option is at-the-money is S=X, in-the-money if S<X and out-of-the-money if
S>X.
FUTURES
A futures contract is an agreement between two parties to buy or sell an asset at a

certain specified time in future for a certain specified price. In this, it is similar to a
forward contract. However, there are a number of differences between forwards and
futures. These relate to the contractual features, the way the markets are organized,
profiles of gains and losses, kinds of participants in the markets and the ways in
which they use the two instruments.
Futures contracts in physical commodities such as wheat, cotton, corn, gold, silver,
cattle, etc. have existed for a long time. Futures in financial assets, currencies,
interest bearing instruments like T-bills and bonds and other innovations like futures
contracts in stock indexes are a relatively new development dating back mostly to
early seventies in the United States and subsequently in other markets around the
world.

Major Features Of Futures Contracts
The principal features of the contract are as follows:
 Organized Exchanges
 Standardization
 Clearing House
 Marking To Market
 Actual Delivery Is Rare
DISTINCTION BETWEEN FORWARD AND FUTURES CONTRACTS
FORWARDS FUTURES
1. Are traded on an exchange 1. Are not traded on an exchange

2. Use a Clearing House which 2. Are private and are negotiated
provides protection for both parties between the parties with no exchange
guarantee
3. Require a margin to be paid 3. Involve no margin payments
4. Are used for hedging and 4. Are used for hedging and physical
speculating delivery
5. Are standardised and published 5. Are dependent on the negotiated
contract conditions
6. Are transparent - futures contracts 6. Are not transparent as they are all
are reported by the exchange private deals
FUTURES & OPTIONS

An interesting question to ask at this stage is – when could one use options
instead of futures? Options are different from future in several interesting senses. At
a practical level, the option buyer faces a interesting situation. He pays for option in
full at the time it is purchased. After this, he only have an upside. There is no
possibility of the options position generating any further losses to him (other than the
fund already paid for option). This is different from futures, which is free to enter
into, but can generate very large losses. This characteristics makes options attractive
to many occasional market participants, who can not put in the time to closely
monitor their futures positions. Buying put options is buying insurance. To buy a put
option on Nifty is to buy insurance, which reimburses the full extent to which Nifty
drops below the strike price of the put option. This is attractive to many people, and
to mutual funds creating “guaranteed return product”.
Distinction between futures and options
Futures Options
 Exchange traded with  Same as futures.
novation
 Exchange defines the  Same as futures
product
 Price is zero, strike price  Strike price is fixed, price
moves moves.
 Price is zero  Price uis always positive.
 Linear payoff  Nonlinear payoff.

 Both long and short at risk  Only short at risk.
PAYOFF FOR DERIVATIVES

CONTRACTS
A pay off is likely profit/loss that would accrue to a market participants with change
in the price of the underlying asset. This is generally depicted in the form of payoff
diagrams, which show the price of the underlying asset on the X-axis and the
profit/loss on the Y-axis. In this section we shall take a look at the payoffs for buyers
and sellers of futures and options.
Payoff for Futures

Futures contracts have linear payoffs. In simple words, it means that the losses as
well as profits for the buyer and the sellers of a future contract are unlimited. These

linear payoffs are fascinating as they can be combined with options and the
underlying to generate various complex payoffs.
Payoff for a Buyer on Nifty Future

The payoff for a person who sells a futures contract is similar to the payoff for a
person who shorts an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside. Take the case of speculator who sells two-month
Nifty index futures contracts when the Nifty stands at 1220. The underlying asset in
this case is the Nifty portfolio. When the index moves down, the short futures
positions start making profits and when the index moves up, it starts making losses
.the following diagram shows the payoff diagram for the seller of a futures contract.
Profit
1220
Nifty
Loss
FIG. PAYOFF FOR A BUYER OF FUTURE

Payoff for a seller on Nifty Futures
The pay off for a person who sells a future contract is similar to the payoff for a
person who shorts an assets. He has a potentially unlimited upsides as well as a

potentially unlimited downside. Take the case of a speculator who sells thea two-
month Nifty index future contract when the nifty stands at 1220. the underlying asset
in this case is the Nifty portfolio. When the index moves down, the short futures
positions start making profits, and when the index moves up, it starts making losses.
Profit
1220 Nifty
Loss
Fig. Payoff for a seller on Nifty futures

Option Payoffs
The optionality characteristics of options results in a non –linear payoff for the
options. In simple words, it means that the losses for the buyer of an option are
limited, however the profits are potentially unlimited. For a writer, the payoff is
exactly the opposite. His profits are limited to the options premium, however his
losses are potentially unlimited. These non-linear payoffs are fascinating as they lend
themselves to be used to generate various payoffs by using combination of options
and underlying. We look here at the six basic payoffs.
 Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance, for
1220, and sells it at a future date at a unknown price. Once it is purchased, the
investor is said to be “long” the asset. Following figure show the pay off for a long
position of Nifty.
Profit
+60---------------------------------------------------------
1160 1220 1280 Nifty
-60 -----------------------------
Loss

Fig. Payoff for investor who went long nifty at 1220
Payoff profile for seller of asset: Short asset
In this basic position, an investor shorts the underlying asset, Nifty for instance, for
1220 and buys it back at a future date at an unknown price. Once it is sold, the
investor is said to be “short” the asset. Following figure show the pay off for a long
position of Nifty.
Profit
1160 1220 1280 Nifty
Loss
Fig. Payoff for investor who went short Nifty at 1220

Payoff profile for buyer of call option: Long run
A call option gives the buyer the right to buy the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the options depends
on the spot price of the underlying. If upon expiration, the spot price exceeds the
strike price, he makes a profit. Higher the spot price, more is the profit he makes. If
the spot price of the underlying is less than the strike price, he lets his option expire
un-exercised. His loss in this case is the premium he paid for buying the option.
Profit
1250 Nifty
0
86.60
loss
Fig. Payoff for buyer of a call
Payoff for the buyer of a three-month call option (often referred to as long
call) with a strike of 1250 bought at a premium of 86.60

 Payoff profile for buyer of call option: Short call
Call option gives the buyer the right to buy the underlying at the strike price
specified in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer make on the option depends upon the spot
price of the underlying. Whatever is the buyer’s profit/loss? If upon expiration, the
spot price exceeds the strike price, the buyer wills exercise the option on the writer.
Hence as the spot price increase the writer of option starts making losses. Hired the
spot price, more is the loss he makes. If upon expiration the spot price of the
underlying is less than the strike price, the buyer lets his option expire unexercised
and the writer gets to keep the premium. Figure gives the pay off for the writer of
three-month call option (often referred to as short call) with the strike of 1250sold at
premium of 86.60
Profit
86.60
1250 Nifty
0
Loss
Fig. Payoff for a writer of calls options

Payoff for buyer of put option: Long put
A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. If upon expiration, the spot price is
below the strike price , he makes a profit. Lower the spot price, more is the profit he
makes. If the spot price is higher than the stike price, he let his option expire un-
exercised. His loss in this case is the premium he paid for buying the option.
Profit
1250 Nifty
0
61.70
loss
Fig. Payoff for buyer of put option
Payoff profile for writer of put option: short put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. For selling the options, the writer of the option charges a

premium. The profit/loss that the buyer makes on the option depends on the spot
price of the underlying. Whatever is the buyer’ profit is the seller loss. If upon
expiration, the spot prices happens to be below the strike price, the buyer will
ecercise the option at write. If upon the expiration the pot price of the underlying is
more than the strike price, the buyer lets his option expired un exercised and the
writer gets to keep the premium.
Profit
61.70
0 1250 Nifty
Loss
Fig. Payoff for writer of put option
Fig shows the payoff for the writer of a three-month put option
(often referred as short put) with a strike price of 1250 sold at a premium
of 61.70

CLEARING AND SETTLEMENT
National Securities Clearing council Limited (NSCCL) undertakes clearing
and settlement of all trades executed on the futures and options (O&P)
segment of the NSE. It also act as legal counter party to all trades on
the F&O segment and guarantees their financial settlement.
Clearing Entities
Clearing and settlement activities in the F&O segment are undertaken by NSCCL
with the help of the following entities:
 Clearing Members
A Clearing Member (CM) of NSCCL has the responsibility of clearing and
settlement of all deals executed by Trading Members (TM) on NSE, who clear and
settle such deals through them. Primarily, the CM performs the following functions:
1. Clearing – Computing obligations of all his TM's i.e. determining positions

to settle.

2. Settlement - Performing actual settlement. Only funds settlement is allowed
at present in Index as well as Stock futures and options contracts
3. Risk Management – Setting position limits based on upfront deposits /
margins for each TM and monitoring positions on a continuous basis.
Types of Clearing Members

• Trading Member Clearing Member (TM-CM)
A Clearing Member who is also a TM. Such CMs may clear and settle their
own proprietary trades, their clients’ trades as well as trades of other TM’s.
• Professional Clearing Member (PCM)

A CM who is not a TM. Typically banks or custodians could become a PCM
and clear and settle for TM’s.
• Self Clearing Member (SCM)

A Clearing Member who is also a TM. Such CMs may clear and settle only
their own proprietary trades and their clients’ trades but cannot clear and settle
trades of other TM’s.
Clearing Banks
NSCCL has empanelled 11 clearing banks namely Canara Bank, HDFC
Bank, IndusInd Bank, ICICI Bank, UTI Bank, Bank of India, IDBI Bank, Hongkong
& Shanghai Banking Corporation Ltd., Standard Chartered Bank, Kotak Mahindra
Bank and Union Bank of India.

Every Clearing Member is required to maintain and operate a clearing account
with any one of the empanelled clearing banks at the designated clearing bank
branches. The clearing account is to be used exclusively for clearing & settlement
operations.
Settlement Mechanism
All futures and options contracts are cash settled, i.e. through exchange of cash. The
underlying for index futures /options of the Nifty index cannot be delivered. These
contracts, therefore, have to be settled in cash. Futures and options on individual
securities can be delivered as in the spot market. However, it has been currently
mandated that stock options and futures would also be cash settled. The settlement
amount for a CM is netted across all their TMs/ clients, with respect to their
obligations on MTM, premium and exercise settlement.
Settlement of future contracts

Futures contracts have two types of settlement, the MTM settlement, which happen
on a continuous basis at the end of each day, and the final settlement, which happens
on the last trading day of the futures contracts.
1. Daily Mark-to-Market Settlement

The position in the futures contracts for each member is marked-to-market to
the daily settlement price of the futures contracts at the end of each trade day.
The profits/ losses are computed as the difference between the trade price or the
previous day’s settlement price, as the case may be, and the current day’s settlement
price. The CMs who have suffered a loss are required to pay the mark-to-market loss
amount to NSCCL which is in turn passed on to the members who have made a
profit. This is known as daily mark-to-market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not
traded during the last half an hour on a day, is currently the price computed as per the
formula detailed below:
F = S x e rt
where:
F = theoretical futures price
S = value of the underlying index
r = rate of interest (LIBOR)
t = time to expiration
Rate of interest may be the relevant MIBOR rate or such other rate as may be
specified. After daily settlement, all the open positions are reset to the daily
settlement price. CMs are responsible to collect and settle the daily mark to market
profits / losses incurred by the TMs and their clients clearing and settling through
them. The pay-in and payout of the mark-to-market settlement is on T+1 days (T =
Trade day). The mark to market losses or profits are directly debited or credited to

the CMs clearing bank account.
2. Final Settlement
On the expiry of the futures contracts, NSCCL marks all positions of a CM to the
final settlement price and the resulting profit / loss is settled in cash..The final
settlement of the futures contracts is similar to the daily settlement process except for
the method of computation of final settlement price. The final settlement profit / loss
is computed as the difference between trade price or the previous day’s settlement
price, as the case may be, and the final settlement price of the relevant futures
contract.
Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing
bank account on T+1 day (T= expiry day).
Open positions in futures contracts cease to exist after their expiration day
SETTLEMENT OF OPTIONS CONTRACTS
Daily Premium Settlement
Premium settlement is cash settled and settlement style is premium style. The
premium payable position and premium receivable positions are netted across all
option contracts for each CM at the client level to determine the net premium
payable or receivable amount, at the end of each day.

The CMs who have a premium payable position are required to pay the premium
amount to NSCCL which is in turn passed on to the members who have a premium
receivable position. This is known as daily premium settlement.
CMs are responsible to collect and settle for the premium amounts from the TMs and
their clients clearing and settling through them.
The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day).
The premium payable amount and premium receivable amount are directly debited or
credited to the CMs clearing bank account.
Interim Exercise Settlement
Interim exercise settlement for Option contracts on Individual Securities is effected

for valid exercised option positions at in-the-money strike prices, at the close of the
trading hours, on the day of exercise. Valid exercised option contracts are assigned to
short positions in option contracts with the same series, on a random basis. The
interim exercise settlement value is the difference between the strike price and the
settlement price of the relevant option contract.
Exercise settlement value is debited/ credited to the relevant CMs clearing bank
account on T+1 day (T= exercise date ).
Final Exercise Settlement
Final Exercise settlement is effected for option positions at in-the-money strike

prices existing at the close of trading hours, on the expiration day of an option

contract. Long positions at in-the money strike prices are automatically assigned to
short positions in option contracts with the same series, on a random basis.
For index options contracts, exercise style is European style, while for options
contracts on individual securities, exercise style is American style. Final Exercise is
Automatic on expiry of the option contracts.Option contracts, which have been
exercised, shall be assigned and allocated to Clearing Members at the client level.
Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of
the relevant Clearing Members with the respective Clearing Bank.Final settlement
loss/ profit amount for option contracts on Index is debited/ credited to the relevant
CMs clearing bank account on T+1 day (T = expiry day).
Final settlement loss/ profit amount for option contracts on Individual Securities is
debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry
day).
Open positions, in option contracts, cease to exist after their expiration day.
The pay-in / pay-out of funds for a CM on a day is the net amount across settlements
and all TMs/ clients, in F&O Segment.

PROS & CONS OF DERIVATIVES
Financial innovation that led to the issuance and trading of derivatives products
has been an important boost to the development of financial market. Derivatives
products such as options, futures or swaps contract have become a standard risk
management tool that enable risk sharing and thus facilitate the efficient allocation of
capital to productive investment opportunities. While the benefits stemming from the
economic function performed by derivative securities have been discussed and
proven by academics, there is increasing concern within the financial community that
the growth of the derivative markets-whether standardize or not-destabilize the
economy. In particular, one often hears that the widespread use of derivatives have
been reduced long term investment since it concentrates capital in short term
speculative transactions. In this study, I have tried to look at the various pros and
cons that the derivatives trading pose.
BENEFITS OF DERIVATIVES FOR FIRMS,

MARKETS AND THE ECONOMY

The recent studies of derivatives activity have led to a broad consensus, both
in the private and public sectors that derivatives provide numerous and substantial
benefits to end –users.
 Derivatives as means of hedging
Derivatives provide a low cost, effective method for end users to hedge and
manage their exposure to interest rate, commodity price, or exchange rates. Interest
rate future and swaps, for example, help banks for all sizes better manage the re-
pricing mismatches in funding long term assets, such as mortgages, with short term
liabilities, such a certificate of deposits. Agricultural futures and options helps
farmers and processors hedge against commodity price risk. Similarly, multi national
corporations can hedge against currency risk using foreign exchange forwards,
futures and options.
 Improves market efficiency and liquidity

Well functioning derivatives improves the efficiency and liquidity of the cash
market. The launch of derivatives has been associated with substantial improvements
in the market quality on the underlying equity market. This happens because of the
law transaction cost involved and arbitrageurs will face low cost when they are
eliminating the mispricings. Traders in individual stock who supply liquidity to these
stock use index futures to offset their exposure and hence able to function at lower
level of risk.
 Allows institution to raise capital at lower costs

Corporations, governmental entities, and financial institutions also
benefit from derivatives through lower funding costs and more diversified funding
sources. Currency and interest rate derivatives provide the ability to borrow in the

cheapest capital market, domestic or foreign, without regard to currency in which the
debt is denominated or the form in which interest is paid. Derivatives can convert the
foreign borrowing into a synthetic domestic currency financing with their fixed or
floating interest rate.
 Allows exchange to offer differentiated products
In spot market, the ability for the exchanges to differentiate their

product is limited by the fact that they are trading the same paper. In contrast, in the
case of derivatives, there are numerous avenues for product differentiation. Each
exchange trading index option has to take major decision like choice of index, choice
of contract size, choice of expiration dates, American Vs European options, rules
governing strike price etc.
 Assists in capital formation in the Economy
By providing investors and issuers with a wider array of tools for

managing risk and raising capital, derivatives improve the allocation of credit and
sharing of risk in the global economy, lowering the cost of capital formation and
stimulating economic growth. It improves the market’s ability to carefully direct
resources toward the projects and the industries where the rate of return is highest.
This improves the allocative efficiency of the market and thus a given stock of
investable funds will be better used in procuring the highest possible GDP growth for
the economy.
The growth in derivatives activities yields substantial benefits to the economy
and by facilitating the access of the domestic companies to international capital
market and enabling them to lower their cost of funds and diversify their funding

source; derivatives improve the position of domestic firms in an expanding,
competitive, global economy.
 Improve ROI for institutions

Derivatives are basically off- balance trading in that no transfer of
principal sum occurs and no posting in the balance sheet will be required.
Consequently, a fund that corresponds to the principal sum in traditional financial
transactions (on balance trading) is unnecessary, thus substantially improving the
return on investment. Looking at the restriction on the ratio of net worth, on the other
hand, the risk ratio of assets that form the basis for calculating the net worth in off
balance trading is assumed to be lower than that in the traditional on balance trading.
In practice, it is provided that the credit risk equivalence calculated by multiplying
the assumed amount of principal of an off-balance trading by a risk to value ratio is
to be weighted by the credit worthiness of the other party.
 Risk sharing
The major economic function of derivatives is typically seen in risk
sharing: derivatives provide a more efficient allocation of economic risks. Examples
of risk management, which have already mentioned are illustrative, but they don’t
address the question why derivatives are necessary to attain a better social allocation
of risks.
 Information gathering:
In a perfect market with no transaction cost, no friction and no
informational asymmetries, ther would be no benefit stemming from the
use of derivatives instruments. However, in the presence of trading
costs and marketing liquidity, portfolio strategies are often implemented
or supplemented with derivatives at substainial lower cost compare to
cash market transactions. In this respect, the welfare effect of derivative

instrument result from a reduction in the transaction cost. Ut, this is
only a part of the real economic benefits of the derivatives. If risk
allocation is the major function of these instrument, and because risk is
also related to information, derivatives markets also affect the
information structure of the financial syatem
DISADVANTAGES OF DERIVATIVES
 Risk associated with the derivatives
Apart from the explicit risk, which arises from various market risk exposure
stemming from the pure service or position taken in a derivative instrument, other
implicit risks also associated with derivatives
• A credit risk is the risk that a loss will be incurred because a counter party
fails to make payment as due. Concern has been expressed that financial
institutions may have used derivatives to take on an excessive level of
credit risk that is poorly managed.
• Market risk is the risk that the value of a position in a contract,financial
instrument, asset,or porflio will decline when market conditions change.
Concern has been expressed that derivatives expose firm to new market
risk while increasing the overall level of exposure.

• Operational risks is the risk that losses will be incurred as a result of
inadequate system and control, inadequate disaster or contingency
planning, human error, or management failure.
• Legal risk is the risk of loss because a contract cannot be enforced or
because the contract term fails to achieve the intended goals of the
contracting parties. This risk, of course, is as old as contracting itself. The
legal uncertainty can result in significant unexpected losses.
 Implication in global world

Global market for trade and finance has become increasingly integrated and
accessible. Derivatives have both benefited from and contributed to this
development. In this circumstances, however, some observed fear that derivatives
make it possible for shocks in one part of the global finance system to be transmitted
farther and faster than before, being reinforce rather than damped. Concern also have
been expressed that derivatives activity may exacerbated market moves through
positive feedback trading.
 Accounting standard for derivatives
As far as derivatives are concerned, accounting standard is not

homogenized across countries and/or market player thereby suggesting that lack of
precision or ambiguous cross-comparisons may be common. Market values are not
uniformly accepted in accounting rules, and thus their absence prevent marketing-to-
marketing of derivatives positions as well as their proper collateralization.
Accounting practices measure values and not risk exposure and thus remain poor
figure for risk management purpose
 Lack of knowledge
Lack of knowledge about derivatives: derivatives are complex. The payoffs

and risks that buyer and seller face, and the economic theory that is used for pricing

derivatives are considerably more difficult than that seen on the equity market. Thus
at times lack of knowledge on part of traders leads to disaster.
 Monetarily Zero sum game

It is impossible for the both the parties in the derivatives transactions to profit
concurrently regardless of the fluctuation of value of underlying assets. Thus one
party has to accept the unprofitable position
Myths behind derivatives

In less than three decades of their coming into vogue, derivatives markets have
become the most important. Today, derivatives have become part of the day-to-day
life for ordinary people in most parts of the world.
Financial derivatives came into the spotlight along with the rise in uncertainty of
post-1970, when the 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. There are still apprehensions about
derivatives. There are also many myths though the reality is 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.
Numerous studies have led to a broad consensus, both in the private and public
sectors, that derivatives provide 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 collapse of the 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 currencies, increased trading in a variety of derivatives instruments,
and on-line trading in the capital markets.
As the complexity of instruments increased, the accompanying risk factors grew.
This situation led to the development derivatives as effective risk-management tools
for the market participants. Looking at the equity market, derivatives allow
corporations and institutional investors to manage effectively their portfolios of
assets and liabilities through instruments such as 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 part of its equity assets, by using stock index
futures or index options.
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 among global markets,

increasing market liquidity and efficiency, and facilitating the flow of trade and
finance.
 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 needed for the introduction of derivatives and how the Indian market fares.
Disasters can happen in any system. The 1992 security scam is a case in
point. Disasters are not necessarily due to dealing in derivatives, but derivatives
make headlines. Careful observation will show that these disasters, such as the
Barings collapse, Metallgesellschaft, Daiwa Bank scandal (not related to derivatives)
and Orange County, occurred due to the lack of internal controls and/or outright
fraud either by employees or promoters.
In essence, these examples suggest that scandals have occurred in the
recent past, not only in derivatives-related instruments, but also in bonds, foreign
exchange trading and commodities trading. Most failures have taken place on the
`over the-counter' deals, except in the case of Barings, where it was a case of internal
fraud, as also with Daiwa Bank, which lost more than $1 billion in debt portfolio.
`Over-the-counter' (OTC) deals lack transparency, sophisticated margining system
and a well-laid-out regulatory framework, which is not the case with the exchange-
traded derivatives.
Many of the failures happened because of the complex nature of
transactions while the exchange-traded derivatives are simple and easy to understand.
In that sense, these derivatives have been found to be the most useful in allowing
participants to transfer their risk, without the problems associated with the OTC
deals. Internal controls would be important in any case, for normal equity or debt
trading as much as in derivatives trading and the participants need to be more careful
in implementing and operating good back-office and control systems to avoid any
internal control failures.

 Derivatives are complex and exotic instruments that Indian
investors will have difficulty in understanding
Trading in standard derivatives such as forwards, futures and options is already
prevalent in India and has a long history. The Reserve Bank of India allows forward
trading in rupee-dollar forward contracts, which has become a liquid market. The
RBI also allows cross currency options trading.
Derivatives in commodities markets have a long history. The first
commodity futures exchange was set up in 1875, in Mumbai, under the aegis of
Bombay Cotton Traders Association. A clearing house for clearing and settlement of
these trades was set up in 1918. In oilseeds, a futures market was established in 1900.
Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up
in Calcutta in 1912 and the bullion futures market in Bombay in 1920.
In the equities markets also, derivatives have existed for long. In fact, official history
of the Native Share and Stock Brokers Association, which is now known as the
Bombay Stock Exchange suggests that the concept of options existed from early as in
1898. A quote ascribed to Mr. James P. McAllen, MP, at the time of the inauguration
of BSE's new Brokers Hall in 1898, is: ``...India being the original home of options, a
native broker would give a few points to the brokers of the other nations in the
manipulations of puts and calls.''
This amply proves that the concept of options and futures is well-ingrained in
the Indian equities market and is not as alien as it is made out to be. Even today,
complex strategies of options are traded in many exchanges which are called teji-
mandi, jota-phatak, bhav-bhav at different places. In that sense, the derivatives are
not new to India and are current in various markets including equities markets.
India has a long history of derivatives trading. In fact, in commodities markets,
Indian exchanges are inviting foreigners to participate for which the approvals have
also been granted.

 Is capital market safer than derivatives?
WORLD OVER, the spot market in equities operates on a principle of rolling
settlement. In this kind of trading, if one trades on a particular day (T), one has to
settle these trades on the third working day from the date of trading (T+3).
Futures market allows you to trade for a period of, say, one or three months and net
the transaction for the settlement at the end of the period. In India, most stock
exchanges allow the participants to trade over a one-week period for settlement in the
following week. The trades are netted for the settlement for the entire one-week
period. In that sense, the Indian market is already operating on the futures-style
settlement.
In this system, additionally, many exchanges also allow the forward-trading called
badla and contango, which was prevalent in the UK. This system is prevalent in
France, in the monthly settlement market. It allows one to even further increase the
time to settle for almost three months, under the current regulations. But this way, a
curious mix of futures style settlement with the facility to carry the settlement
obligations forward, creates discrepancies.
The more efficient way will be to separate the derivatives from the cash market, that
is, introduce rolling settlement in all exchanges and, simultaneously, allow futures
and options to trade. This way, the regulators will also be able to regulate both the
markets easily and it will provide more flexibility to the market participants.
In addition, the existing system does not ask for any margins from the clients. Given
the volatility of the equities market in India, this system has become quite prone to
systemic collapse.
The Indian capital market operates on a account period system which is actually a
seven-day futures market, while internationally, the cash market operates on T+3
rolling settlement basis _ one of the G-30 recommendations for an efficient clearing
and settlement mechanism. In the futures market, there is a daily mark-to-market

settlement (T+1), leading to faster settlement and risk reduction, unlike the cash
market where settlement takes seven days. Client positions are not segregated from
the trading member's proprietary role and clearing members are not segregated,
affecting the system.

Derivatives Market in India
Approval For Derivatives trading

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 was
developed for governing derivatives trading. The act also made it clear that
derivatives shall be legal and valid only if such contracts are traded on a 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 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(Sensex) 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.
Exchange-traded vs. OTC (Over The Counter) 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 globalization 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. 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.
DERIVATIVES MARKET AT NSE
Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2000. SEBI permitted the derivative segments of two
stock exchanges, viz NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivative contracts. To begin with,
SEBI approved trading in index futures contracts based on S&P CNX Nifty Index
and BSE−30 (Sensex) Index. This was followed by approval for trading in options
based on these two indices and options on individual securities. The 3 trading in
index options commenced in June 2001 and those in options on individual securities
commenced in July 2001. Futures contracts on individual stock were launched in
November 2001.

Table 1 – growth of options &future trading at NSE
Month & Stock Future Stock Call Option Stock Put Option
year No. of Turnover No. of Turnover No. of Turnover
contrac (Rs.Cror contract (Rs.Crore) contract (Rs.Crore)
ts e) s s
Jul-01 ----- ---- 13082 290 4746 106
Aug-01 ----- ---- 38971 844 12508 263
Sep-01 ----- ---- 64344 1322 33480 690
Oct-01 ----- ----- 85844 1632 43747 801
Nov-01 125946 2811 112499 2327 31484 683
Dec-01 309755 7515 84134 1986 28425 674
Jan-02 489793 13261 133947 3836 44498 1253
Feb-02 528947 13939 133630 3635 33055 846
Mar-02 503415 13989 101708 2863 37387 1094
Apr-02 552727 15065 121225 3400 40443 1107
May-02 605284 15981 126867 3490 57984 1643
Jun-02 616461 16178 123493 3325 48919 1317
Jul-02 789290 21205 154089 4341 65530 1837
Aug-02 726310 17881 147646 3437 65630 1725

USERS OF DERIVATIVES
The institutional investor in India could be meaningfully classified

into:
1. Banks
2. All India Financial institution (FIs)
3. Mutual Funds
4. Foreign Institutional Investor
5. Life & General Insurers
The intensity of derivatives usage by any institutional investor

is a function of its ability and willingness to use derivatives
for one or more of the following purposes:
a) Risk containment: Using derivatives for hedging and risk

containment purpose,
b) Risk Trading /Market Making: Running derivatives

trading book for profits and arbitrage, and / or
c) Covered Intermediation: On-Balance Sheet derivatives

intermediation for client transaction, without retaining any net risk
on the Balance Sheet (except credit risk).

BANKS
Types of Banks
Based on the differences in governance structure, business

practices and organizational ethos, it is meaningful to classify the
Indian banking sector into the followings:
I. Public Sector Banks(PSBs)
II. Private Sector Banks(Old generation),
III. Private Sector Banks (new generation),
IV. Foreign Banks( with banking and authorized dealer license)
Credit Derivatives
The market of fifth type of derivatives namely, credit derivatives, is
currently non–existent in India, hence has been dealt with in brief
here. Credit derivatives seek to transfer credit risk and returns of an
asset from one counter party to another without transferring its
ownership. The market for credit derivatives is currently non-
existent in India, though it has the potential to develop.
Equity Derivatives in Banks
Given the highly leveraged nature of banking business, and the

attendant regulatory concerns of their investment in equities, banks
in India can, at best, be turned as marginal investor in equities. Use
of equity derivatives by banks ought to be inherently limited to risk
containment (hedging) and arbitrage trading between the cash

market and options and futures markets. However, for the following
reasons, banks with direct and indirect equity market exposure are
yet to use exchange traded equity derivatives (viz.., index futures,
index options, security specified futures r options) currently
available on the National Stock Exchange (NSE) or Bombay Stock
Exchange (BSE).
1) RBI guidelines on investment by the banks in capital

market instruments do not authorize banks to use equity
derivatives for any purpose. RBI guidelines also do not
authorized banks to undertake securities lending and/ or
borrowings of equities. This disables also banks
possessing arbitrage trading skills and institutionalized
risk management process for running an arbitrage trading
book to capture risk free pricing mis–match spread
between the equity cash and options and futures market-
an activity banks currently any way undertake in the
fixed income and FX cash and forward markets;
2) Direct and indirect equity exposure of banks is negligible
and does not warrant serious management attention and
resources for hedging purpose;
3) The internal resources and processes in most bank
treasuries are inadequate to mange the risk of equity
market exposure, and monitor use of equity derivatives;
4) Inadequate technological and business process readiness
of their treasuries to run equity arbitrage trading book,
and mange related risks.

Fixed Income Derivatives in Bank
Scheduled Commercial banks, Primary Dealers (PDs and All India

Financial Institution (FIs have been allowed by RBI since July 0993
to write Interest Rate Swaps(IRS) and Forward Rate
Agreement(FRAs)as product for their own assets liability
management (ALM) or for market making (risk trading)purpose.
The presence of Public Sector Banks major in the rupee IRS market
is marginal. Most PSBs are either unable or unwilling of PSB majors
seemingly stem from the following key are yet to overcome;
1) Inadequate technological and business process readiness

of their treasuries to run a derivatives trading books, and
manage related risks;
2) Inadequate of willingness of bank managements to ‘risk’

being held accountable for bonafide trading losses in the
derivatives book;
3) Inadequate readiness of their Board of Directors to permit
the bank to run a derivatives trading book, partly for

reasons cited above and partly due to their own
‘discomfort of the unfamiliar’.
Commodity Derivatives in Banks

In 1997, RBI permitted seven banks to import and resell gold as
canalizing agencies. It is understood that now about 13 banks (;
bullion banks’, for short) are active in this business. The quantum of
gold Imported through bullion banks is in the region of 500 tones per
annum. The commodity risk accepted by banks is limited to price
risk of gold accepted by 5 bullion banks that launched their schemes
under the RBI guidelines on the Gold Deposit Scheme 1999
announced in the union budget of 1999-2000. in brief, these bullion
banks accept assayed gold as a deposit for 3 to 7 years tenures, at the
end of which the deposit is repayable at the price of gold as on date
of maturity. These gold deposits carry interest ranging from 3% to
4% per annum. SBI is a market leader in this segment with a market
share of over 90%. There is no forward market for gold in India. In
fact, forward contract on gold are prohibited. And, for this purpose, a
contract settled later than T+11 days is treated as a forward contract.
ALL INDIA FINANCIAL INSTITUTIONS (FIs)
The All India FIs Universe
With the merger of ICICI into ICICI Bank, the universe of all India
FIs comprises IDBI, IFCI, IIBI, SIBDI, EXIM. NABARD and
IDFC. In the context of use of financial derivatives, the universe of
FIs could perhaps be extended to include a few other financially
significant players such as HDFC and NHB.
Equity Derivatives in FIs

Equity risk exposure of most FIs is rather insignificantly, and often
limited-to-limited to equity developed on them under underwriting
commitments they made in the era upto mid 1990s. use of equity
derivatives by FIs could be for risk containment (hedging purpose,
and for arbitrage trading purposes between the cash market and
options and futures market. For reason identical to those outlined
earlier vis-à-vis banks, FIs too are not users of equity derivatives.
However, there are no RBI guidelines disabling FIs from running
equities arbitrage- trading book to capture risk free pricing mis-
match spreads between the equity cash and options and futures
markets.
Fixed income Derivatives

Since July 1999, like Banks, even FIs are permitted to write RIS and
FRA for their asset liability management (ALM) as well as for
market making purpose. Some FIs actively use IRS and FRA for
their ALM. Also, a few have plans to offer IRS and FRA as products
to their corporate customer (to hedge their liabilities), albeit on a
fully covered back-to- back basis, to begin with. However, none are
yet to run a rupee derivatives trading book.
Commodities Derivatives Fis
FIs have no proximate exposure to commodities. There are also no
credit products whose interest rate is benchmarked to any
commodity price. Therefore, the issue of they using commodity
derivatives (whether in the overseas or Indian market) does not rise.

MUTUAL FUNDS
Equity Derivatives in Mutual Funds
Mutual Funds ought to be natural players in the equity derivatives

market. SEBI (Mutual Funds) Regulations also authorize use of
exchange traded equity derivatives by mutual funds for hedging and
portfolio rebalancing purpose, and, being tax exempt, there are no
tax issues relating to use of equity derivatives by them. However,
most mutual funds are not yet active in use of equity derivatives
available on the NSE and BSE. The following impediments seem to
hinder use of exchange trade equity derivatives by mutual funds:
1. SEBI (Mutual Funds) Regulation restrict use of

exchange traded equity derivatives to ‘hedging and
portfolio rebalancing purpose’. The popular view in
the mutual fund industry is that this regulation is very
open to interpretation, and the trustees of mutual
funds do not wish to be caught on the wrong foot.
2. Inadequate technological and business process
readiness of several players in the mutual fund
industry to use equity derivatives and manage related
risks;
3. The regulatory prohibition on the use of equity
derivatives for portfolio optimization return

enhancement strategies, and arbitrage strategies
constricts their ability to use equity derivatives; and
4. Relatively insignificant investor interest in equity
funds ever since exchange traded options and futures
were launched in June 2000(on NSE, later on BSE).
Fixed Income Derivatives in Mutual Funds
SEBI (Mutual Funds) regulations are silent about use of IRS and
FRA by mutual funds. Evidently, IRS and FRA transactions entered
into by mutual funds are not construed by SEBI as derivatives
transaction covered by the restrictive provisions which limit use of
derivatives by mutual funds to exchange traded derivatives for
hedging and portfolio balancing purposes. Mutual funds are
emerging as important users of IRS and FRA in the Indian fixed
income derivatives market.
Foreign Currency Derivatives in Mutual Funds

In September 1999, Indian mutual funds were allowed to invest in
ADRs/GDRs of Indian companies in the overseas market within the
overall limit of US $ 500 million with a sub ceiling for individual
mutual funds of 10% of net assets managed by them (at previous
year end), subject to maximum of US $ 50 million per mutual fund.
Several mutual funds had obtained the requisite approvals from SBI
and RBI for making such investments. However, given that most
ADRs /GDRs of Indian companies traded in the overseas market at a

premium to their prices on domestic equity markets, this facility has
remained largely unutilized.
Commodity derivatives in Mutual Funds
Under SEBI (Mutual Funds) Regulations, mutual fund

can invest only in the transferable financial securities. In
absence of any financial security linked to commodity
prices, mutual funds can not offer a fund product that
entails a proximate exposure to the price of any
commodity. Therefore, the issue of they using commodity
derivatives (whether in the overseas or Indian
market)does not arise.
FOREIGN INSTITUTIONAL INVESTORS

(FIIs)
Equity Derivatives in FIIs
Till January 2002, applicable SEBI & RBI Guidelines permitted FIIs
to trade only in index future contracts on NSE & BSE. It is only
since 4 February 2002 that RBI has permitted (as a sequel to SEBI
permission in December 2001) FIIs to trade in all exchange traded
derivatives contract within the position limits for trading of FIIs and
their sub-accounts. With the enabling regulatory framework
available to FIIs from Feb 2002, their activity in the exchange traded
equity derivatives market in India should increase noticeably in the

emerging future. Perhaps, the two years of successful track record of
the NSE in managing the systematic risk associated with its futures
and options segment would also pave way for greater FIIs activity in
the equity derivatives market in India in the emerging future.
Fixed Income Derivatives in FIIs
Since May 2000, FIIs are permitted to invest in domestic

sovereign or corporate debt market under the 100% debt rout
subject to an overall cap under the external commercial borrowing
(ECB) category, with individual sub ceilings allocated by SEBI to
each FII or sub accounts. FIIs are also permitted to enter into foreign
exchange derivatives contract by RBI to hedge the currency and
interest rate risk to the extent of market value of their debt
investment under the 100% debt route. However, investment by FIIs
in the domestic sovereign or corporate debt market has been
negligible till now.
Foreign Currency Derivatives in FIIs

Equity investing FIIs leave their foreign currency risk largely
unhdged since they believe that the currency risk can be readily
absorbed by the expected returns on the equity investments, barring
in periods of unforeseen volatility (such as the Far Eastern crisis).
And, as indicated above, FII investment in the domestic sovereign
and corporate debt market has been negligible. Consequently, FII in
the foreign currency derivative market in India has also been
negligible till now.

LIFE & GENERAL INSURERS
Equity Derivatives in Life & General Insurers
The Insurance Act as well as the IRDA (Investment) Regulation

2000 is silent about use of equity (or other) derivatives by life or
general insurance companies. It is the view of the IRDA that life &
general insurers are not permitted to use equity (or other financial)
derivatives until IRDA frames guideline/ regulation related to their
use. And IRDA is yet to frame this guidelines/ regulation, though it
is seized of the urgent need to frame them. Life or general insurers
would have to wait for these guidelines /regulations to fall in the
place before they can use equity (or other financial) derivatives.
Fixed Income Derivatives in Life and General

Insurers
As indicate earlier, it is view of the IRDA that use of rupee fixed

income derivatives (including IRS and FRA) by Life & General
insurers too would have to wait for IRDA guidelines/regulations on
the use of financial derivatives.

Foreign Currency Derivatives in Life &
General Insurers
Given the long term nature of life insurance contracts,

insurance regulations in the many parts of the world apply currency
–matching principle for assets and liability under life insurance
contracts. Indian insurance law too prohibits investment of fund
from insurance business written in India, into overseas or foreign
securities.
REGULATORY FRAMEWORKS
Evolution of a Legal Framework for

Derivatives Trading
Derivatives are supposed to be defined as security under
Section 2(h) of SC(R) Act, 1956. Present definition of securities
includes shares, stocks, bonds, debentures, debentures stocks or
other marketable securities in or of any incorporated company or
other body corporate Government securities Rights or interest in
securities, such other instrument as may be declared by the central
government to be securities. An important step towards introduction
of derivatives trading in India was the promulgation of the Securities
Laws (Amendment) Ordinance, 1995, which lifted the prohibition on
"options in securities" (NSEIL, 2001). However, since there was no
regulatory framework to govern trading of securities, the derivatives

market could not develop. SEBI set up a committee in November
1996 under the chairmanship of Dr. L.C. Gupta to develop
appropriate regulatory framework for derivatives trading. The
committee suggested that if derivatives could be declared as
"securities" under SCRA, the appropriate regulatory framework of
"securities" could also govern trading of derivatives. SEBI also set
up a group under the chairmanship of Prof. J.R. Varma in 1998 to
recommend risk containment measures for derivatives trading. The
Government decided that a legislative amendment in the securities
laws was necessary to provide a legal framework for derivatives
trading in India. Consequently, the Securities Contracts (Regulation)
Amendment Bill 1998 was introduced in the Lok Sabha on 4th July
1998 and was referred to the Parliamentary Standing Committee on
Finance for examination and report thereon. The Bill suggested that
derivatives may be included in the definition of "securities" in the
SCRA whereby trading in derivatives may be possible within the
framework of that Act. The said Committee submitted the report on
17th March 1999.
Securities Exchange Board of India (SEBI) the oversight regular
for the securities market appointed a Committee on derivatives under
the Chairmanship of Dr. L.C. Gupta on 18, November 1996 to
develop appropriate regulatory framework introducing of derivatives
trading in India, starting with stock index futures.
Regulatory objectives
The Committee believes that regulation should be designed
to achieve specific, well-defined goals. It is inclined towards positive

regulation designed to encourage healthy activity and behavior. It
has been guided by the following objectives:
A. Investor Protection: Attention needs to be given to

the following four aspects:
1. Fairness and Transparency: The trading rules

should ensure that trading is conducted in a fair and
transparent manner. Experience in other countries
shows that in many cases, derivatives brokers/dealers
failed to disclose potential risk to the clients. In this
context, sales practices adopted by dealers for
derivatives would require specific regulation. In some
of the most widely reported mishaps in the derivatives
market elsewhere, the underlying reason was
inadequate internal control system at the user-firm itself
so that overall exposure was not controlled and the use
of derivatives was for speculation rather than for risk
hedging. These experiences provide useful lessons for
us for designing regulations.
2. Safeguard for clients' moneys: Moneys and
securities deposited by clients with the trading members should
not only be kept in a separate clients' account but should also not
be attachable for meeting the broker's own debts. It should be
ensured that trading by dealers on own account is totally
segregated from that for clients.

3. Competent and honest service: The eligibility
criteria for trading members should be designed to encourage
competent and qualified personnel so that investors/clients are
served well. This makes it necessary to prescribe qualification for
derivatives brokers/dealers and the sales persons appointed by
them in terms of a knowledge base.
4. Market integrity: The trading system should ensure
that the market's integrity is safeguarded by minimizing the
possibility of defaults. This requires framing appropriate rules
about capital adequacy, margins, Clearing Corporation, etc.
B. Quality of markets: The concept of "Quality of

Markets" goes well beyond market integrity and aims at enhancing
important market qualities, such as cost-efficiency, price-continuity,
and price-discovery. This is a much broader objective than market
integrity.
C. Innovation: While curbing any undesirable tendencies,

the regulatory framework should not stifle innovation which is the
source of all economic progress, more so because financial
derivatives represent a new rapidly developing area, aided by
advancements in information technology.

Recommendations of Dr. L.C.Gupta Committee
The recommendations of the L.C. Gupta Committee were
made with relation to Exchange operations, membership, products,
and participants, trading and clearing regulations.
A. The main recommendation relating to a derivatives
exchange are as follows:
 The derivatives Exchange should have online screen
based trading system with online surveillance
capabilities.
 The Derivatives Exchange shall disseminate
information in real –time through at least two
information vendors
 Existing Stock exchange can carry out derivatives
trading as a separate segment.
 The Derivatives Exchange should inspect every
broker/member annually.
 SEBI to approve Rules, Bye-laws and Regulation of the
Derivatives Exchange before commencement of
trading.
 The Derivatives Exchange should have investor
grievance and redressal Mechanism operative from all
four regions of the country.
B. Main recommendations relating to membership of
a derivatives exchange are as follows:

 The Derivatives Exchange should have at least 50
trading members to start Derivatives trading.
 Existing members cannot automatically become
derivative members.
 Membership norms include certain net worth criterion
passing SEBI approved certification.
 Membership shall be trading members being a member
of the Exchange and Clearing member being of
Clearing Corporations
 Clearing members should have minimum net worth of
Rs.300 lakhs and make a deposit of Rs.50 lakhs with
clearing corporations.
C. Recommendations relating to introduction and

trading of derivatives product are as follows
 SEBI shall approve any new derivatives product if it serves an
economical function.
 The Exchange may suspend any derivatives contract due to
suspension of Trading in underlying securities, for protection
of Interest of Investor and for the purpose of maintaining a fair
and orderly market.
D. Recommendation relating to participants in the
derivatives market is as follows:
 Restriction on investment institutions on uses old
derivatives should be removed.

 Corporate and mutual funds allowed trading in derivatives
to the extent authorized by Board of Directors or Trustees
as the case may be.
 Margin collection will be mandatory from all clients
including institutions.
 Employees of broker/members should be adequately
qualified and trained (certified).
E. Recommendations relating to trading regulations
are as follows:
 Investor should read the Risk Disclosure document made
available to him by the broker/ member and sign the Client
Registration form.
 Contract note that must be stamped with time of order-
receipt and order execution (trade).
F. Recommendations relating to clearing regulations
are as follows:
 Exposure limit of clearing member linked to deposit
maintained with Clearing Co-operation.
 Level of Initial margin will be calculated using “Value at
risk” concept and will be large enough to cover one-day loss
99% of the days.
 Clearing members may be cleared defaulter if he is unable
to fulfill obligations, he fails to pay within specified times,
damages and money differences due to compulsory close-
out and fails to abide arbitration proceedings.

SEBI board has accepted the LC Gupta report’s
recommendations and further prescribed that all derivatives contract
should have a minimum contract size of Rs. 1 lakh.
POLICY ISSUES FOR DEVELOPMENT

OF THE MARKETS
1. Strengthening of Financial Infrastructure
While the Indian regulatory framework for derivatives is

mostly consistent with the international practices, some elements of
financial infrastructure need to be strengthened. It is suggested that
the bankruptcy and insolvency laws should 10 clearly prescribe
providing due concern to rights of securities holders on winding up
or on insolvency of intermediaries and multilateral netting
procedures in novation.
2. Transparency of Derivatives Transactions

and Financial Stability
The Basel Committee on Banking Supervision and IOSCO

Technical Committee have presented recommendations for public
disclosure of trading and derivatives activities of banks and
securities firms which could also be used by such non−financial
companies that make material use of complex financial products.

These recommendations emphasize the importance of transparency
in promoting financial stability. It is observed that transparency
based on meaningful public disclosure plays an important role in
reinforcing the efforts of supervisory authorities in encouraging the
sound risk management practices and promoting financial market
stability (IOSCO 1999). This goes beyond simple accounting
treatment of derivatives in the books of the clients or participants.
Enhanced transparency would also benefit bank and securities firms
themselves by enhancing their ability to evaluate and manage their
exposures to counter parties. Institutions should, therefore, provide
meaningful information, both qualitative and quantitative, on the
scope and nature of trading and derivatives activities and elaborate
how these activities contribute to their earning profile. Accounting
and valuation and reporting requirements for forward rate
agreements and interest rates swaps have been prescribed in the RBI
guidelines (for regulatory reporting), to all scheduled commercial
banks, primary dealers and All India Financial Institutions by RBI in
July 1999. However, what is being suggested is that the IOSCO
principles would need to be suitably incorporated (through a
statutory mandate) in the public disclosure of trading and derivatives
activities of banks and securities firms.
3. Declaring Transactions in Derivatives as

Non−speculative

The derivatives markets have three categories of participants−
hedgers, speculators and arbitrageurs. Viewed from the perspective
of risk management, derivatives markets are an inter play of hedgers
and speculators, i.e., those who are risk averse need to have a
counter party who are risk takers. That is why it is absolutely
essential that while taking decisions about various aspects of
derivatives trading, such as taxation, accounting etc. a balance needs
to be struck between the interests of hedgers as well as speculators
(Sahoo, 2000). 3.2 There are no specific tax provisions for
derivatives transactions under the Income Tax Act, 1961. However,
some provisions have indirect relevance for derivatives transactions.
Under section 73(1) of the Income Tax Act, 1961 any losses on
speculative business are eligible for set off against profits and gains
of speculative business only, up to a maximum of eight years. The
section 43(5) of the Income Tax Act, 1961 defines a speculative
transaction where the contract for purchase or sale of any
commodity, including share, is settled otherwise than by actual
delivery. There are exceptions given to jobbing/arbitrage
transactions and hedging of underlying positions. It follows that a
transaction is speculative if it is settled otherwise than by actual
delivery. The hedging and arbitrage transactions, even though not
settled by actual delivery, are considered non−speculative. Thus, a
speculative transaction is one, which is
(i) A transaction in commodities/ shares,
(ii) Settled otherwise than actual delivery,
(iii) The participant has no underlying position, and
(iv) The transaction is not for jobbing/arbitrage.

.
Further, a transaction is construed as speculative, if a participant

enters into a hedging transaction in shares outside his holdings. It is
possible that an investor does not have all the 30 or 50 stocks
represented by the index. As a result, it is apprehended that an
investor’s losses or profits out of derivatives transactions, even
though they are of hedging nature, may be treated as speculative.
This is contrary to capital asset pricing model, which states that
portfolios in any economy move in sympathy with the index
although the portfolios do not necessarily contain any security in the
index.
To summaries, in view of
(i) Practical difficulties in administration of tax for different
purposes of the same transaction,
(ii) Innate nature of a derivative contract requiring its settlement
otherwise than by actual delivery,
(iii) Need to provide level playing field to all the parties to
derivatives contracts (which includes hedgers as well as speculators
and treating the income of all parties to a derivatives contract
equitably), and
(iv) And the need to promote the economic purpose of future price
discovery, hedging and risk management in the securities market, it
is suggested that the exchange traded derivatives contracts are
exempted from the purview of speculative transactions. These must,
however, be taxed as normal business income or capital gains at the
option of the assesses. This would be fiscally more prudent since it

would avoid arbitrary exercise of discretion and possible resultant
litigation. This suggestion would need to be flagged to the tax
authorities.
Legality of OTC Derivatives: International

Experience and Lessons for India
Pursuant to the amendment made through the Securities Laws
(Amendment) Act, 1999 in SCRA regarding legally permitted
"derivatives," a doubt was raised about the legality of the OTC
derivatives such as forward rate agreements and interest rate swaps
permitted under RBI guidelines issued to banks, primary dealers and
All−India financial institutions in July 1999. It was felt that these
OTC derivatives could be deemed as illegal in view of express
exemption to only exchange based derivatives from wagering
contracts under SCRA. Efforts need to be made to examine solution
to the issue so that the legality of OTC derivatives can be ensured. In
this connection, it would be instructive to study the US experience of
the recent past when the US Government was involved in clarifying
the uncertainty in the OTC derivatives markets. The US efforts are
documented in the report of the President’s Working Group on
Financial Markets (Report of The President’s Working Group on 13
Financial Markets 1999) entitled "Over the Counter Derivatives
Markets and the Commodity Exchange Act" and the Commodity
Futures Modernization Act (CFMA) of 2000.

CONCLUDING REMARKS
For the genuine portfolio (non- strategic), the percentage share

available to the public is so little and varied that it is impossible for
anybody to hold any significant amount of index portfolio, which
would need hedging. Even tracking the index portfolio would be non
efficient, as most of the share do not have a high correlation with the
index. And even this small correlation varies a great deal over a
period of time. Given this scenario, it was imperative on the
committee to have done some credible and verifiable investigation to
support their demand hypothesis for hedging.
If trading in index futures is advocated on the basis of hedging
needs an investors, one must assess the market demand and supply
source of trading in the market risk before introducing the index
futures. To determine demand, one would need to know.

 How many investors (individual and/ or institutional hold the
index portfolio)?
 What are the objectives of these investors in holding such a
portfolio?
 What is the size of their portfolio?
 What are their hedging needs given the stated objective of
their business?
 What price they would be willing to pay for such hedging?
 Would it be possible to have a reasonably continuous demand
curve given the number of hedge seekers and their stated price
preferences?
 Would it be possible to have reasonably continuous demand
curve given the number of hedge seekers and their stated price
preference?
Similarly, on the supply side the question is : would there be a

sufficient number of hedgers who would like to offset the opposite
risks or liquidate another hedge as a result of a change in their
positions in the cash markets? And if hedgers are few in number and
if all hedge seekers are on same side, which is most often the case,
arbitrageurs and speculators would be needed to provide the other
side of the transactions. For arbitrageurs to function properly, we
would need to examine the working of the cash market. If the above
is not possible in our existing cash markets, then only speculators are
going to dominate the futures markets. Speculators who are going to
specifically benefit from futures trading are those who have access
to large funds, an appetite to risk and decisive edge in expertise; the

rest would first losers and then mere speculators. We would not able
to have a competitive market. Few speculators would be able to
dictate the markets because there would not be many left to provide
the opposite side of the transactions. This question becomes much
more crucial when settlements are done in cash and not by actual
delivery. One would have no choice but to enter the settlement
contract at dictated prices.
As a report by SEBI, trading volumes on 22 bourses in India

increased from Rs.227, 368 crore to Rs.644,116 crore during 1997-
98, showing a growth of 184%. The BSE shows a growth of 148%
and the NSE 442%. A significant achievement by any standards.
However, one also noticed that delivery percentage is only 10 to c5
percent of the volume of trade. The rest of the business is squared
off during the same valance system. Even in this small percentage of
derivatives, if one take out the deliveries made on account of
arbitrage business between BSE and NSE (both have different
trading period), the actual investment deliveries would not be more
than one or two percent.
In 1994, a well-established BADLA SYSTEM, which is akin to a

weekly forward, was mainly because SEBI did not think system risk
was being satisfactory managed by SROs. Now, SEBI has
reintroduced it realizing that it serve much need functions like
margin trading and short sale which are not available in India.
However, severe restrictions put while reintroducing it indicate that

SEBI either does not trust the independent functioning or capabilities
of SROs to supervise the system risk as a regulator.
The desirability of successful derivatives, such as futures

trading, depends crucially on the solidity and maturity of cash
market in underlying securities. To make cash market robust and
effective, first let us put in place the mechanism of margin trading,
short sale, dematerialized settlement and electronic transfer of funds
among market participants.
Undue haste may well result in a major scandal that may

undermine both the confidence in and acceptance of equity
derivatives in the country, as well as the reputation of the entities
involved in introducing these products.
RECOMMENDATION

The Derivatives committee strongly favors the introduction of
financial derivatives in order to provide the facility for hedging in
the most cost-efficient way against market risk. This is an important
economic purpose. At the same time, it recognizes that in order to
make hedging possible, the market should also have recognizes that
in order to make hedging possible, the market should also have
speculator who are prepared to be counter parties to hedgers. A
derivatives market, wholly or mostly consisting of speculator, is
unlikely to be a sound economic institution. A soundly based
derivatives market requires the presence of both hedger and
speculators.
The above recommendation makes sense if there is a genuine

demand for hedging by a large number of investor in India. And if
sufficient numbers of hedgers with genuine hedging needs are not
there and we still introduce future market, then we would end up
having only speculators. Such a futures market would be devoid of
any connection with the cash or th spot market and would have its
own life full of speculation and bubbles. So now the question arises,
does Indian investor need futures trading?
The Committee should have made an endeavor to estimate

the hedging needs of portfolio owners in the country. For an
academician, it is difficult to quantify such hedging needs without

resources and an authority to procure information. However, if one
examines the security holding structure and the market operation in
India, one can easily conclude that such numbers are not very large
and given there mandate, genuine hedging needs are not there. In
India, among the index stock most of the shareholding is strategic
holding, owned either by the government (SBI, BHEL, BPCL,
MTNL etc), or by multinationals (Hindustan lever, Nestle, Colgate,
etc) or by promoters (Tatas, Birlas, Bajaj, Mahindras) or by a few
developmental financial institutions (like ICICI, IDBI,IFCI etc.).
These strategic shareholders are certainly not seeking a hedging
facility because they are not having genuine hedging needs.

LIMITATIONS
As per the researcher following are the limitations of this study:-
1. Time Factor
As we know that nobody can hold time therefore in my study of
derivatives in Indian capital market, researcher find less time to
expose his efforts and knowledge to collect thorough details of the
topic.
2. Source of data
According to researcher this study is completely based on secondary

data and does not involve any personal interaction with any financial
entities.

BIBLIOGRAPHY
I. Futures & Options by N.D. VOHRA & B.R. BAGRI

II. Financial Derivatives by V.K. BHALLA
III. Regulatory framework for financial derivatives in India
by DR. L.C. GUPTA
IV. http://www.derivativesindia.com
V. http://www.igidr.ac.in
VI. http://www.nseindia.com
VII. http://www.rediff/money/derivatives
VIII. https://www.sebi.gov.in
IX. http://www.bseindia.com
X. http://google.com
XI. http://www.edelweiss.in
XII. http://www.capitalmarket.com

INDIA’S LISTED DERIVATIVES
EXCHANGES
1. The Bombay stock exchange (BSE)

2. The Cochin stock exchange (CSE)
3. The Delhi Stock Exchange (DSE)
4. The National Stock Exchange (NSE)
5. The Over The counter Exchange of India (OTCEI)
6. The Stock Exchange Of Ahmedabad (SEA)

LISTED FUTURES AND OPTIONS
EQUITY
 Equity Futures and Options

 Index Futures and Options
FIXED INCOME
 Fixed Income Deposit Futures / Options

 Interest Rate Futures and Options
CURRENCY
 Currency Futures / Options
COMMODITY
 Commodity futures and Options

Tarun Jaju Summer Project

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RESEARCH PROJECT REPORT

SUBMITTED TOWARDS THE PARTIAL FULFILLMENT OF

STUDY OF DERIVATIVES IN INDIAN CAPITAL

DELHI INSTITUTE OF MANAGEMENT AND RESEARCH

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 1

The well planned, properly executed and evaluated industrial

EDELWEISS is a broking company which deals in investment banking,

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 2

First of all it is my privilege to acknowledge with gratitude to Edelweiss broking

STUDY OF DERIVATIVES IN INDIAN CAPITAL

No acknowledge would suffice for the support of my family members, my training

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 3

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 4

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 6

Participants in Derivatives Markets

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 7

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 8

 Swaps: A Swap is a simultaneous buying and selling of the same

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 9

 Leaps: the acronym LEAPS means long term Equity Anticipation

 Swaptions: Swaptions are options to buy or sell a swap that will

Factors driving the growth of financial derivatives

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 10

“Study of Derivatives in the India capital market”

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 11

CAUSAL: It is undertaken when the researcher is interested in knowing the cause

The research design of my study is “Exploratory”

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 12

Data collection is the heart of all research work. It is an elaborate process

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 13

The 1850's witnessed a rapid development of commercial enterprise and brokerage

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 15

Other leading cities in stock market operations

Ahmedabad gained importance next to Bombay with respect to cotton textile

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 16

Indian Stock Exchanges - An Umbrella Growth

On account of the restrictive controls on cotton, bullion, seeds and other

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 17

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 18

Growth Pattern of the Indian Stock Market

As on 31st 1946 1961 1971 1975 1980 1985 1991 1995

Trading Pattern of the Indian Stock Market

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 19

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 20

Trading at NSE can be classified under two broad categories:

(a) Wholesale debt market and

(b) Capital market.

Wholesale debt market operations are similar to money market operations -

There are two kinds of players in NSE:

(a) trading members and (b) participants.

Trading at NSE takes place through a fully automated screen-based trading

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 21

• Delays in communication, late payments and the malpractice’s prevailing in

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 22

A forward contract is a simple derivative – It is an agreement to buy or sell an asset

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 24

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 25

 Strike Price (also called exercise price)

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 26

A European option is an option that can be exercised only on maturity date.

 Premium (Option price, Option value)

 Intrinsic value of the option