CONTENT Chapter- 1 INTODUCTION TO THE PROJECT 1.1 Introduction to the subjects 1.

2 Objectives of the study LITERATURE REVIEW DATA ANALYSIS 3.1 Research Design 3.2 Analysis and interpretation of data CONCLUSION OF THE PROJECT 5.1 Summary of Findings 5.2 Suggestions and recommendations 5.3 Conclusion 5.4 Bibliography 5.6 Appendix

Chapter -2 Chapter-3

Chapter-4

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Introduction
GROWTH AND DEVELOPMENT OF DERIVATIVE MARKET IN INDIA WITH REFERENCE TO FUTURE AND OPTION MARKET Everyone talks about derivatives these days. Derivative products have been around for a long time. Do you know derivatives first came about in Japanese rice markets. Yes, as early as the 1650s, dealings resembling present day derivative market transactions were seen in rice markets in Osaka, Japan. The first leap towards an organized derivatives market came in 1848, when the Chicago Board of Trade, the largest derivative exchange in the world, was established. Today, equity and commodity derivative markets are rapidly gaining in size in India. In terms of popularity too, these markets are catching on like a forest fire. So, what are these markets all about? What are the products that they trade in? Why do people feel the need to trade in such products and what sort of traders benefit from such trades. Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.

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 24member 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 preconditions 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

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system, methodology for charging initial margins, broker net worth, deposit requirement and realtime 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 BSE30(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. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that
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brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent. Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.

Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and those traded one to one or 'over the counter'. They are hence known as: 1. Exchange traded derivatives 2. OTC Derivatives (Over the Counter)

OTC Equity Derivatives

y y y

Traditionally equity derivatives have a long history in India in the OTC market. Options of various kinds (called Teji and Mandi and Fatak) in un-organized markets were traded as early as 1900 in Mumbai The SCRA however banned all kind of options in 1956.

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OBJECTIVES OF STUDY

LITERATURE REVIEW
The term "Derivative" indicates that it has no independent value, i.e. its value is entirely derived from the value of the underlying assets. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of securities.

STATISTICAL TOOLS
There are four types of financial derivatives contract: 1. 2. 3. 4. Forward contract Future contract Option contract Swap contract.

Forward contract This is a derivative contract where one party promises to buy something from other party on a certain day in future at a certain price determined today, the contract is called forward contract. In forward contract the buyer is called long or long position.He is having responsibility and obligation to accept delivery from the seller and making of payment on the future date.
y y y

The price at which delivery is to be made on future date which is decided today is called strike price denoted as k. The actual price available in the market on the date of delivery is called spot price denoted as s. The date on which the contract is made is called contract date and the date on which the contract is to be performed is called delivery date or settlement date.

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The seller in the forward contract is called short or short position who is having responsibility and obligation to make delivery of the goods contracted on the contract date at the strike price. There is every possibility that either party may fail to fulfil the terms and conditions of the contract. If anyone fails in complying with the terms and conditions of the contract,it is called default risk. Futures Contract A futures contract is a standardised, tradable contract, which requires the delivery of the underlying asset (commodity, stock etc.) at a specified price and specified future date. Unlike options, buying a futures contract gives you the obligation to buy the underlying and thus involves greater risk. Another difference is that commodities like gold, cotton, crude oil etc are especially prominent in futures markets. Futures transactions can be settled in three ways: squaring off, delivery and cash settlement.
y

How to trade in futures

Squaring off means taking a position opposite your initial one. For example, you square off the purchase of a gold futures contract by selling the identical contract. Delivery means physically delivering the underlying asset on the agreed date. If you sell a gold futures contract of say 1 kilogram then you will have to give real gold to the buyer on the mutually agreed date. Cash settlement involves paying the difference between the futures price and the spot price of the underlying asset. For example, if you sell a gold futures contract worth one kilogram for say Rs 1.2 lakhs and the price of the contract on expiry day is Rs 1.3 lakhs then you will have to pay the buyer the difference of Rs 10,000. Standardization Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
y y y

y y

The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc. The currency in which the futures contract is quoted. The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the

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y y y

NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing point -- the location where delivery must be made. The delivery month. The last trading date. Other details such as the commodity tick, the minimum permissible price fluctuation.

Settlement - Physical versus Cash-settled futures Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
y

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.[5] Cash settled futures are those that, as a practical matter, could not be settled by delivery of the referenced item - i.e. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.

TRADERS I N FUTURES CONTRACT Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical use for or intent to actually take or make delivery of the underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract. Hedgers Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest

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rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

Speculators Speculators typically fall into three categories: position traders, day traders, and swing traders (swing trading), though many hybrid types and unique styles exist. In general position traders hold positions for the long term (months to years), day traders (or active traders) enter multiple trades during the day and will have exited all positions by market close, and swing traders aim to buy or sell at the bottom or top of price swings.[7] With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil, and experts are divided on the matter. [8] An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced diversification, maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased), the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example.

Options on futures In many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. Futures are often used since they are delta one instruments. Calls and options on futures may be priced similarly to those on traded assets by using an extension of the Black-Scholes formula, namely Black's formula for futures. Investors can either take on the role of the option seller/option writer or the option buyer. Option sellers are generally seen as taking on more risk because they are contractually obligated to take the opposite futures position if the options buyer exercises his or her right to the futures position specified in the option. The price of an option is determined by supply and demand principles and consists of the option premium, or the price paid to the option seller for offering the option and taking on risk. [9]

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Futures versus Forwards Contract While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects:
y

Futures are exchange-traded, while forwards are traded over-the-counter. Thus futures are standardized and face an exchange, while forwards are customized and face a non-exchange counterparty.

Futures are margined, while forwards are not. Thus futures have significantly less credit risk, and have different funding.

Exchange versus OTC Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties. Thus:
y y

Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter. In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.

Margining Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Forwards do not have a standard. They may transact only on the settlement date. More typical would be for the parties to agree to true up, for example, every quarter. The fact that forwards are not margined daily means that, due to movements in the price of the underlying asset, a large differential can build up between the forward's delivery price and the settlement price, and in any event, an unrealized gain (loss) can build up. Options Contract An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price.The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding

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obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. An option gives you the right to buy or sell the underlying asset but not any obligation. A call option gives you right to buy the underlying asset while a put option gives you the right to sell. An option contract specifies the strike price, that is, the price at which you can buy or sell the underlying and the expiry date after which the option is no longer valid. In other words, the expiry is the last day on which a contract expires or ends. In Indian markets, expiry is the last Thursday of every month.
y

A mutual fund with a difference

Options are also classified into American, which can be exercised at any time prior to the expiry date and European which can only be exercised at the expiry date. In India options on individual stocks are American-style while options on indices like the Nifty are European. So in the newspaper if you read, say, a Ranbaxy option contract: CA-330-Mar, it means that this is an American-style call option which gives you the right to buy Ranbaxy shares at Rs 330 and which expires in March (the last Thursday). Similarly a PE-4300-April Nifty contract is a European-style put option, which gives you the right to sell at Rs 4,300 and expires in April.

An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless. In return for granting the option, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised. An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.[2][3]

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of Options can be classi ied int following t pes:

The Opti E
y

nge-traded options E ange-traded options (also called "listed options" are a class of exchange-traded deri ati es. Exchange traded options have standardi ed contracts, and are settled through a clearing house with fulfil ent guaranteed by the credit of the exchange. Since the contracts are standardi ed, accurate pricing models are often available. Exchange-traded options include: o stock options, o commodity options, o bond options and other interest rate options o stock market index options or, simply, index options and o options on futures contracts o callable bull/bear contract


Over-the-counter
y

Over-the-counter options (OTC options, also called "dealer options" are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a wellcapitali ed institution. Option types commonly traded over the counter include:

1. Interest rate options 2. Currency cross rate options, and 3. Options on swaps or swaptions. The basic trades of traded stock options (American style) These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contractin US markets usually represents 100 shares of the underlying security.[18] Long call

Payoff from buying a call.

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A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just purchase the stock itself. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium (price) paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can control leverage) a much larger ( number of shares. Long put

Payoff from buying a put. A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above he t exercise price, he will let the put contract expire worthless and only lose the premium paid. Short call

Payoff from writing a call. A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercis price by more than e the amount of the premium, the short will lose money, with the potential loss unlimited.

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Short put

Pay off from writing a put. A trader who believes that a stock price will increase can buy the stock or instead sell, or "write", a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the s tock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock. A benchmark index for the performance of a cash-secured short put option position is the CBOE S&P 500 Put rite Index (ticker PUT).

Option strategies

Payoffs from buying a butterfly spread.

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Pay offs from selling a straddle.

Pay offs from a covered call. Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several. Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss. An Iron condor is a strategy that is similar to a butterfly spread, but with different strikes for the short options offering a larger likelihood of profit but with a lower net credit compared to the butterfly spread. Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss. Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the risk of loss in the trade. One well-known strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially
 

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offset by the premium received from selling the call. Overall, the payoffs match the payoffs from selling a put. This relationship is known as put-call parity and offers insights for financial theory. A benchmark index for the performance of a buy-write strategy is the CBOE S&P 500 BuyWrite Index (ticker symbol BXM). Swap Contract A swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more than $426.7 trillion in 2009, according to International Swaps and Derivatives Association (ISDA).

Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG. The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world productwhich is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as:

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The CDS and currency swap markets are dwarfed by the interest rate swap market. All three markets peaked in mid 2008. Source: BIS Semiannual OTC derivatives statistics at end-December 2008 Notional
in USD trillion

outstanding

Currency Euro US dollar

End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006 16.6 13.0 20.9 18.9 10.1 5.0 1.2 58.9 31.5 23.7 12.8 6.2 1.5 79.2 44.7 33.4 17.4 7.9 2.0 111.2 59.3 44.8 21.5 11.6 2.7 147.4 81.4 74.4 25.6 15.1 3.3 212.0 112.1 97.6 38.0 22.3 3.5 292.0

Japanese yen 11.1 Pound sterling 4.0 Swiss franc Total 1.1 48.8

Source: "The Global OTC Derivatives Market at end -December 2004", BIS, [1], "OTC Derivatives Market Activity in the Second Half of 2006", BIS [2] ,

Usually, at least one of the legs has a rate that is variabl . It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by the British Bankers Association, an independent trade body.

Types of swaps 16
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The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types. Interest rate swaps

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. N ormally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments. The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets When companies want to borrow they . look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variabl interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the ti al amount. The first rate is called variabl , because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread. Currency swaps A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivat d by comparative e advantage. Currency swaps entail swapping both principal and interest between the parties,
!" "!

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with the cashflows in one direction being in a different currency than those in the opposite direction. Commodity swaps A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil. Equity Swap An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do. Credit default swap A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

DERIVATIVES TRADING IN INDIA

Derivative trading in India can take place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organisation and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment. With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act,1992. Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lays down the provisions for trading and settlement of derivative contracts.

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The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances.

Derivative Markets today

y y y y

The prohibition on options in SCRA was removed in 1995. Foreign currency options in currency pairs other than Rupee were the first options permitted by RBI. The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products. Besides the Forward market in currencies has been a vibrant market in India for several decades. In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures.

E.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI).
y y

In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products. The year 2000 will herald the introduction of exchange traded equity derivatives in India for the first time. Equity Derivatives Exchanges in India

In the equity markets both the National Stock Exchange of India Ltd. (NSE) and The Stock Exchange, Mumbai (BSE) have applied to SEBI for setting up their derivatives segments. The exchanges are expected to start trading in Stock Index futures by mid-May 2000. BSE's and NSEs plans

y y y

Both the exchanges have set-up an in-house segment instead of setting up a separate exchange for derivatives. BSEs Derivatives Segment, will start with Sensex futures as its first product. NSEs Futures & Options Segment will be launched with Nifty futures as the first product.

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BLACK SCHOLES MODEL An option pricing formula initially derived by Fisher Black and Myron Scholes for securities options and later refined by Black for options on futures. A model used to calculate the value of an option, by considering the stock price, strike price and expiration date, risk-free return, and the standard deviation of the stock's return. The BlackScholes model is a mathematical description of financial markets and derivative investment instruments. The model develops partial differential equations whose solution, the BlackScholes formula, is widely used in the pricing of European-style options. A mathematical formula designed to price an option as a function of certain variablesgenerally stock price, striking price, volatility, time to expiration, dividends to be paid, and the current risk-free interest rate.

Model assumptions
The BlackScholes model of the market for a particular equity makes the following explicit assumptions:
y y y y y y y

It is possible to borrow and lend cash at a known constant risk-free interest rate. It is possible to borrow and lend cash at a known constant risk-free interest rate. The underlying security does not pay a dividend. The stock price follows a geometric Brownian motion with constant drift and volatility. All securities are infinitely divisible (i.e., it is possible to buy any fraction of a share). There are no restrictions on short selling. There are no transaction costs, taxes or bid-ask spread.

Black-Scholes Example
Suppose you want a function that implements the Black-Scholes pricing model. The BlackScholes model, first published in 1973 by Fischer Black and Myron Scholes, is used to calculate the present value of a call option. Without going into the background theory here, we will simply present the resulting equations we wish to implement as a model. The present value of a call option is:

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P E t v =

= the = =

the

current strike or time volatility

price exercise to of

of price

the in

underlying the of options the security's

security contract option price

the the

expiration the

underlying

r = the risk-free interest rate The function Cnorm is the cumulative normal distribution function; it is used frequently in statistics and management science. Cnorm is defined as:

The Cnorm function alone is a good candidate for a separate library model. In fact, to build the Black-Scholes model, it is best first to build a separate Cnorm model. You will not find a closed form solution to the integral in the Cnorm definition because the integral cannot be solved. Instead, you are likely to find a table in the back of every statistics book that lists the value of this function for a range of input values. However, DecisionPro can handle the integration quite easily using the integral primitive, which performs numerical integration. The Cnorm function can be implemented with two definitions taken straight from the equations above:

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Once defined, this model should be saved in LBM format under the name Cnorm.lbm. The complete Black-Scholes model can be implemented as follows:

Once created, this model should be saved in LBM format under the name Black.lbm. From then on, this model can be used in any other model simply by using the function Black(P,E,t,v,r) where the arguments P, E, t, v, and r are replaced with the appropriate input values. Nesting Models The Black-Scholes model has been split into two separate models, Black and Cnorm, where Black uses the model Cnorm. Library models can use other library models as components. In fact, there is no practical limit to how deeply you can nest library models. The ability to nest models allows you to build libraries of models hierarchically. Each successive model can draw on previous models you have developed to perform increasingly more complex tasks. For example, once you have the Black model, you can build a model that uses Black to evaluate investment options. When DecisionPro loads a library model, all component models are automatically loaded as well.

FINDINGS SUGGESTIONS AND RECOMMENDATIONS CONCLUSION

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