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CHAPTER-1 PART A: ABOUT INDUSTRY PATR B: ABOUT SUBJECT

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EXECUTIVE SUMMARY Stock market has been growing at a phenomenal rate over the past few years. Advances in the market, improvement in computer and telecommunications capability and robust clearing and settlement, significantly expanded opportunities and lowered the costs of operations for hedging risks not readily managed in earlier decades. These products contributed to the development of a more flexible and efficient financial system, both domestically and internationally. The development of stock market and its extensive use in the financial sector has been synonymous with the rapid growth in the financial sector itself. In the context of the changing financial environment and the consequent increases in the nature and quantum of financial risks it is mandatory to have a thorough knowledge about stock market & portfolio, which help in managing risks in the present-day financial world. The saving of an individual are spread through different means of investment one of them is mutual fund which is a growing investment now a days because of diversified risk and lack of time to look their money. Financial derivatives are quite new to the Indian financial market, but the derivatives market has shown an immense potential which is visible by the growth it has achieved in the recent past. In the present changing financial environment and an increased exposure towards financial risks, and in this project let us see how investor consider the derivative as their portfolio part.

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[Type the document title] INTRODUCTION

1.1 ABOUT THE INDUSTRY

Indian capital market is one of the oldest and largest capital markets of the world. It history can be traced back to 19th century. The first instance of organized trading corporate securities in India is related to the trading in securities of east India Company. The concept of limited liability introduced with enactment of companies act, 1850 helped in commencing an era of joint-stock companies, which in turn paved the way for the development of capital market. In due course, broker used to assemble at some common places to conduct trade. By 1874, dalal street in Mumbai became a prominent place of meeting of the broker. Bombay stock exchange (BSE) the first organized stock exchange in the country was started functioning in 1875. However, it was in 1887 the BSE formally established as a society named native share and stock grocers association. The effect of industrial revolution began to be felt in India by the dawn of 20th century. This period was also marked by the swadeshi movement which created much industrial enthusiasm in the country. During the period of first and Second World War, industrial sector as well as capital market exhibited much dynamism. After independence the Indian government gave priority to the infrastructure development, considering the urgency of proceeding with large industrial development. Accordingly many financial institutions like IFC, ICICI, LIC, UTI, and IDBI were established to accelerate the pace of industrialization in India. The promulgation of the companies act, 1956 based on recommendations of the company law committee was another important event. The passing of FERA 1973 limited the share holding of foreign firms to 40%, if they were recognized to be as Indian company. For diluting their share holding, many MNCs offered shares to the public at attractive rates. En courage by good response to these issues, much domestic company also came out with public issues. Individual investors were enthusiastic to invest in the capital market as the found equity investment to be hedge against inflation and source of higher earnings compared to other investments.

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CAPITAL MARKET OPERATION It consist mainly of primary market operation and secondary market operations. Primary market or new issue market deals with the issue of new securities to investors on facilitates the corporate sectors in raising funds. The primary market is made up of two components: where the firms go public for the first time through initial public offering and where the firms which are already traded raise additional capital through seasoned equity offerings. In the secondary market the securities which are floated and subscribed in the primary market are traded. The primary function of stock exchange or secondary market is to provide liquidity of capital and continuous market for outstanding securities. The stock exchange brings about a correct evaluation of securities and set prices of securities close to their investment worth.

OVERVIEW OF INDIAN STOCK MARKET The only stock exchanges operating in the 19th century were those of Mumbai set up in 1875 and Ahmadabad set up in 1894. These were organized as voluntary non-profit making associations of brokers to regulate and protect their interest. Before the control on securities trading became a central subject under the constitution in 1950, it was a state subject and the Bombay security contracts (control) act of 1925 used to regulate trading in securities under this act, the Bombay stock exchange was recognized in 1927 and Ahmadabad in 1937. During the war boom, a number of stock exchanges were organized even in Mumbai, Ahmadabad and other centers, but they were not recognized. Soon after it became a central subject. Central legislation was proposed and a committee headed by A.D.Gorwala went into the bill for securities regulation. On the basics of the committees recommendations and public discussion, the securities contracts (regulation) act SC(R) act became in 1956.

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Stock exchange Stock exchange means ant body or individual whether incorporate or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling, or dealing in securities. It is an association of member brokers for the purpose of self regulation and protecting the interests of its members. It can operate only if it is recognized by the government under the securities contracts (regulation) act, 1956. The recognition is granted under section 3 of the central government, ministry of finance. Present recognized stock exchanges At present, there are 21 stock exchanges recognized under the securities contracts (regulation) act 1956. They are located at Bombay, Calcutta, and madras, Delhi, Ahmedabad, Hyderabad, Indore, Bhubaneswar, Mangalore, Patna, Bangalore, Rajkot, Guwahati, Jaipur, Kanpur, Ludhiana, Baroda, Cochin and Pune. The recent recognized stock exchanges are at Coimbatore and Meerut. Visakhapatnam stock exchange was recognized in 1996 for electronic trading. A stock exchange has also been sought for this body as the jurisdiction of the areas covered by the state. Contracts (regulation) act, 1956 has not so far been extended to the areas covered by the state. A decade ago, there were hardly 8 stock exchanges in the country. There is no trading, however, in Meerut and Visakhapatnam stock exchanges. The Bombay stock exchanges (BSE) and the national stock exchanges of India Ltd (NSE) are the two primary exchanges in India. In addition, there are 22 regional stock exchanges in India. However, the BSE and NSE have established themselves as the two leading exchanges and account for about 80% of the equity volume traded in India. The NSE and BSE are equal in size in terms of daily traded volume. The average daily turnover at the exchanges has increased from 851 crore in 1997-98 to 1,284 crore in 1998-99 and further to Rs 2,273 crore in 1999-2000(April-August 1999).

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NSE has around 1500 shares listed with a total market capitalization of around 9, 21,500 crores. The BSE has over 6000 stocks listed and has a market capitalization of around 9, 68,000 crores. The primary index of BSE is BSE sensex comprising 30 stocks. NSE has the S & P NSE 50 index (NIFTY) which consists of fifty stocks. The BSE sensex is the older and more widely followed index. Both the exchanges have switched over from the open outcry trading system to a fully automated computerized mode trading known as (BSW online trading) BOLT and (National Exchange Automated Trading) NEAT system. It facilitates more efficient processing, automatic order matching, faster execution of trades and transparency The key regulator governing stock exchanges, brokers, depositories, depository participants, mutual funds, FII and other participants in Indian secondary and primary market is the securities & exchanges board of India (SEBI) ltd.

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The geographical location of all the stock exchanges is shown below:

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1.2ABOUT THE SUBJECT HISTORY OF THE DERIVATIVES DERIVATIVES: Development in India

The derivatives markets has existed for centuries as a result of the need for both users and producers of natural resources to hedge against price fluctuations in the underlying commodities. Although trading in agriculture and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instrumentssuch as bond, currencies, stocks and stock indices- have now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before moraji desais government banned forward contracts. Derivatives on stock were traded in the form of teji and mandi in unorganized markets. Recently futures contracts in various commodities were allowed to trade on exchanges. For example, now cotton and oil futures trade in Mumbai. Soybean futures trade in Bhopal, pepper futures in Kochi, coffee in Bangalore etc. In June 2000, national stock exchange and Bombay stock exchange started trading in futures on sensex and Nifty. Options trading on sensex and nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. Currently there are 41 stocks trading on NSE derivatives and the list keeps growing.

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How many stocks are trading in futures & opinions? What is the minimum quantity we need to trade? The minimum quantity trade in is one market lot the market lot is different stocks /index. Time to time list will keep changing. CNXIT 100 Nifty 200 ACC 1500 Andhra Bank 4600 Bajaj auto 400 Bank of Baroda 1400 Bank of India 3800 BEL 550 Bank of India 3800 Grasim Ind 350 BHEL 600 BPCL 550 Canada Bank 1600 Cipla 1000 Dr.reddys 200 GAIL 1500 ICICI Bank 1400 Infosys 200 IOC 600 MTNL 1600 ONGC 300 Nalco 1150 Tisco 1350 M&M 625 Maruti 400 BEL 550 IPCL 1100 Hero Honda 400 HDFC bank 800 HDFC 600 Gujarat Ambuja 1100 HCL tech 1300 Oriented Bank 1200 PNB 1200 POLARIS 1400 Ranbaxy 400 Wipro 600 REL 550 Union Bank 4200 TCS 250 Tata Tea 550 ITC 300 RIL 600 i-flex 300 HPCL 650 Hll 2000 Hindalco 300 Tata Power 800

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Development prior to 1998-99 In the last few years there have been substantial improvements in the functioning of the securities market. Requirements of adequate capitalization, margining and establishment of clearing corporations have reduced market and credit risks. System improvement have been effected through introduction of screen based trading system and electronic transfer and maintenance of ownership records of securities. However, there are inadequate advanced risk management tools. In order to provide such tools and to deepen and strengthen cash market, a need was felt for trading of derivatives like futures and options. But it was not possible in view of prohibitions in the SCRA. Its preamble stated that the act is to prevent undesirable transactions in securities by prohibiting opinions and by providing for certain others matters connected therewith. Section 20 of the act explicitly prohibited all options in securities. The act empowered central government to prohibit by notification any type of transaction in any security. In exercise of this power, government by its notification in 1969 prohibited all forward trading in securities. As the need for derivatives was felt, it was thought that if these prohibitions were withdrawn, trading in derivatives could commence. The securities laws (amendment) ordinance, 1995, promulgated on 25th January 1995, lifted the ban by repealing sections 20 of the SCRA and amending its preamble. 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 18th November 1996 to develop appropriate regulatory frame work for derivatives trading in India. The committee submitted its report on March 17th, 1998.

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Market went ahead with preparation. It was soon realized that there was no law under which the regulations could be framed for derivatives. It was felt that if derivatives would be securities under the SC(R) act, trading in derivatives would be possible within the framework of that act. According to sections 2(h) of the SC(R) act, securities includes shares, scripts, stock bonds, debentures, debentures stock, or other marketable securities of a like nature in or of any incorporated company or other body corporate, government securities, such other instruments as may be declared by the central government to be securities, and rights and interest in securities. SEBI felt that the definition of securities under SC(R)A could be expanded by declaring derivatives contracts based on index of prices of securities and other derivatives contracts as securities. It was thought that government could declare derivatives to be securities under its delegated powers. Government, however did not declares derivatives as securities, probably because its power was circumscribed by the words such other. Only those instruments, which resemble the ones listed in the Act could be declared.

DERIVATIVES TRADING
Derivatives are instruments which derive their value from the underlying asset, which could be a commodity, foreign exchange, Treasury bill, debt instruments, equity shares or index. Derivatives in the form of index futures made their appearances on the Indian stock market in June 2000, when trading in nifty and sensex futures was stared in NSE and BSE respectively.

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EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA

November 1996, SEBI set up a committee under the chairmanship of Dr.L.C.Gupta, the well known economist and former SEBI board member. The committee submitted its report on the march 17th 1998. It advocated the introduction of derivatives in Indian market in a phased manner, starting with the index futures. SEBI accepted the report on May 11th, 1998 and June 16th, 1998; it issued a circulation allowing exchanges to submit their proposals for introduction of derivatives trading. Government issued notification delineating the areas of responsibility between RBI and market regulator SEBI. On June 2000, derivatives trading started in NSE and BSE.

WHAT ARE DERIVATIVES? Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee. Example of derivatives: the prices of reliance triple option convertible debentures (reliance TOCD) used to vary with the price of reliance shares. And the price of Telco warrants depends upon the price of Telco shares.

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TYPES OF DERIVATIVES
The following are the popular and important derivatives: Forwards Futures Options and Swaps

What are forward contracts? A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. The rupee-dollar exchanges rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants. The main features of a forward contract are: Each contract is custom designed and hence unique in terms of contract size, expiration date, asset quality etc. A contract has to be settled in delivery or cash on expiration date. In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants. Traded in over the counter (OTC) markets. No down payment required. Settlement is done on the date of maturity.

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(ii) FUTURES A future contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on an organized exchanges. A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made.

Features of future contracts

1. Highly standardized in nature. 2. No down payment is required at the time of agreement. 3. Settlement: futures instruments are marked to the market and the exchange records profit and loss on them on daily basis though held till maturity. 4. Hedging of price risk is mostly common in futures. 5. Non-linearity. 6. Non- delivery of asset: In future contracts generally parties simply exchange the difference between the future and spot prices.

The advantages of a future are that it eliminates risk. Since there is an exchange involved in between, and the exchanges guarantees each trace, the buyer or seller does not get affected with the opposite party defaulting.

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FUTURES V/S FORWARDS

Futures Futures are traded on stock exchanges. Forwards Forwards instruments. Futures are contracts having standard terms Forwards are contracts customized by the and conditions. buyer and seller. are non-tradable, negotiated

No default risk as the exchange provides a High risk of default by either party. counter guarantee. Exit route is provided because of high liquidity No exit route for these contracts. on the stock exchange. Highly regulated with strong margining and No such systems are present in a forward surveillance systems. market.

a) Commodity futures
A commodity future is a futures contract in commodities like agriculture products, metals and minerals etc. in organized commodity futures markets, contracts are standardized with standard quantities. Of course, this standard varies from commodity to commodity. They also fixed delivery date in each month or a few months in a year. In India commodity futures in agricultural products are popular.

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b) Financial futures
Financial futures refer to futures contracts in foreign exchanges or financial instruments like Treasury bill, commercial paper, and stock market index or interest rate. It is an area where financial service companies can play a very dynamic role. Financial futures are very popular in western countries as hedging instruments to protect against exchanges rate/interest rate fluctuations and for ensuring future rates on loans. The stock index futures contracts is a futures contracts on major stock market indices. This type of contracts is very much useful for speculators, investors and especially portfolio managers. They can hedge against future decline or increases in prices of portfolios depending upon the situation. Generally the asset will not be delivered on the maturity of the contract. The parties simply exchange the difference between the future and spot prices on the data of maturity. But, these kinds of financial futures are relatively new in India.

(III) OPTIONS In the volatile environment, risk of heavy fluctuations in the prices of assets is very heavy. Options are yet another tool to manage such risks. Options are one better than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a stock, bond, currency or a commodity. But since the other party has an obligation and a risk associated with making good the obligation, he receives a payment for that. This payment is called as premium. The party that had the option or the right to buy/sell enjoys low risk. The cost or this low risk is the premium amount that is paid to the other party. The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer; the cost of this transaction is the premium.
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In an option contract, the seller is usually referred to as a writer since he is said to write the contract. It is similar to the seller who is said to be in short position in a obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell. American option Vs European option In an option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On other hand, if it can be exercised only the time of maturity, it is termed as European option. Types of options Options may fall under any one of the following main categories: Call Option Put Option 1) CALL OPTION A call options is one which gives the options holder the right to buy a underlying asset (commodities, foreign exchanges, stocks, shares, etc.) at a predetermined price called

(exercise price) or strike pieces on or before specified data in future. In such a case, the writer of a call option is under an obligation to sell the asset at the specified price, in case the buyer exercises his options to buy. Thus, the obligation to sell arises only when the option is exercises.

2) PUT OPTION A put option is one, which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of put options is under an obligation to buy the asset at the exercise price provided the options holder exercises his option to sell.
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A) Option Premium
In an option contract, the option writer agrees to buy or sell am underlying asset at a future dates for an agreed price from/to the option buyer/seller at his option, this contract, like any other contract must be supported by consideration. The consideration for this contract is a sum of money called premium. The premium is nothing but the prices, which is required to be paid for the purchases of right to buy or sell. The premium, one pays is the maximum amount to which he is exposed in the market, since, in any case he cannot lose more than that amount. Thus, his risk is limited to that extent only. However, His gain potential is unlimited. In the case of a double option, this premium money is also double.

B) Option Market

Options market refers to the market where options contracts are bought and sold. Once an option contract is written, it can be brought or sold on the options market. The first options market namely the Chicago board of options exchanges was set up in 1973. Thereafter, several options markets have been established.

Features of options market

1. Highly flexible. 2. Down payment. 3. Settlement. 4. Non-linearity. 5. No obligation to buy or sell. iv) SWAPS Swap is yet another exciting trading instrument. In fact, it is a combination of forward by two counterparties. It is arranged to reap the benefits arising from the fluctuation in the market either currency market or interest rate market or any other market for that matter.

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Features of swaps
1. Basically a forward. 2. Double coincidence of wants. 3. Necessity of n intermediary. 4. Settlement. 5. Long term agreement.

Kinds of swap A swap can be arranged for the exchange of currencies, interest rates etc. A swap in which two currencies are exchanges are exchanged is called cross-currency swap. A swap in which a fixed rate of interest is exchanged for a floating rate is called interest rate swap. This interest rate swap can also be arranged in multi- currencies. A swap in which on stream of floating interest rate is exchanged for another stream of floating interest is called basic swap. Thus, swap can be arranged according to the requirements of the parties concerned and may innovative swap instruments can be evolved like this.

Advantages 1. Borrowing at lower cost. 2. Access to new financial markets. 3. Hedging of risks. 4. Tool to correct asset-liability mismatch. 5. Additional income

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