Management Research Project Report On Study of Financial Derivatives in Indian Context

Submitted by: Enrollment No:

Anuj Goel 0901200352 Class of 2011 IBS, Bangalore

FINAL REPORT Of Management Research Project (MRP)

Topic:
Study of Financial Derivatives in Indian Context
By

ANUJ GOEL 0901200352

Date of Submission: January 25th, 2011

Final MRP Report ON

Study of Financial Derivatives in Indian Context
By

ANUJ GOEL 0901200352

A report submitted in the partial fulfillment of the requirements of MBA program of the ICFAI University, Dehradun

Distribution List MRP Guide: Prof. Shafiulla B IBS, Bangalore

ACKNOWLEDGMENTS
Learning is only aspect that doesnt subject to Law of Diminishing Marginal Returns
Preservation, Inspiration and motivation have always played a key role in Success of my venture. In the present world of Competition and success training is like a bridge between theoretical and practical working. It is often said that the The journey of Success and Excellence is not completed without proper support and continuous guidance we may have not come this far without the extended support and guidance from the people who acted as our Guides and Supported us in every way. I would like to express my sincere thanks to Prof. Shafiulla B. Faculty Guide, IBS Bangalore for his guidance, Cooperation and valuable suggestions towards achieving the objective of the project. And as my faculty guide I thank him for being a constant source of inspiration, mentor and for his efforts. I would also like to pay my indebt sincere thanks to Prof. C M Madtha for his valuable guidance in my project. With his extended help I was able to timely complete my project.

Place: Bangalore Date: 25th January, 2011

ANUJ GOEL IBS, Bangalore

Abstract
The project report entitled, Study of Financial Derivatives in Indian Context covers all the necessary information regarding derivatives, their existence and strategies which is considered to be most important way to hedge the market risks associated with the portfolio of an investor. Since the beginning of commerce, the main concentration had been on investment. To get a reward in terms of tangible appreciation, people always looked out for commercial avenues. But with the passage of time, people started to sharpen their investment skills to maximize their earnings. Everybody understood that higher risk can increase their returns. So, they became more innovative in various types of investments. One major contribution of this innovativeness in the financial sector is derivatives. The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse* economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices.

However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

*Note: A risk-averse investor dislikes risk, and therefore will stay away from adding highrisk stocks or investments to their portfolio and in turn will often lose out on higher rates of return. Investors looking for "safer" investments will generally stick to index funds and government bonds, which generally have lower returns.

Table of Contents
Acknowledgements Abstract Introduction ii 1 3 4 i

Introduction to Financial Markets Introduction to Derivatives Trends in Financial Derivatives 5

General Terminologies of Financial Derivatives 6 Products & Participants 6 Need for Derivatives Market Types of Derivatives Futures Options Swaps 7 8 8 9 7 7

Swaptions9 Factors driving the growth of Derivatives

Global Derivatives Market Derivatives Market in India

10 12 14

Structure of Derivatives in India 13 Strategies for Hedging of Market Risks using Derivatives Options Terminologies 14 Payoff Schedule for Different Options Strategies 16 Buy Call Option 16 Sell Call Option Buy Put Option Sell Put Option Covered Call Protected Put Long Straddle Short Straddle Conclusion References 24 25 17 18 19 20 21 22 23

Introduction

The main purpose of this project is: Getting an in-depth knowledge of the derivatives market, its functions and its importance. To answer some important questions : Why derivatives market exists? What is the importance of this market? How is it beneficial? Understanding the development of Derivatives Market and finding out the reasons for the slow progress of Derivatives in India. To understand the different strategies, which can be used by an investor to maximize the pay-offs (Profits).

Methodology Used The entire project is divided into five phases: Phase I. Phase II. Phase III. Phase IV. Phase V. Introduction to Financial Markets Introduction to Derivatives Development of Derivatives in International Markets Strategies use to hedge the risks by investors. Reasons for the slow progress of derivative market in India and various criticisms related to it.

The secondary data sources used for the completion of project includes: Research Papers published by various institutions as Institute of Chartered Financial Analyst of India (ICFAI). Relevant books containing the subject matter (Options, Futures, and Other Derivatives by John C. Hull and Sankarshan Basu). Magazines like Forbes, Business World, Analyst and current news articles of top most financial newspapers (Economic times, Financial Express).

Limitations The major limitation embedded with this project report is the widely spread area of derivatives. Derivatives consist of a huge area of finance which cannot be wholly covered within a short span of time.

Background

History of financial markets is replete with crises, such as the collapse of the fixed exchange rate system in 1971, the Black Monday of October 1987, the steep fall in the Nikkei in 1989, the US bond debacle of 1994, all of these events occur because of very high degree of volatility of financial markets and their unpredictability. Such disasters have become more frequent with

increased global integration of markets. Innovative financial instruments have emerged to protect against hazards, these include Future and Options, which are the most dominant forms of financial derivatives, since such volatility and associated disasters cannot be washed away. They are called derivatives because their values are derived from an underlying primary financial instrument, commodity or index, such as interest rates, exchange rates, commodities and equities. For examples, a commodity future price depends on the value of the underlying commodity; the price of a stock option depends on the value of the underlying stock and so on. A derivative provides a mechanism, which market participants use to hedge their position against the adverse movement of variables over which they have no control. Financial derivatives came into the spotlight along with the growing instability in current markets during the post- 1970 period, when the US announced its decision to give up gold- dollar parity, the basic king pin of the Bretton Wood System of fixed exchange rates. The derivative markets became an integral part of modern financial system in less than three decades of their emergence. According to Greenspan* (1997) By far the most significant event in finance during the past decades has been the extraordinary development and expansion of financial derivatives Derivatives include a wide range of financial contracts, including forwards, futures, swaps and options. The International Monetary Fund (2001) defines derivatives as financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues. While some derivatives may have complex structures, all of them can be divided into basic building blocks of forward and option contracts or some combination thereof.

Alan Greenspan (born March 6, 1926) is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006.

For the purpose of hedging, speculating, arbitraging price differences and adjusting portfolio risks, derivatives allow financial institution and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities.

The risks that are associated with derivatives include credit risk, liquidity risk and market risk (comprising commodity price risk, currency, interest-rate risk and equity price risk.). The risks of derivatives are more directly related to size and price volatility of the cash flows they represent than they are to the size of the notional amounts on which the cash flows are based. In fact the risk of derivatives and cash flows, which are derived from them are usually only a small portion of notional amounts. Financial institutions may use derivatives as dealers and end-users. For example, an institution acts as a end-user when it uses derivatives to take positions as part of its proprietary trading or for hedging as a part of its asset and liability management; it acts as a dealer when it quotes bids and offers and commits capital to satisfying customers demand for derivatives. The emergence of the market for derivative products most notably forwards, futures and options can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuation in asset prices. The financial markets can be subject to a very high degree of volatility by their very nature. It is possible to partially or fully transfer the price risks by locking-in assets prices, through the use of derivative products. As instruments of risk management, derivative products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investor. Derivatives produce initially emerged, as hedging devices against fluctuation in commodity prices and commodity-linked derivatives remained the sole form of such products for many years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. In recent years, the market for financial derivatives both OTC (Over the Counter) as well as exchange traded has grown both in terms of variety of instruments available, their complexity and also turnover. The factors generally attributed as the major driving force behind growth of financial derivatives are: Increased volatility in asset prices in financial markets. Increased integration of financial markets with the international markets. Market improvement in facilities of communication and a sharp decline in costs.

Providing economic agents a wider choice of risk management strategies through development of more sophisticated risk management tools. Optimally combining the risks and returns over a large number of financial assets, leading to higher returns, reduces risk as well as transaction cost as compared to individual financial assets by innovations in the derivative markets.

Evolution of Derivatives Trading in India

All markets face different kind of risks. The derivative is one of the categories of risk management tools. As this consciousness about risk management capacity for derivative grew, the market for derivatives developed. Derivatives markets are generally an integral part of capital markets in developed as well as in emerging market economies. These instruments support business growth by disseminating effective price signals concerning indices, reference rates or other assets, exchange rates and thereby render both derivatives and cash markets more efficient. Possible adverse market movements offer protection through these instruments and can be used to offset or manage exposure by hedging or shifting risks particularly during the periods of volatility thereby reducing costs. By allowing the transfer of unwanted risk, derivatives can promote more efficient allocation of capital across the economy, increasing productivity in the economy. Though the commodity features trading has been in existence since 1953 and certain OTC derivatives such as Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRSs) were allowed by RBI through its guidelines in 1999, the trading in securities based derivatives on stock exchange was permitted only in June 2000. The discussion that follows is mainly focussed on securities based derivatives on stock exchanges. The legal framework for derivatives trading is a critical part of overall regulatory framework of derivative markets. With the role of state intervention in the functioning of markets is a matter of considerable debate, it is generally agreed that regulation has a very important and critical role to ensure the efficient functioning if markets and avoidance of systemic failures. The purpose of regulation is to promote the efficiency and competition rather than impeding it.

According to Berkshire Hathaway (1998), while there is a perceived similarity of regulatory objective, there is no single preferred model for regulation of derivative markets. The major contributory factors for success or failure of derivatives market are market culture, the underlying market including its depth and liquidity and financial infrastructure including the regulatory framework. The efficiency of derivatives market can be impaired through government interventions. For example, governmental trade agreements or price controls aimed at stabilizing prices, which do not allow derivative market to flourish are such examples of government intervention. Further, since the financial integrity, efficiency, market integrity, integrity and customer protection which are the common regulatory objectives in all jurisdictions, are critical to the success of any financial market. Anyone responsible for operating such a market would have strong incentives independent of external regulation to ensure that these conditions are present in the market place. The incentives for self-regulation can be complemented through the observation of a successful regulatory system while reducing the incentives and opportunity for behavior, which threatens the success and integrity of market (International Organization of Securities Commission 1996a). The derivatives market that have emerged will require legislation normally, which addresses issues regarding legality of derivatives instruments, specially protecting such contracts from anti-gambling laws, because these involve contracts for differences to be settled by exchange of cash, prescription of appropriate regulations and power to monitor compliance with regulation and power to enforce regulations. The type and scope of regulation also change, as the industry grows. Therefore, regulatory flexibility is critical to the long run success of both regulation and industry it regulates. It would be interesting to observe the historical evolution of development of derivatives market and then examine what needs to be done to build up these markets.

History of Derivatives: A Time Line

The Ancient Derivatives 1400s -Japanese rice futures

1500s- Dutch tulip bulb options 1800s- Puts and options The Recent: Financial Derivatives Listed Markets 1972- Financial currency futures 1973 - Stock options 1977 - Treasury bond futures 1981- Eurodollar futures 1982- Index futures 1983- Stock index options 1990- Foreign index warrants and leaps 1991- Swap futures 1992-Insurance futures 1993- Flex options OTC Markets 1981- Currency Swaps 1982 - Interest rate swaps 1983- Currency and bond options 1987- Equity derivatives markets 1988 Hybrid derivatives Source: Fortune India, September 16-30, 1993

Analysis

Financial Markets
In finance, financial markets facilitate: the raising of capital (in the capital markets), the transfer of risk (in the derivatives markets), and international trade (in the currency markets). Types of Financial Markets The financial markets can be divided into different subtypes:

Capital markets which consist of: Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contracts for trading products at some future date. Insurance markets, which facilitate the redistribution of various risks. Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.

Derivatives
During the 1980s and 1990s, a major growth sector in financial markets is the trade in so called derivative products, or derivatives for short. In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics. 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. Derivative is a financial instrument whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. 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. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to

growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines Derivative to include 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. Financial Derivatives: Trends Changing interest rate and exchange rate expectations, new highs reached by equity markets and the sharp reversal of leveraged positions in the latter part of 1998 stimulated activity in derivatives markets in 1998. Exchange traded business soared in the third quarter of 1998 as investors withdrew from risky assets and shifted their exposure towards highly rated and liquid government securities. Competition between exchanges remained intense, particularly in Europe, where the imminence of the euro and the inexorable advance of automated exchanges challenged the dominance of established marketplaces. Moreover, exchanges continued to face competition from the rapidly growing over the counter (OTC)* markets, forcing them to offer a wider range of services to make up for the loss of their franchises. The sharp increase in OTC outstanding positions in the second half of 1998 showed that the need for a massive reversal of exposures following the Russian moratorium more than offset the dampening impact of increased concerns about liquidity and counter party risks. Nevertheless, the turbulence and related losses revealed the weaknesses of existing risk management systems in periods of extreme volatility and vanishing liquidity, prompting market participants to reconsider their risk models and internal control procedures.

Over the counter (OTC) markets, a decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. There is no central exchange or meeting place for this market.

General Terminologies used in Derivatives Market Hedging Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. Speculation Derivatives can be used by investors to take a risk and make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level).

Products & Participants Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants - hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.

Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Need for Derivatives Market The derivatives market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. Fourth, speculative trades shift to a more controlled environment of derivatives market. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize

others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

Types of Derivatives
Futures Contract Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash. Option Contract Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchase the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. Under Securities Contracts (Regulations) Act, 1956 options on securities has been defined as "option in securities" meaning a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities.

An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.

Swaps Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties with the cash flows in one direction being in a different currency than those in the opposite direction.

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 swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Factors driving the growth of financial derivatives

The main factors which are responsible for the growth of financial derivatives are: Increased volatility in asset prices in financial markets, increased integration of national financial markets with the international markets, marked improvement in communication facilities and sharp decline in their costs, Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, 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.

Global Derivatives Market

The derivatives markets have grown manifold in the last two decades. The total estimated notional amount of outstanding overthecounter (OTC) contracts stood at US$ 516 trillion as at endJune 2007, an increase of 135% over endDecember 2004. Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of interest rate contracts, which reflected growing corporate bond markets and increased interest

rate uncertainty at the end of 2004. The amount outstanding in organized exchange markets increased by 1.5% from US$ 53 trillion as at endJune 2004 to US$ 81 trillion as at end March 2008. The turnover data are available only for exchangetraded derivatives contracts. The turnover in derivative contracts traded on exchanges has increased by 9.8% during 2008 to US$ 384 trillion as compared to US$ 350 trillion in 2004. While interest rate futures and options accounted for nearly 80% of total turnover during 2008, the popularity of stock market index futures and options grew modestly during the year. According to BIS, the turnover in exchangetraded derivative markets rose by a record amount in the second quarter of 2008, while there was some moderation in the OTC volume.

(Source: http://en.wikipedia.org/wiki/Derivatives_market)

As per World Federation of Exchanges 2009 Market Highlights

Top 5 exchanges by number of stock options contracts traded in 2009
Exchange Number of contracts traded in 2009 Number of contracts traded in 2008 % change

1. 2. 3. 4. 5.

International Securities Exchange Chicago Board Options Exchange Philadelphia Stock Exchange BM&FBOVESPA Eurex

946 693 771 911 976 695 579 907 593 546 317 664 282 834 019

989 525 443 933 855 344 537 954 692 350 063 629 349 331 404

-4.3% -2.3% 7.8% 56.1% -19.0%

Top 5 exchanges by number of single stock futures contracts traded in 2009

Exchange 1. 2. 3. 4. 5. NYSE Liffe Europe National Stock Exchange India Eurex Johannesburg Stock Exchange BME Spanish Exchanges Number of contracts traded in 2009 165 796 059 161 053 345 113 751 549 88 866 925 37 509 467 Number of contracts traded in 2008 124 468 809 225 777 205 130 210 348 420 344 791 46 237 747 % change 33.2% -28.7% -12.6% -78.8% -18.9%

Top 5 exchanges by number of stock index options contracts traded in 2009

Exchange 1. 2. 3. 4. 5. Korea Exchange Eurex National Stock Exchange India Chicago Board Options Exchange Taifex Number of contracts traded in 2009 2 920 990 655 364 953 360 321 265 217 222 781 717 76 177 097 Number of contracts traded in 2008 2 766 474 406 514 894 678 150 916 778 259 496 193 98 122 308 % change 5.6% -29.1% 112.9% -14.1% -22.4%

Top 5 exchanges by number of stock index futures contracts traded in 2009

Exchange 1. 2. 3. 4. 5. CME Group Eurex National Stock Exchange India Osaka Securities Exchange Korea Exchange Number of contracts traded in 2009 703 072 175 367 546 179 195 759 414 130 107 633 83 117 062 Number of contracts traded in 2008 882 432 628 511 748 879 202 390 223 131 028 334 66 436 912 % change -20.3% -28.2% -3.3% -0.7% 25.1%

Source: http://www.world-exchanges.org/statistics

Derivatives Market in India

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, 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 index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. 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.

Source: http://www.nseindia.com

Table 1: Secondary Market Turnover in Financial and Commodities Markets ( Amount in Rs crore) Market segments/Year 1 Government Securities Market Forex Market (inclusive of cash, tom, spot and forward) Total Stock Market Turnover (I+ II) Derivatives Cash Commodities Market 2002-03 1941673 (79.0) 2 658035 (26.9) 3 1374403 (56.1) 442341 (18.1) 932062 (38.0) 66500 2003-04 2639244 (95.6) 2318531 (84.0) 3744841 (135.7) 2142686 (77.6) 1602155 (58.0) 129400 2004-05 2692129 (86.2) 4042435 (129.5) 4221952 (135.3) 2563165 (82.1) 1658787 (53.1) 571759 2005-06 2559260 (72.5) 5239674 (148.4) 7209892 (204.2) 4824260 (136.6) 2385632 (67.6) 2134000 2006-07 3578037 (86.7) 8023078 (194.5) 10316749 (250.1) 7415278 (179.7) 2901471 (70.3) 3676335 2007-08 5602602 (119.4) 12726832 (271.2) 18462682 (393.4) 13332787 (284.1) 5129895 (109.3) 4065989 4467013 5403856 3782519 5360594 2007-08 upto July 1403062 2008-09 upto July 1671663

I II 4

3232150 1234863 1179766

3819817 1584039 1654443

GDP at market prices

(2.7) (4.6) (18.3) (60.4) (89.1) (86.6) 2449736 2760224 3121414 3531451 4125725 4693602 Note: (i) Figures in brackets represent percent to GDP at current market prices. Source: Rakshitra and other Publications of CCIL, Sebi Bulletin and NSE NEWS.

The above figure shows the turnover of various financial instruments in Indian market for a period of 6 years i.e. from 2002-03 to 2008-09.

What is the Structure of Derivative Markets in India? Derivative trading in India takes can 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 (SRO) 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.

Strategies for Hedging of Market Risk using Derivatives

The most common derivative contract used in hedging is Options. So we are discussing the various strategies linked with options contract only. OPTIONs TERMINOLOGY Index options: These options have the index as the underlying. In India, they have a European style settlement. For ex. Nifty options, Mini Nifty options etc. Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer / seller of an option: The writer / seller of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. European options: European options are options that can be exercised only on the expiration date itself. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash-flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash-flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash-flow if it were exercised immediately. A call option on the index is out-ofthe-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max[0, K St],i.e. the greater of 0 or (K St). K is the strike price and St is the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The

longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value. This strategy can be used by an investor who is very bullish on the market. Under this strategy the investor pays the seller of the option a premium to buy an option to buy shares at a price in future.

Payoffs (Profits/Losses) Schedule for different Options Strategies

The strike price of this option to buy is 520 and the premium for the contract is 71.95.

Buy call option for BPCL expiring 26th Aug, 2010

Strike Price Premium Spot Price Payoff 520 71.95 260 0 520 520 520 520 520 520 520 520 520 520 520 520 71.95 71.95 71.95 71.95 71.95 71.95 71.95 71.95 71.95 71.95 71.95 71.95 300 340 380 420 460 500 540 580 620 660 700 740 0 0 0 0 0 0 20 60 100 140 180 220

Profitbreakeven point for the contract is The & Loss

520+ 71.95= 591.95. -71.95

-71.95 -71.95 This strategy limits the losses at the lower level to the extent of the -71.95 premium to be paid and there are no -71.95 limits to the profits if prices move high. -71.95 -71.95 -51.95 -11.95 28.05 68.05 108.05 148.05

This strategy can be used by an investor who is very bearish on the market. Under this strategy the seller receives 71.95 520 premium and sells a right to the buyer to buy shares if prices rise above the strike price.

780

260

188.05

The strike price of this option to buy is Spot 520 and Strike the premiumPremium for the contract is Price Payoff Price 71.95. 520 520 71.95 71.95 260 300 0 0 0 0 0 0 0 -20 -60 -100 -140 -180 -220 -260

Sell call option for BPCL 26th Aug, 2010

Profit & Loss 71.95 71.95 71.95 71.95 71.95 71.95 71.95 51.95 11.95 -28.05 -68.05 -108.05 -148.05 -188.05

expiring

520 71.95 340 The breakeven point for the contract is 520 71.95 520+ 71.95= 591.95. (from380 the point of call buyer) 71.95 520 420 520 71.95 460

This strategy limits 71.95gains to500 the the 520 amount of premium received but the 520 71.95 540 losses can be unlimited. Thus it is a highly risky and aggressive strategy 520 71.95 580 usually followed by an person who is 520 71.95 620 very bearish on market. 520 71.95 660 520 520 520 71.95 71.95 71.95 700 740 780

Buy put option for BPCL expiring 26th Aug, 2010

Strike Price 520 520 520 520 520 520 520 520 520 520 520 520 520 520 Premium Spot Price Payoff 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 495 500 505 510 515 520 525 530 535 540 545 550 555 560 25 20 15 10 5 0 0 0 0 0 0 0 0 0 Profit & Loss 12.45 7.45 2.45 -2.55 -7.55 -12.55 -12.55 -12.55 -12.55 -12.55 -12.55 -12.55 -12.55 -12.55

This strategy is a bearish strategy followed by a person who is aggressive and expecting market to fall. Under this strategy the buyer pays a premium to buy a right to sell stocks at a higher price than the strike price.

The strike price of this option to buy is 520 and the premium for the contract is 12.55.

The breakeven point for the contract is 520-12.55= 507.45. The losses in this strategy are limited to the premium paid but there is a possibility of huge profits. Thus it is a good strategy if market seems to be bearish.

This strategy is used by a person who is bullish on market. The investor expects the stock prices to Sell put option for BPCL move up and thus he sells option to Aug, 2010 sell shares at a certain price. If the stock price increases above strike Strike Price Premium Profit & price, the investor makes money Spot Price Payoff Loss equal to the premium received. 520 12.55 495 -25 -12.45 520 12.55 500 505 510 515 520 525 530 535 540 545 550 555 560 -20 -15 -10 -5 0 0 0 0 0 0 0 0 0 -7.45 -2.45 2.55 7.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55

expiring 26th

520 12.55 This strategy limits the gains to the 520 12.55 amount of premium received but the 520 chances of losses is huge12.55 can and increase with decline in prices. 520 12.55 520 520 520 520 520 520 520 520 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55

This strategy is used by an investor who is neutral to bearish on the stock prices. If the investor believes that the prices will not fall much and profits Covered call for BPCL for option cannot be made on the short position expiring on 26th Aug 2010 of stocks. Thus the investor sells put options and get returns. If prices Strike Price Premium Spot Price Payoff Profit & Payoff on Net profit and doesnt increase or move sideways Loss Long Loss the premium earned becomes the profit for the investor. 520 71.95 260 0 71.95 -260 -188.05 520 520 520 71.95 71.95 71.95 300 340 380 0 0 0 0 0 0 -20 -60 -100 -140 -180 -220 -260 71.95 71.95 71.95 71.95 71.95 71.95 51.95 11.95 -28.05 -68.05 -108.05 -148.05 -188.05 -220 -180 -140 -100 -60 -20 20 60 -148.05 -108.05 -68.05 -28.05 11.95 51.95 71.95 71.95

520 71.95 420 The payoff for this strategy shows that using this strategy gives a return 520 71.95 460 equal to the premium received. The option sold is generally 71.95 and the OTM 520 500 combined payoff of short position and 520 71.95 540 option gives a payoff which is same as sell call option. 520 71.95 580 520 520 520 520 520 71.95 71.95 71.95 71.95 71.95 620 660 700 740 780

This 100 strategy is used by a person who is 71.95

having a long position in the stock and is 140 expecting the market not to move up 71.95 significantly or to move sideways in the 180 term. Thus the investor can sell 71.95 near buy make 220 calls and 71.95 money equal to the premium received.

260

Protected Put for BPCL for option expiring on 26th Aug 2010

In this strategy, the long stock position and short put position eventually makes the payoff diagram look like a short put strategy. This strategy can be exercised and investor can make gain equal to the premium received even if the stock price doesnt increase in market. Thus it is a good strategy to make profits from stocks which are not expected to move up or rather expected to go sideways.

71.95

Strike Premium Price

Spot Price

Payoff

Profit & Loss

Payoff on Long

Net payoff

520 520 520 520 520 520 520 520 520 520 520 520 520 520

12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55

495 500 505 510 515 520 525 530 535 540 545 550 555 560

-25 -20 -15 -10 -5 0 0 0 0 0 0 0 0 0

-12.45 25 -7.45 -2.45 2.55 7.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 12.55 20 15 10 5 0 -5 -10 -15 -20 -25 -30 -35 -40

12.55 12.55 12.55 12.55 12.55 12.55 7.55 2.55 -2.45 -7.45 -12.45 -17.45 -22.45 -27.45

Long Straddle for BPCL expiring on 26th Aug 2010

Profit Strike Spot Payof & Price Premium Price f Loss 520 71.95 260 0 -71.95 520 71.95 300 0 -71.95 520 71.95 340 0 -71.95 520 71.95 380 0 -71.95 520 71.95 420 0 -71.95 520 71.95 460 0 -71.95 520 71.95 500 0 -71.95 520 71.95 540 20 -51.95 520 71.95 580 60 -11.95 520 71.95 620 100 28.05 520 71.95 660 140 68.05 520 71.95 700 180 108.05 520 71.95 740 220 148.05 520 71.95 780 260 188.05 Strike Price Premium 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 Spot Price 260 300 340 380 420 460 500 540 580 620 660 700 740 780 Payof f 260 220 180 140 100 60 20 0 0 0 0 0 0 0 Profit & Loss 247.45 207.45 167.45 127.45 87.45 47.45 7.45 -12.55 -12.55 -12.55 -12.55 -12.55 -12.55 -12.55 Net payoff 175.5 135.5 95.5 55.5 15.5 -24.5 -64.5 -64.5 -24.5 15.5 55.5 95.5 135.5 175.5

This strategy is a combination of long put and long call. It is used when the stock prices are extremely volatile. Under this strategy a call option is bought and a put option is bought at the same strike price and maturity. There are 2 breakeven points for this strategy. One being the strike price + net premium and lower one being strike price net premium paid.

Short Straddle for BPCL expiring on 26th Aug 2010

Strike Price Premium 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 520 12.55 Spot Price 260 300 340 380 420 460 500 540 580 620 660 Payof f -260 -220 -180 -140 -100 -60 -20 0 0 0 0 Profit & Loss -247.45 -207.45 -167.45 -127.45 -87.45 -47.45 -7.45 12.55 12.55 12.55 12.55 Net Payoff -175.5 -135.5 -95.5 -55.5 -15.5 24.5 64.5 64.5 24.5 -15.5 -55.5

Strike Premium Spot Payof Profit If stock price are Price fthe upper Loss above Price &

breakeven level itll yield returns 520 71.95 260 0 71.95 and if stock price is below lower 520 71.95 300 0 71.95 breakeven itll yield profits. Only 520 71.95 340 0 71.95 between the 2 levels itll be in loss.
520 520 520 520 520 520 520 520 71.95 71.95 71.95 71.95 71.95 71.95 71.95 71.95 380 420 460 500 540 580 620 660 0 0 0 0 -20 -60 -100 -140 71.95 71.95 71.95 71.95 51.95 11.95 -28.05 -68.05

520 520

71.95 71.95

700 740

-180 -220

-108.05 -148.05

520 520

12.55 12.55

700 740

0 0

12.55 12.55

-95.5 -135.5

There can be several more option strategies, which can be formed with the help of different combinations of Call and Put options depending on the needs of an investor. This strategy is again a combination of long put and long call. It is used when the Conclusion stock prices are expected not to move significantly. Under this strategy a call With the help of previously mentioned strategies, it is option and a put option is sold at the same clear that derivatives can be used as a source for strike price and maturity. There are 2 breakeven points for this hedging of Market Risks or can also be used as an arbitrage opportunity for an investor depending on the strategy. If stock price are above the upper breakeven level itll be in loss and if stock price is below lower breakeven itll be in loss. Only between the 2 levels itll be in profit. Thus it is a risky strategy to exercise and should be practiced only when stock prices are not expected to move much. stock position. Despite of this property, particularly in India, investment in Options (form of Derivatives) is considered to be much riskier than investing in a single stock or portfolio of various instruments. According to the World Federation of Exchanges 2009, NSE was amongst top 5 exchanges having large numbers of contracts traded and the main reason behind this fact is the volume of contracts in India is bundled with small quantities, say, 100s or 1000s units

per contract. While in other exchanges like Chicago Mercantile Exchange (CME), this quantity starts with a minimum of 0.1 millions of units. After the whole study, the reasons for slow progress of Derivatives in Indian Context can be summarized as: Less awareness amongst investors towards Derivatives and its variants. High risks involved in Derivatives if not taken care of the regular market positions. Stringent regulatory requirements for starting investment in derivatives market in India.

References

Monomita Nandy (2008). Present Status of Indian Derivatives Market: A Perspective. Portfolio Organizer, September 2008, 41-47.

Venkata Chakrapani Chaturvedula (2008). Price Effects of Introduction of Derivatives: Evidence from India. The Icfai University Journal of Applied Economics, Vol. VII, No. 5, 59-75.

Pretimaya Samanta (2007). Impact of Futures Trading on the Underlying Spot Market Volatility. The Icfai Journal of Applied Finance, Vol. 13, No. 10, 52-65.

Sabrina Khanniche (2008). Measuring Hedge Fund Risks. The Icfai University Journal of Financial Risk Management, Vol. V, No. 2, 51-69.

Santanu Kumar Ghosh (2007). Time Diversification and Risk Management. The Analyst, September.

Managing Financial Risks (Technical Note), ICFAI Knowledge Centre, Hyderabad http://www.world-exchanges.org/statistics http://en.wikipedia.org/wiki/Derivatives_market
http://www.world-exchanges.org/files/statistics/excel/WFE%20Annual%20Report %20140509.pdf