22151898 Project on Derivative Market

7/30/2019 22151898 Project on Derivative Market

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Project report submitted towards fulfillmentof

PGDMLBSIMT, Bareilly

Academic Session[2008-2010]

Submitted bySarang Mani

UNDER THE GUIDANCE OF

Mr. Rahul Kumar AgarwalArea Sales Manager

IL & FS InvestSmart Securities Ltd.

Submitted by:Name Sarang Mani

TABLE OF CONTENTS

S.No.

TOPICSPAGENO.

1

Indian Derivative Market


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1. Executive Summary ...... 062. Company Profile................... 103. Introduction ................... 164.

5.6.7.8.9.

Need of the Study............................................................................

Literatural Review............................................................................Objective of the Study.....................................................................Scope of the Study..........................................................................Research Methodology....................................................................Limitations of Study.........................................................................

17

1819202122

10. Main Topics of Study1) Introduction to Derivative............................................................. 232) Derivative Defined......................................................................... 243) Types of Derivatives Market........................................................... 254) Types of Derivatives...................................................................... 25

i) Forward Contracts...................................................................... 26

ii) Future Contracts........................................................................ 27iii)iv)

Options.......................................................................................Swap.......................................................................................

3233

5) Other Kinds of Derivatives......................................................... 3411. History of Derivatives......................................................................... 3512. Indian Derivative Market .......... 38

1)2)

i)

ii)

3)4)5)

Need of Derivatives in India today................................Myths and realities about derivatives..................

Derivatives increase speculation and do not serve anyeconomic purpose .....................................................................

Indian Market is not ready for derivative trading.........................

Comparison of New System with Existing System.........Exchange-traded vs. OTC derivatives markets...............................Factors Contributing To The Growth Of Derivatives........................

3939

4041

434547

i) Price Volatility.............................................................................. 47ii)iii)

Globalisation of Markets..............................................................Technological Advances..............................................................

4849

iv) Advances in Financial Theories........................................ 4913. Development of Derivative Markets in India....... 5014.

1)2)

3)4)5)

Benifits of Derivatives...................................Risk Management............................................................................Price Discovery..............................................................................

Operational Advantages.................................................................Market Efficiency............................................................................Easy to Speculation.........................................................................

545454

545555

.

INTRODUCTION

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A Derivative is a financial instrument whose value depends on other, more

basic, underlying variables. The variables underlying could be prices of traded

securities and stock, prices of gold or copper.

Derivatives have become increasingly important in the field of finance, Options

and Futures are traded actively on many exchanges, Forward contracts, Swap

and different types of options are regularly traded outside exchanges by

financial intuitions, banks and their corporate clients in what are termed as over-

the-counter markets in other words, there is no single market place or

organized exchanges.

OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading.

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To know different types of Financial Derivatives

To know the role of derivatives trading in India.

To analyse the performance of Derivatives Trading since 2001with

special reference to Futures & Options

RESARCH METHODOLOGY

Method of data collection:-

Secondary sources:-

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It is the data which has already been collected by some one or an

organization for some other purpose or research study .The data for study has

been collected from various sources:

Books

Journals

Magazines

Internet sources

CONCEPT

2. DERIVATIVE DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset

can be equity, forex, commodity or any other asset. In our earlier discussion, we

saw that wheat farmers may wish to sell their harvest at a future date to

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eliminate the risk of change in price 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 in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the Forward

Markets Commission (FMC) continues to have jurisdiction over commodity

futures contracts. However when derivatives trading in securities was

introduced in 2001, the term security in the Securities Contracts (Regulation)

Act, 1956 (SCRA), was amended to include derivative contracts in securities.

Consequently, regulation of derivatives came under the purview of Securities

Exchange Board of India (SEBI). We thus have separate regulatory authorities

for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of

derivatives is governed by the regulatory framework under the SCRA. The

Securities Contracts (Regulation) Act, 1956 defines derivative to include-

A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of

underlying securities.

3. TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

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Derivatives

Future Option Forward Swaps

National Stock Bombay Stock National Commodity &Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Figure.2 Types of Derivatives

(i) FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified

date for a specified price. One of the parties to the contract assumes a long

position and agrees to buy the underlying asset on a certain specifiedfuture date for a certain specified price. The other party assumes a short

position and agrees to sell the asset on the same date for the same

price. Other contract details like delivery date, price and quantity are

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negotiated bilaterally by the parties to the contract. The forward contracts

are normally traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

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

Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to the

same counter-party, which often results in high prices being charged.

However forward contracts in certain markets have becomevery

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market. Forward

contracts are often confused with futures contracts. The confusion is

primarily becau se both serve essentially th e same economic fun cti ons

of allocating risk in the presence of future price uncertainty. However futures

are a significant improvement over the forward contracts as they

eliminate counterparty risk and offer more liquidity.

(ii) FUTURE CONTRACT

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

exchange, to buy or sell a certain underlying instrument at a certain date in the

future, at a pre-set price. The future date is called the delivery date or final

settlement date. The pre-set price is called the futures price. The price of the

underlying asset on the delivery date is called the settlement price. The

settlement price, normally, converges towards the futures price on the delivery

date.

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A futures contract gives the holder the right and the obligation to buy or sell,

which differs from an options contract, which gives the buyer the right, but not

the obligation, and the option writer (seller) the obligation, but not the right. To

exit the commitment, the holder of a futures position has to sell his long position

or buy back his short position, effectively closing out the futures position and its

contract obligations. Futures contracts are exchange traded derivatives. The

exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:

Futures contracts ensure their liquidity by being highly standardized, usually byspecifying:

The underlying. This can be anything from a barrel of sweet crude oil to a

short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amountand 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 interestrate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds

can be delivered. In case of physical commodities, this specifies not only the

quality of the underlying goods but also the manner and location of delivery. The

delivery month.

The last trading date. Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:

Although the value of a contract at time of trading should be zero, its price

constantly fluctuates. This renders the owner liable to adverse changes in value,

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and creates a credit risk to the exchange, who always acts as counterparty. To

minimize this risk, the exchange demands that contract owners post a form of

collateral, commonly known as Margin requirements are waived or reduced in

some cases for hedgers who have physical ownership of the covered

commodity or spread traders who have offsetting contracts balancing the

position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that

contract, as determined by historical price changes, which is not likely to be

exceeded on a usual day's trading. It may be 5% or 10% of total contract price.

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

exhaust the initial margin, a further margin, usually called variation or

maintenance margin, is required by the exchange. This is calculated by the

futures contract, i.e. agreeing on a price at the end of each day, called the

"settlement" or mark-to-market price of the contract.

To understand the original practice, consider that a futures trader, when taking a

position, deposits money with the exchange, called a "margin". This is intended

to protect the exchange against loss. At the end of every trading day, the

contract is marked to its present market value. If the trader is on the winning

side of a deal, his contract has increased in value that day, and the exchangepays this profit into his account. On the other hand, if he is on the losing side,

the exchange will debit his account. If he cannot pay, then the margin is used as

the collateral from which the loss is paid.

3. Settlement

Settlement is the act of consummating the contract, and can be done in one of

two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract

is delivered by the seller of the contract to the exchange, and by the exchange

to the buyers of the contract. In practice, it occurs only on a minority of

contracts. Most are cancelled out by purchasing a covering position - that is,

buying a contract to cancel out an earlier sale (covering a short), or selling a

contract to liquidate an earlier purchase (covering a long).

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Cash settlement - a cash payment is made based on the underlying reference

rate, such as a short term interest rate index such as Euribor, or the closing

value of a stock market index. A futures contract might also opt to settle against

an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many

equity index and interest rate futures contracts, this happens on the Last

Thursday of certain trading month. On this day the t+2 futures contract becomes

the t forward contract.

PRICING OF FUTURE CONTRACT

In a futures contract, for no arbitrage to be possible, the price paid on delivery

(the forward price) must be the same as the cost (including interest) of buying

and storing the asset. In other words, the rational forward price represents the

expected future value of the underlying discounted at the risk free rate. Thus, for

a simple, non-dividend paying asset, the value of the future/forward, , will

be found by discounting the present value at time to maturity by the rate

of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields,and convenience yields. Any deviation from this equality allows for arbitrage as

follows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today

(on the spot market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and

receives the agreed forward price.

3. He then repays the lender the borrowed amount plus interest.

4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today

(on the spot market); he invests the proceeds.

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2. On the delivery date, he cashes in the matured investment, which has

appreciated at the risk free rate.

3. He then receives the underlying and pays the agreed forward price using

the matured investment. [If he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.

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TABLE 1-DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

OperationalMechanism

Traded directly betweentwo parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes thecounter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs of

the needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

Examples Currency market in India. Commodities, futures, Index Futures

and Individual stock Futures in India.

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OPTIONS -

A derivative transaction that gives the option holder the right but not the

obligation to buy or sell the underlying asset at a price, called the strike price,

during a period or on a specific date in exchange for payment of a premium isknown as option. Underlying asset refers to any asset that is traded. The price

at which the underlying is traded is called the strike price.

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

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an

underlying asset-stock or any financial asset, at a specified price on or before a

specified date is known as a Call option. The owner makes a profit provided he

sells at a higher current price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an

underlying asset-stock or any financial asset, at a specified price on or before a

specified date is known as a Put option. The owner makes a profit provided he

buys at a lower current price and sells at a higher future price. Hence, no option

will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally

preference shares, bonds and warrants become the subject of options.

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SWAPS -

Swaps are transactions which obligates the two parties to the contract to

exchange a series of cash flows at specified intervals known as payment or

settlement dates. They can be regarded as portfolios of forward's contracts. A

contract whereby two parties agree to exchange (swap) payments, based on

some notional principle amount is called as a SWAP. In case of swap, only the

payment flows are exchanged and not the principle amount. The two commonly

used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange

his series of fixed rate interest payments to a party in exchange for his variable

rate interest payments. The fixed rate payer takes a short position in the forward

contract whereas the floating rate payer takes a long position in the forward

contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the

interest on loan in one currency are swapped for the principle and the interest

payments on loan in another currency. The parties to the swap contract of

currency generally hail from two different countries. This arrangement allows the

counter parties to borrow easily and cheaply in their home currencies. Under a

currency swap, cash flows to be exchanged are determined at the spot rate at a

time when swap is done. Such cash flows are supposed to remain unaffected

by subsequent changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to

access one market and then exchange the liability for another type of liability. It

also allows the investors to exchange one type of asset for another type of

asset with a preferred income stream.

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5. OTHER KINDS OF DERIVATIVES

The other kind of derivatives, which are not, much popular are as follows:

BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options

are most popular form of baskets.

LEAPS -

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years.

These long-term option contracts are popularly known as Leaps or Long term

Equity Anticipation Securities.

WARRANTS -

Options generally have lives of up to one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated

options are called warrants and are generally traded over-the-counter.

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. Ratherthan 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.

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12. INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where

prices fluctuate every day. The introduction of risk management instruments in

India gained momentum in the last few years due to liberalisation process andReserve Bank of Indias (RBI) efforts in creating currency forward market.

Derivatives are an integral part of liberalisation process to manage risk. NSE

gauging the market requirements initiated the process of setting up derivative

markets in India. In July 1999, derivatives trading commenced in India

Table 2. Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy

framework for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an

Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index

futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

(1) Need for derivatives in India today

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

become the most important markets in the world. Today, derivatives have

become part and parcel of the day-to-day life for ordinary people in major part of

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the world.

Until the advent of NSE, the Indian capital market had no access to the latest

trading methods and was using traditional out-dated methods of trading. There

was a huge gap between the investors aspirations of the markets and the

available means of trading. The opening of Indian economy has precipitated the

process of integration of Indias financial markets with the international financial

markets. Introduction of risk management instruments in India has gained

momentum in last few years thanks to Reserve Bank of Indias efforts in

allowing forward contracts, cross currency options etc. which have developed

into a very large market.

(2) Myths and realities about derivatives

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

become the most important markets in the world. Financial derivatives came

into the spotlight along with the rise in uncertainty of post-1970, when US

announced an end to the Bretton Woods System of fixed exchange rates

leading to introduction of currency derivatives followed by other innovations

including stock index futures. Today, derivatives have become part and parcel

of the day-to-day life for ordinary people in major parts of the world. While this is

true for many countries, there are still apprehensions about the introduction of

derivatives. There are many myths about derivatives but the realities that are

different especially for Exchange traded derivatives, which are well regulated

with all the safety mechanisms in place.

What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose

Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveragedinstruments.

Derivatives are complex and exotic instruments that Indian investors will

find difficulty in understanding

Is the existing capital market safer than Derivatives?

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(i) Derivatives increase speculation and do not serve any

economicpurpose:

Numerous studies of derivatives activity have led to a broad consensus, both in

the private and public sectors that derivatives provide numerous and substantial

benefits to the users. Derivatives are a low-cost, effective method for users to

hedge and manage their exposures to interest rates, commodity prices or

exchange rates. The need for derivatives as hedging tool was felt first in the

commodities market. Agricultural futures and options helped farmers and

processors hedge against commodity price risk. After the fallout of Bretton wood

agreement, the financial markets in the world started undergoing radical

changes. This period is marked by remarkable innovations in the financial

markets such as introduction of floating rates for the currencies, increased

trading in variety of derivatives instruments, on-line trading in the capital

markets, etc. As the complexity of instruments increased many folds, the

accompanying risk factors grew in gigantic proportions. This situation led to

development derivatives as effective risk management tools for the market

participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities through

instruments like stock index futures and options. An equity fund, for example,

can reduce its exposure to the stock market quickly and at a relatively low cost

without selling off part of its equity assets by using stock index futures or index

options.

By providing investors and issuers with a wider array of tools for

managing risks and raising capital, derivatives improve the allocation of credit

and the sharing of risk in the global economy, lowering the cost of capital

formation and stimulating economic growth. Now that world markets for trade

and finance have become more integrated, derivatives have strengthened these

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important linkages between global markets, increasing market liquidity and

efficiency and facilitating the flow of trade and finance

(ii) Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian

capital market is not ready for derivatives trading. Here, we look into the pre-

requisites, which are needed for the introduction of derivatives, and how Indian

market fares:

TABLE 3.

PRE-REQUISITES INDIAN SCENARIO

Large marketCapitalisation

India is one of the largest market-capitalisedcountries in Asia with a market capitalisation ofmore than Rs.765000 crores.

High Liquidity in theunderlying

The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which meanson an average every month 14% of the countrysMarket capitalisation gets traded. These are clearindicators of high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing tradeshas become fully functional from July 1996 in theform of National Securities Clearing Corporation(NSCCL). NSCCL is responsible for guaranteeingall open positions on the National Stock Exchange(NSE) for which it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL)which started functioning in the year 1997 hasrevolutionalised the security settlement in ourcountry.

A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital marketenjoys a strong, independent, and innovative legalguardian who is helping the market to evolve to ahealthier place for trade practices.

(3) Comparison of New System with Existing System

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Many people and brokers in India think that the new system of Futures &

Options and banning of Badla is disadvantageous and introduced early, but I

feel that this new system is very useful especially to retail investors. It increases

the no of options investors for investment. In fact it should have been introduced

much before and NSE had approved it but was not active because of

politicization in SEBI.

The figure 3.3a 3.3d shows how advantages of new system (implemented from

June 20001) v/s the old system i.e. before June 2001

New System Vs Existing System for Market Players

Figure 3.3a

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril&Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis losspossibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premiumhold till expiry.

Advantages

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

Figure 3.3b

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Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril&Prize1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game.another exchange. the Market moves. in weekly settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril&Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option.

3)Sell deep OTM call optionwith underlying shares, earnpremium + profit with increase prcie

Advantages

Availability of Leverage

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Figure 3.3d

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril&Prize

1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains

profit/loss. 2) Hedge position if protected &holding underlying upsidestock unlimited.

Advantages Losses Protected.

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4. Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last

few years, which has accompanied the modernization of commercial and

investment banking and globalisation of financial activities. The recent

developments in information technology have contributed to a great extent to

these developments. While both exchange-traded and OTC derivative contracts

offer many benefits, the former have rigid structures compared to the latter. It

has been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in

1998. These episodes of turbulence revealed the risks posed to market stability

originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to

exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and

located within individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or

margining,

3. There are no formal rules for risk and burden-sharing,4. There are no formal rules or mechanisms for ensuring market stability

and integrity, and for safeguarding the collective interests of market participants,

and

5. The OTC contracts are generally not regulated by a regulatory authority

and the exchanges self-regulatory organization, although they are affected

indirectly by national legal systems, banking supervision and market

surveillance.

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

market stability.

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The following features of OTC derivatives markets can give rise to instability in

institutions, markets, and the international financial system: (i) the dynamic

nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of

OTC derivative activities on available aggregate credit; (iv) the high

concentration of OTC derivative activities in major institutions; and (v) the

central role of OTC derivatives markets in the global financial system. Instability

arises when shocks, such as counter-party credit events and sharp movements

in asset prices that underlie derivative contracts, occur which significantly alter

the perceptions of current and potential future credit exposures. When asset

prices change rapidly, the size and configuration of counter-party exposures can

become unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions.

However, the progress has been limited in implementing reforms in risk

management, including counter-party, liquidity and operational risks, and OTC

derivatives markets continue to pose a threat to international financial stability.

The problem is more acute as heavy reliance on OTC derivatives creates the

possibility of systemic financial events, which fall outside the more formal

clearing house structures. Moreover, those who provide OTC derivativeproducts, hedge their risks through the use of exchange traded derivatives. In

view of the inherent risks associated with OTC derivatives, and their

dependence on exchange traded derivatives, Indian law considers them illegal.

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5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the

financial theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects

having value maybe commodities, local currency or foreign currencies. The

concept of price is clear to almost everybody when we discuss commodities.

There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc.

the price one pays for use of a unit of another persons money is called interest

rate. And the price one pays in ones own currency for a unit of another

currency is called as an exchange rate.

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

demand and producers or suppliers have supply, and the collective interaction

of demand and supply in the market determines the price. These factors are

constantly interacting in the market causing changes in the price over a short

period of time. Such changes in the price are known as price volatility. This has

three factors: the speed of price changes, the frequency of price changes and

the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The break down of the

BRETTON WOODS agreement brought and end to the stabilising role of fixed

exchange rates and the gold convertibility of the dollars. The globalisation of the

markets and rapid industrialisation of many underdeveloped countries brought a

new scale and dimension to the markets. Nations that were poor suddenly

became a major source of supply of goods. The Mexican crisis in the south

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east-Asian currency crisis of 1990s has also brought the price volatility factor

on the surface. The advent of telecommunication and data processing bought

information very quickly to the markets. Information which would have taken

months to impact the market earlier can now be obtained in matter of moments.

Even equity holders are exposed to price risk of corporate share fluctuates

rapidly.

These price volatility risks pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against

adverse price changes in commodity, foreign exchange, equity shares and

bonds.

B.} GLOBALISATION OF MARKETS

Earlier, managers had to deal with domestic economic concerns; what

happened in other part of the world was mostly irrelevant. Now globalisation has

increased the size of markets and as greatly enhanced competition .it has

benefited consumers who cannot obtain better quality goods at a lower cost. It

has also exposed the modern business to significant risks and, in many cases,

led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis--vis depreciated currencies. Export of

certain goods from India declined because of this crisis. Steel industry in 1998

suffered its worst set back due to cheap import of steel from south East Asian

countries. Suddenly blue chip companies had turned in to red. The fear of china

devaluing its currency created instability in Indian exports. Thus, it is evident

that globalisation of industrial and financial activities necessitates use of

derivatives to guard against future losses. This factor alone has contributed to

the growth of derivatives to a significant extent.

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C.} TECHNOLOGICAL ADVANCES

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed

processors, network systems and enhanced method of data entry. Closely

related to advances in computer technology are advances in

telecommunications. Improvement in communications allow for instantaneous

worldwide conferencing, Data transmission by satellite. At the same time there

were significant advances in software programmes without which computer and

telecommunication advances would be meaningless. These facilitated the more

rapid movement of information and consequently its instantaneous impact on

market price.

Although price sensitivity to market forces is beneficial to the economy as a

whole resources are rapidly relocated to more productive use and better

rationed overtime the greater price volatility exposes producers and consumers

to greater price risk. The effect of this risk can easily destroy a business which

is otherwise well managed. Derivatives can help a firm manage the price risk

inherent in a market economy. To the extent the technological developments

increase volatility, derivatives and risk management products become that much

more important.

D.} ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward

contracts in its traditional form, was the only hedging tool available. Option

pricing models developed by Black and Scholes in 1973 were used to determine

prices of call and put options. In late 1970s, work of Lewis Edeington extended

the early work of Johnson and started the hedging of financial price risks with

financial futures. The work of economic theorists gave rise to new products for

risk management which led to the growth of derivatives in financial markets.

The above factors in combination of lot many factors led to growth of derivatives

instruments

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13. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern

trading of derivatives. SEBI set up a 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 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 includederivatives within the ambit of securities and the regulatory framework were

developed for governing derivatives trading. The act also made it clear that

derivatives shall be legal and valid only if such contracts are traded on a

recognized stock exchange, thus precluding OTC derivatives. The government

also rescinded in March 2000, the three decade old notification, which

prohibited forward trading in securities. Derivatives trading 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 (Sense) index. This

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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 continue to

remain poor. This may be due to the low volatility of the spot index. Typically,

options are considered more valuable when the volatility of the underlying (in

this case, the index) is high. A related issue is that brokers do not earn high

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commissions by recommending index options to their clients, because low

volatility leads to higher waiting time for round-trips.

Put volumes in the index options and equity options segment have

increased since January 2002. The call-put volumes in index options have

decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put

volumes ratio suggests that the traders are increasingly becoming pessimistic

on the market.

Farther month futures contracts are still not actively traded. Trading in

equity options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment

as a less risky alternative (read substitute) to generate profits from the stock

price movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. If calls and puts are not looked as just substitutes for spot

trading, the intra-day stock price variations should not have a one-to-one impact

on the option premiums.

The spot foreign exchange market remains the most important

segment but the derivative segment ha s also grown. In the derivative

market foreign exchange swaps account for the largest share of the total

turnover of derivatives in India followed by forwards and options.

Significant milestones in the development of derivatives market have

been (i) permission to banks to undertake cross currency derivative

transactions subject to certain conditions (1996) (ii) allowing corporates to

undertake long term foreign currency swaps that contributed to the

development of the term currency swap market (1997) (iii) allowing dollar

rupee options (2003) and (iv) introduction of currency futures (2008). I

would like to emphasise that currency swaps allowed companies wi th ECBs

to swap their foreign currency liabilit ies into rupees. However, since banks

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could not carry open positions the risk was allowed to be transferred to any

other resident corporate. Normally such risks should be taken by corporates

who have natural hedge or have potential foreign exchange earnings. But

often corporate assume these risks due to interest rate differentials and

views on currencies.

This period has also witnessed several relaxations in regulations relating to

forex markets and also greater liberalisation in capital account regulations

leading to greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any underlying

need or exposure a n d on a leveraged basis on the recognized stock

exchanges with credit risks being assumed by the central counterparty

Since the commencement of trading of currency futures in all the three

exchanges, the value of the trades has gone up steadily from Rs 17, 429

crores in October 2008 to Rs 45, 803 crores in December 2008. The average

daily turnover in all the exchanges has also increased from Rs871 crores to

Rs 2,181 crores during the same period. The turnover in the currencyfutures market is in line with the international scenario, where I understand

the share of futures market ranges between 2 3 per cent.

Table 4 .1ForexMarketActivity

April05-

Mar06

April06-

Mar07

April07-

Mar08

April08-

Dec08Total turnover (USD billion) 4,404 6,571 12,304 9,621

Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1

Spot/Total Turnover (%) 50.5 51.9 49.7 45.9

Forward/Total Turnover (%) 19.0 17.9 19.3 21.5

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Swap/Total Turnover (%) 30.5 30.1 31.1 32.7

Source: RBI

14. BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot

market. For instance, consider an investor who owns an asset. He will always

be worried that the price may fall before he can sell the asset. He can protect

himself by selling a futures contract, or by buying a Put option. If the spot price

falls, the short hedgers will gain in the futures market, as you will see later. This

will help offset their losses in the spot market. Similarly, if the spot price falls

below the exercise price, the put option can always be exercised.

2.] PRICE DISCOVERY

Price discovery refers to the markets ability to determine true equilibrium prices.

Futures prices are believed to contain information about future spot prices and

help in disseminating such information. As we have seen, futures markets

provide a low cost trading mechanism. Thus information pertaining to supply

and demand easily percolates into such markets. Accurate prices are essential

for ensuring the correct allocation of resources in a free market economy.

Options markets provide information about the volatility or risk of the underlying

asset.

3.] OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction

costs. Secondly, they offer greater liquidity. Large spot transactions can often

lead to significant price changes. However, futures markets tend to be more

liquid than spot markets, because herein you can take large positions by

depositing relatively small margins. Consequently, a large position in derivatives

markets is relatively easier to take and has less of a price impact as opposed to

a transaction of the same magnitude in the spot market. Finally, it is easier to

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take a short position in derivatives markets than it is to sell short in spot

markets.

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4.] MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot, futures and

options markets are inextricably linked. Since it is easier and cheaper to trade in

derivatives, it is possible to exploit arbitrage opportunities quickly and to keep

prices in alignment. Hence these markets help to ensure that prices reflect true

values.

5.] EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in

spot transactions. Also, the amount of capital required to take a comparable

position is less in this case. This is important because facilitation of speculation

is critical for ensuring free and fair markets. Speculators always take calculated

risks. A speculator will accept a level of risk only if he is convinced that the

associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions. The prices of derivatives converge with the prices of the underlying at the

expiration of derivative contract. Thus derivatives help in discovery of future as

well as current prices.

An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long

run. Transfer of risk enables market participants to expand their volume ofactivity.

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15. National Exchanges

In enhancing the institutional capabilities for futures trading the idea of

setting up of National Commodity Exchange(s) has been pursued since 1999.

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,

(NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX),

Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become

operational. National Status implies that these exchanges would be

automatically permitted to conduct futures trading in all commodities subject to

clearance of byelaws and contract specifications by the FMC. While the NMCE,

Ahmedabad commenced futures trading in November 2002, MCX and NCDEX,

Mumbai commenced operations in October/ December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised multi commodity exchange has permanent recognition from

Government of India for facilitating online trading, clearing and settlement

operations for commodity futures markets across the country. Key shareholders

of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC

Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of

Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank of India,

Bank of Baroda, Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team

with deep domain knowledge of the commodity futures markets. Today MCX is

offering spectacular growth opportunities and advantages to a large cross

section of the participants including Producers / Processors, Traders,Corporate, Regional Trading Canters, Importers, Exporters, Cooperatives,

Industry Associations, amongst others MCX being nation-wide commodity

exchange, offering multiple commodities for trading with wide reach and

penetration and robust infrastructure.

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MCX, having a permanent recognition from the Government of India, is

an independent and demutualised multi commodity Exchange. MCX, a state-of-

the-art nationwide, digital Exchange, facilitates online trading, clearing and

settlement operations for a commodities futures trading.

NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted

by Central Warehousing Corporation (CWC), National Agricultural Cooperative

Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation

Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National

Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited

(NOL). While various integral aspects of commodity economy, viz.,

warehousing, cooperatives, private and public sector marketing of agricultural

commodities, research and training were adequately addressed in structuring

the Exchange, finance was still a vital missing link. Punjab National Bank (PNB)

took equity of the Exchange to establish that linkage. Even today, NMCE is the

only Exchange in India to have such investment and technical support from the

commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by

CMC. It has robust delivery mechanism making it the most suitable for the

participants in the physical commodity markets. It has also established fair and

transparent rule-based procedures and demonstrated total commitment towards

eliminating any conflicts of interest. It is the only Commodity Exchange in the

world to have received ISO 9001:2000 certification from British Standard

Institutions (BSI). NMCE was the first commodity exchange to provide tradingfacility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The

contracts are marked to market on daily basis. The system of upfront margining

based on Value at Risk is followed to ensure financial security of the market. In

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the event of high volatility in the prices, special intra-day clearing and settlement

is held. NMCE was the first to initiate process of dematerialization and

electronic transfer of warehoused commodity stocks. The unique strength of

NMCE is its settlements via a Delivery Backed System, an imperative in the

commodity trading business. These deliveries are executed through a sound

and reliable Warehouse Receipt System, leading to guaranteed clearing and

settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a

technology driven commodity exchange. It is a public limited company

registered under the Companies Act, 1956 with the Registrar of

Companies, Maharashtra in Mumbai on April 23,2003. It has an

independent Board of Directors and professionals not having any vested

interest in commodity markets. It has been launched to provide a world-

class commodity exchange platform for market participants to trade in a

wide spectrum of commodity derivatives driven by best global practices,

professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futurestrading in commodities. Besides, NCDEX is subjected to various laws of the

land like the Companies Act, Stamp Act, Contracts Act, Forward Commission

(Regulation) Act and various other legislations, which impinge on its working. It

is located in Mumbai and offers facilities to its members in more than 390

centres throughout India. The reach will gradually be expanded to more

centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm

Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute

sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed -

Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber,

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Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black

Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal.

FINDINGS & CONCLUSION

From the above analysis it can be concluded that:

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

turnover of Derivative Market is increasing year by year in the Indias largest

stock exchange NSE. In the case of index future there is a phenomenal

increase in the number of contracts. But whereas the turnover is declined

considerably. In the case of stock future there was a slow increase observed in

the number of contracts whereas a decline was also observed in its turnover. In

the case of index option there was a huge increase observed both in the

number of contracts and turnover.

2. After analyzing data it is clear that the main factors that are driving thegrowth of Derivative Market are Market improvement in communication facilities

as well as long term saving & investment is also possible through entering into

Derivative Contract. So these factors encourage the Derivative Market in India.

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

take more risk & earn more return. So in this way it helps the Indian Economy

by developing entrepreneurship. Derivative Market is more regulated &

standardized so in this way it provides a more controlled environment. In

nutshell, we can say that the rule of High risk & High return apply in Derivatives.

If we are able to take more risk then we can earn more profit under Derivatives.

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RECOMMENDATIONS & SUGGESTIONS

RBI should play a greater role in supporting derivatives.

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

other derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to

educate individual investors.

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

to much extent. So, SEBI should take necessary steps for improvement in

Derivative Market so that more investors can invest in Derivative market.

There is a need of more innovation in Derivative Market because in

today scenario even educated people also fear for investing in Derivative

Market Because of high risk involved in Derivatives.

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BIBLIOGRAPHY

Books referred:

Options Futures, and other Derivatives by John C Hull Derivatives FAQ by Ajay Shah

NSEs Certification in Financial Markets: - Derivatives Core module

Financial Markets & Services by Gordon & Natarajan

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.ncdex.com

www.google.com

www.derivativesindia.com

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http://www.nse-india.com/http://www.bseindia.com/http://www.sebi.gov.in/http://www.ncdex.com/http://www.google.com/http://www.derivativesindia.com/http://www.nse-india.com/http://www.bseindia.com/http://www.sebi.gov.in/http://www.ncdex.com/http://www.google.com/http://www.derivativesindia.com/


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Documents

22151898 Project on Derivative Market