CHAPTER 1

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1.1 INTRODUCTION :
Derivatives are one of the most complex instruments. The word
derivative comes from the word to derive. It indicates that it has no independent
value. A derivative is a contract whose value is derived from the value of another
asset, known as the underlying asset, which could e a share, a stock market index,
an interest rate, a commodity, or a currency. The underlying is the identification tag
for a derivative contract. !hen the price of the underlying changes, the value of the
derivative also changes. !ithout an underlying asset, derivatives do not have any
meaning. "or example, the value of a gold futures contract derives from the value of
the underlying asset i.e., gold. The prices in the derivatives market are driven y the
spot or cash market price of the underlying asset, which is gold in this example.
Derivatives are very similar to insurance. Insurance protects against
specific risks, such as fire, floods, theft and so on. Derivatives on the other hand,
take care of market risks # volatility in interest rates, currency rates, commodity
prices, and share prices. Derivatives offer a sound mechanism for insuring against
various kinds of risks arising in the world of finance. They offer a range of
mechanisms to improve redistriution of risk, which can e extended to every
product existing, from coffee to cotton and live cattle to det instruments.
In this era of gloalisation, the world is a riskier place and exposure to
risk is growing. $isk cannot e avoided or ignored. %an, however is risk averse. The
risk averse characteristic of human eings has rought aout growth in derivatives.
Derivatives help the risk averse individuals y offering a mechanism for hedging
risks.
Derivative products, several centuries ago, emerged as hedging
devices against fluctuations in commodity prices. &ommodity futures and options
1
have had a lively existence for several centuries. "inancial derivatives came into the
limelight in the post#'()* period+ today they account for ), percent of the financial
market activity in -urope, .orth America, and -ast Asia. The asic difference
etween commodity and financial derivatives lies in the nature of the underlying
instrument. In commodity derivatives, the underlying asset is a commodity+ it may e
wheat, cotton, pepper, turmeric, corn, orange, oats, /oya eans, rice, crude oil,
natural gas, gold, silver, and so on. In financial derivatives, the underlying includes
treasuries, onds, stocks, stock index, foreign exchange, and -uro dollar deposits.
The market for financial derivatives has grown tremendously oth in terms of variety
of instruments and turnover.
0resently, most ma1or institutional orrowers and investors use
derivatives. /imilarly, many act as intermediaries dealing in derivative transactions.
Derivatives are responsile for not only increasing the range of financial products
availale ut also fostering more precise ways of understanding, 2uantifying and
managing financial risk.
Derivatives contracts are used to counter the price risks involved in
assets and liailities. Derivatives do not eliminate risks. They divert risks from
investors who are risk averse to those who are risk neutral. The use of derivatives
instruments is the part of the growing trend among financial intermediaries like
anks to sustitute off#alance sheet activity for traditional lines of usiness. The
exposure to derivatives y anks have implications not only from the point of capital
ade2uacy, ut also from the point of view of estalishing trading norms, usiness
rules and settlement process. Trading in derivatives differ from that in e2uities as
most of the derivatives are market to the market.
2
1.2 DEFINITION OF DERIVATIVES :
Derivative is a product whose value is derived from the value of one or
more asic variales, called ases 3underlying asset, index, or reference rate4, in a
contractual manner. The underlying asset can e e2uity, forex, commodity or any
other asset.
According to Securities Contracts (Reu!ation" Act# 1$%& 'SC(R"A(,
derivatives is
A security derived from a det instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security.
A contract which derives its value from the prices, or index of prices, of
underlying securities.
Derivatives are securities under the /ecurities &ontract 3$egulation4
Act and hence the trading of derivatives is governed y the regulatory framework
under the /ecurities &ontract 3$egulation4 Act.
3
1.) HISTOR* OF DERIVATIVES :
The history of derivatives is 2uite colourful and surprisingly a lot longer
than most people think. "orward delivery contracts, stating what is to e delivered
for a fixed price at a specified place on a specified date, existed in ancient 5reece
and $ome. $oman emperors entered forward contracts to provide the masses with
their supply of -gyptian grain. These contracts were also undertaken etween
farmers and merchants to eliminate risk arising out of uncertain future prices of
grains. Thus, forward contracts have existed for centuries for hedging price risk.
The first organi6ed commodity exchange came into existence in the
early ')**s in 7apan. The first formal commodities exchange, the C+icao ,oar-
o. Tra-e (C,OT", was formed in '898 in the :/ to deal with the prolem of credit
risk and to provide centralised location to negotiate forward contracts. "rom
forward trading in commodities emerged the commodity futures. The first type of
futures contract was called to arrive at. Trading in futures egan on the &;<T in
the '8=*s. In '8=,, &;<T listed the first exchange traded derivatives contract,
known as the futures contracts. "utures trading grew out of the need for hedging the
price risk involved in many commercial operations. The C+icao /ercanti!e
E0c+ane (C/E", a spin#off of &;<T, was formed in '('(, though it did exist
efore in '8)9 under the names of 1C+icao Pro-uce E0c+ane2 (CPE" and
1C+icao E an- ,utter ,oar-2 (CE,,". The first financial futures to emerge
were the currency in '()> in the :/. The first foreign currency futures were traded
on %ay '=, '()>, on Internationa! /onetar3 /ar4et (I//"# a division of &%-. The
currency futures traded on the I%% are the ;ritish 0ound, the &anadian Dollar, the
7apanese ?en, the /wiss "ranc, the 5erman %ark, the Australian Dollar, and the
-uro dollar. &urrency futures were followed soon y interest rate futures. Interest
rate futures contracts were traded for the first time on the &;<T on <ctoer >*,
'(),. /tock index futures and options emerged in '(8>. The first stock index futures
contracts were traded on @ansas &ity ;oard of Trade on "eruary >9, '(8>.
4
The first of the several networks, which offered a trading link etween
two exchanges, was formed etween the Sina5ore Internationa! /onetar3
E0c+ane (SI/E6" and the &%- on /eptemer ), '(89.
<ptions are as old as futures. Their history also dates ack to ancient
5reece and $ome. <ptions are very popular with speculators in the tulip cra6e of
seventeenth century Aolland. Tulips, the rightly coloured flowers, were a symol of
affluence+ owing to a high demand, tulip ul prices shot up. Dutch growers and
dealers traded in tulip ul options. There was so much speculation that people
even mortgaged their homes and usinesses. These speculators were wiped out
when the tulip cra6e collapsed in '=B) as there was no mechanism to guarantee the
performance of the option terms.
The first call and put options were invented y an American financier,
$ussell /age, in '8)>. These options were traded over the counter. Agricultural
commodities options were traded in the nineteenth century in -ngland and the :/.
<ptions on shares were availale in the :/ on the over the counter 3<T&4 market
only until '()B without much knowledge of valuation. A group of firms known as 0ut
and &all rokers and Dealers Association was set up in early '(**s to provide a
mechanism for ringing uyers and sellers together.
<n April >=, '()B, the &hicago ;oard options -xchange 3&;<-4 was
set up at &;<T for the purpose of trading stock options. It was in '()B again that
lack, %erton, and /choles invented the famous ,!ac47Sc+o!es O5tion For8u!a.
This model helped in assessing the fair price of an option which led to an increased
interest in trading of options. !ith the options markets ecoming increasingly
popular, the American /tock -xchange 3A%-C4 and the 0hiladelphia /tock
-xchange 30ADC4 egan trading in options in '(),.
The market for futures and options grew at a rapid pace in the eighties
and nineties. The collapse of the ;retton !oods regime of fixed parties and the
introduction of floating rates for currencies in the international financial markets
5
paved the way for development of a numer of financial derivatives which served as
effective risk management tools to cope with market uncertainties.
The &;<T and the &%- are two largest financial exchanges in the
world on which futures contracts are traded. The &;<T now offers 98 futures and
option contracts 3with the annual volume at more than >'' million in >**'4.The
&;<- is the largest exchange for trading stock options. The &;<- trades options
on the /E0 '** and the /E0 ,** stock indices. The 0hiladelphia /tock -xchange
is the premier exchange for trading foreign options.
The most traded stock indices include /E0 ,**, the Dow 7ones
Industrial Average, the .asda2 '**, and the .ikkei >>,. The :/ indices and the
.ikkei >>, trade almost round the clock. The .>>, is also traded on the &hicago
%ercantile -xchange.
6
CHAPTER 2
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2.1 DERIVATIVES IN INDIA :
India has started the innovations in financial markets very late. /ome
of the recent developments initiated y the regulatory authorities are very important
in this respect. "utures trading have een permitted in certain commodity
exchanges. %umai /tock -xchange has started futures trading in cottonseed and
cotton under the ;<<- and under the -ast India &otton Association. .ecessary
infrastructure has een created y the Nationa! Stoc4 E0c+ane (NSE" and the
,o89a3 Stoc4 E0c+ane (,SE" for trading in stock index futures and the
commencement of operations in selected scripts. Dieralised exchange rate
management system has een introduced in the year '((> for regulating the flow of
foreign exchange. A committee headed y /./.Tarapore was constituted to go into
the merits of full convertiility on capital accounts. $;I has initiated measures for
freeing the interest rate structure. It has also envisioned /u89ai Inter ,an4 O..er
Rate (/I,OR" on the line of :on-on Inter ,an4 O..er Rate (:I,OR" as a step
towards introducing "utures trading in Interest $ates and "orex. ;adla transactions
have een anned in all >B stock exchanges from 7uly >**'. ./- has started
trading in index options ased on the .I"T? and certain /tocks.
A.( E;UIT* DERIVATIVES IN INDIA <
In the decade of '((*s revolutionary changes took place in the
institutional infrastructure in Indias e2uity market. It has led to wholly new ideas in
market design that has come to dominate the market. These new institutional
arrangements, coupled with the widespread knowledge and orientation towards
e2uity investment and speculation, have comined to provide an environment where
7
the e2uity spot market is now Indias most sophisticated financial market. <ne
aspect of the sophistication of the e2uity market is seen in the levels of market
li2uidity that are now visile. The market impact cost of doing program trades of
$s., million at the .I"T? index is around *.>F. This state of li2uidity on the e2uity
spot market does well for the market efficiency, which will e oserved if the index
futures market when trading commences. Indias e2uity spot market is dominated y
a new practice called "utures G /tyle settlement or account period settlement. In its
present scene, trades on the largest stock exchange 3./-4 are netted from
!ednesday morning till Tuesday evening, and only the net open position as of
Tuesday evening is settled. The future style settlement has proved to e an ideal
launching pad for the skills that are re2uired for futures trading.
/tock trading is widely prevalent in India, hence it seems easy to think
that derivatives ased on individual securities could e very important. The index is
the counter piece of portfolio analysis in modern financial economies. Index
fluctuations affect all portfolios. The index is much harder to manipulate. This is
particularly important given the weaknesses of Daw -nforcement in India, which
have made numerous manipulative episodes possile. The market capitalisation of
the ./-#,* index is $s.>.= trillion. This is six times larger than the market
capitalisation of the largest stock and ,** times larger than stocks such as /terlite,
;0D and Hideocon. If market manipulation is used to artificially otain '*F move in
the price of a stock with a '*F weight in the .I"T?, this yields a 'F in the .I"T?.
&ash settlements, which is universally used with index derivatives, also helps in
terms of reducing the vulneraility to market manipulation, in so far as the short#
s2uee6e is not a prolem. Thus, index derivatives are inherently less vulnerale to
market manipulation.
,.( CO//ODIT* DERIVATIVES TRADIN= IN INDIA <
In India, the futures market for commodities evolved y the setting up of the
I;omay &otton Trade Association Dtd.J, in '8),. A separate association y the
name K;omay &otton -xchange DtdJ was estalished following widespread
discontent amongst leading cotton mill owners and merchants over the functioning
8
of the ;omay &otton Trade Association. !ith the setting up of the 5u1arati Hyapari
%andaliJ in '(**, the futures trading in oilseed egan. &ommodities like groundnut,
castor seed and cotton etc egan to e exchanged.
$aw 1ute and 1ute goods egan to e traded in &alcutta with the
estalishment of the I&alcutta Aessian -xchange Dtd.J in '('(. The most notale
centres for existence of futures market for wheat were the &hamer of &ommerce at
Aapur, which was estalished in '('B. <ther markets were located at Amritsar,
%oga, Dudhiana, 7alandhar, "a6ilka, Dhuri, ;arnala and ;hatinda in 0un1a and
%u6affarnagar, &handausi, %eerut, /aharanpur, Aathras, 5a6iaad, /ikenderaad
and ;arielly in :.0. The ;ullion "utures market egan in ;omay in '((*. After the
economic reforms in '((' and the trade lierali6ation, the 5ovt. of India appointed
in 7une '((B one more committee on "orward %arkets under &hairmanship of 0rof.
@... @ara. The &ommittee recommended that futures trading e introduced in
asmati rice, cotton, raw 1ute and 1ute goods, groundnut, rapeseedLmustard seed,
cottonseed, sesame seed, sunflower seed, safflower seed, copra and soyean, and
oils and oilcakes of all of them, rice ran oil, castor oil and its oilcake, linseed, silver
and onions. All over the world commodity trade forms the ma1or ackone of the
economy. In India, trading volumes in the commodity market have also seen a
steady rise # to $s ,,)',*** crore in "?*, from $s ',>(,*** crore in "?*9. In the
current fiscal year, trading volumes in the commodity market have already crossed
$s B,,*,*** crore in the first four months of trading. /ome of the commodities
traded in India include Agricultural &ommodities like $ice !heat, /oya, 5roundnut,
Tea, &offee, 7ute, $uer, /pices, &otton, 0recious %etals like 5old E /ilver, ;ase
%etals like Iron <re, Aluminium, .ickel, Dead, Minc and -nergy &ommodities like
crude oil, coal. &ommodities form around ,*F of the Indian 5D0. Though there are
no institutions or anks in commodity exchanges, as yet, the market for
commodities is igger than the market for securities. &ommodities market is
estimated to e around $s 99,**,*** &rores in future. Assuming a future trading
multiple is aout 9 times the physical market, in many countries it is much higher at
around '* times.
9
2.2 T*PES OF DERIVATIVES :
There are mainly four types of derivatives i.e. "orwards, "utures,
<ptions and swaps.
Derivatives


Forwards Futures Options Swaps

1. FOR>ARDS 7
A contract that oligates one counter party to uy and the other to sell
a specific underlying asset at a specific price, amount and date in the future is
known as a forward contract. "orward contracts are the important type of forward#
ased derivatives. They are the simplest derivatives. There is a separate forward
market for multitude of underlyings, including the traditional agricultural or physical
10
commodities, as well as currencies and interest rates. The change in the value of a
forward contract is roughly proportional to the change in the value of its underlying
asset. These contracts create credit exposures. As the value of the contract is
conveyed only at the maturity, the parties are exposed to the risk of default during
the life of the contract. "orward contracts are customised with the terms and
conditions tailored to fit the particular usiness, financial or risk management
o1ectives of the counter parties. .egotiations often take place with respect to
contract si6e, delivery grade, delivery locations, delivery dates and credit terms.
2. FUTURES 7
A future contract is an agreement etween two parties to uy or sell an
asset at a certain time the future at the certain price. "utures contracts are the
special types of forward contracts in the sense that are standardi6ed exchange#
traded contracts.
-2uities, onds, hyrid securities and currencies are the commodities
of the investment usiness. They are traded on organised exchanges in which a
clearing house interposes itself etween uyer and seller and guarantees all
transactions, so that the identity of the uyer or the seller is a matter of indifference
to the opposite party. "utures contract protect those who use these commodities in
their usiness.
"utures trading are to enter into contracts to uy or sell financial
instruments, dealing in commodities or other financial instruments for forward
delivery or settlement on standardised terms. The futures market facilitates stock
holding and shifting of risk. They act as a mechanism for collection and distriution
of information and then perform a forward pricing function. The futures trading can
e performed when there is variation in the price of the actual commodity and there
exists economic agents with commitments in the actual market. There must e a
possiility to specify a standard grade of the commodity and to measure deviations
from this grade. A futures market is estalished specifically to meet purely
speculative demands is possile ut is not known. &onditions which are thought of
necessary for the estalishment of futures trading are the presence of speculative
11
capital and financial facilities for payment of margins and contract settlement. In
addition, a strong infrastructure is re2uired, including financial, legal and
communication systems.
). OPTIONS 7
A derivative transaction that gives the option holder the right ut not
the oligation to uy 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 is
known as 1o5tion2. :nderlying asset refers to any asset that is traded. The price at
which the underlying is traded is called the 1stri4e 5rice2.
There are two types of options i.e., CA:: OPTION AND PUT
OPTION.
a. CA:: OPTION :
A contract that gives its owner the right ut not the oligation
to uy an underlying asset#stock or any financial asset, at a specified
price on or efore a specified date is known as a 1Ca!! o5tion2. The owner
makes a profit provided he sells at a higher current price and uys at a
lower future price.
9. PUT OPTION :
A contract that gives its owner the right ut not the oligation
to sell an underlying asset#stock or any financial asset, at a specified price
on or efore a specified date is known as a Put o5tion2. The owner
makes a profit provided he uys at a lower current price and sells at a
higher future price. Aence, no option will e exercised if the future price
does not increase.
12
0ut and calls are almost always written on e2uities, although
occasionally preference shares, onds and warrants ecome the su1ect of options.
?. S>APS 7
/waps are transactions which oligates the two parties to the contract
to exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can e regarded as portfolios of forwardNs contracts. A
contract wherey two parties agree to exchange 3swap4 payments, ased on some
notional principle amount is called as a 1S>AP2. In case of swap, only the payment
flows are exchanged and not the principle amount. The two commonly used swaps
areO
a. INTEREST RATE S>APS :
Interest rate swaps is an arrangement y which one party
agrees to exchange his series of fixed rate interest payments to a party in
exchange for his variale 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.
9. CURRENC* S>APS :
&urrency swaps is an arrangement in which oth 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 orrow easily
13
and cheaply in their home currencies. :nder a currency swap, cash flows
to e exchanged are determined at the spot rate at a time when swap is
done. /uch cash flows are supposed to remain unaffected y suse2uent
changes in the exchange rates.
c. FINANCIA: S>AP :
"inancial swaps constitute a funding techni2ue which permit a
orrower to access one market and then exchange the liaility for another
type of liaility. It also allows the investors to exchange one type of asset
for another type of asset with a preferred income stream.
T+e ot+er 4in- o. -eri@ati@es# A+ic+ are not# 8uc+ 5o5u!ar are as
.o!!oAs :
%. ,ASBETS 7
;askets options are option on portfolio of underlying asset. -2uity Index
<ptions are most popular form of askets.
&. :EAPS 7
.ormally option contracts are for a period of ' to '> months. Aowever,
exchange may introduce option contracts with a maturity period of >#B years. These
long#term option contracts are popularly known as Deaps or Dong term -2uity
Anticipation /ecurities.
C. >ARRANTS 7
14
<ptions generally have lives of up to one year, the ma1ority of options traded
on options exchanges having a maximum maturity of nine months. Donger#dated
options are called warrants and are generally traded over#the#counter.
D. S>APTIONS 7
/waptions are options to uy or sell a swap that will ecome operative at the
expiry of the options. Thus a swaption is an option on a forward swap. $ather 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.
15
2.) FUTURES VS. FOR>ARD /ARBET :
16
/ettlements are made daily through /ettlement occurs on date agreed
17
Fut ur es Mar ket For war d Mar ket
%argin deposits are to e re2uired
of all participants.
Typically, no money changes hands
until delivery, although a small
margin deposit might e re2uired of
non#dealer customers on certain
occasions.
&ontract terms are standardised
with all uyers and sellers
negotiating only with respect to
price.
All contract terms are negotiated
privately y the parties.
.on#memer participants deal
through rokers 3exchange
memers who represent them on
the exchange floor4
0articipants deal typically on a
principal#to#principal asis.
0articipants include anks,
corporations, financial institutions,
individual investors, and
speculators.
0articipants are primarily institutions
dealing with one other and other
interested parties dealing through
one or more dealers.
The clearing house of the exchange
ecomes the opposite side to each
cleared transactions+ therefore, the
credit risk for a futures market
participant is always the same and
there is no need to analyse the
credit of other market participants.
A participant must examine the
credit risk and estalish credit limits
for each opposite party.
the exchange clearing house. 5ains
on open positions may e
withdrawn and losses are collected
daily.
upon etween the parties to each
transaction.
Dong and short positions are usually
li2uidated easily.
"orward positions are not as easily
offset or transferred to the other
participants.
/ettlements are normally made in
cash, with only a small percentage
of all contracts resulting actual
delivery.
%ost transactions result in delivery.
A single, round trip 3in and out of
the market4 commission is charged.
It is negotiated etween roker and
customer and is relatively small in
relation to the value of the contract.
.o commission is typically charged
if the transaction is made directly
with another dealer. A commission
is charged to orn uyer and seller,
however, if transacted through a
roker.
Trading is regulated. Trading is mostly unregulated.
The delivery price is the spot price. The delivery price is the forward
price.
2.? PARTICIPANTS IN THE DERIVATIVES /ARBET :
The participants in the derivatives market are as followsO
18
A.( TRADIN= PARTICIPANTS :
1.E HED=ERS <
The process of managing the risk or risk management is called as
hedging. Aedgers are those individuals or firms who manage their risk with the help
of derivative products. Aedging does not mean maximising of return. The main
purpose for hedging is to reduce the volatility of a portfolio y reducing the risk.
2.E SPECU:ATORS <
/peculators do not have any position on which they enter into futures
and options %arket i.e., they take the positions in the futures market without having
position in the underlying cash market. They only have a particular view aout future
price of a commodity, shares, stock index, interest rates or currency. They consider
various factors like demand and supply, market positions, open interests, economic
fundamentals, international events, etc. to make predictions. They take risk in turn
from high returns. /peculators are essential in all markets G commodities, e2uity,
interest rates and currency. They help in providing the market the much desired
volume and li2uidity.
).E AR,ITRA=EURS <
Aritrage is the simultaneous purchase and sale of the same
underlying in two different markets in an attempt to make profit from price
discrepancies etween the two markets. Aritrage involves activity on several
different instruments or assets simultaneously to take advantage of price distortions
1udged to e only temporary.
Aritrage occupies a prominent position in the futures world. It is the
mechanism that keeps prices of futures contracts aligned properly with prices of
underlying assets. The o1ective is simply to make profits without risk, ut the
complexity of aritrage activity is such that it is reserved to particularly well#informed
19
and experienced professional traders, e2uipped with powerful calculating and data
processing tools. Aritrage may not e as easy and costless as presumed.
,.( INTER/EDIAR* PARTICIPANTS :
?.E ,ROBERS <
"or any purchase and sale, rokers perform an important function of
ringing uyers and sellers together. As a memer in any futures exchanges, may
e any commodity or finance, one need not e a speculator, aritrageur or hedger.
;y virtue of a memer of a commodity or financial futures exchange one get a right
to transact with other memers of the same exchange. This transaction can e in
the pit of the trading hall or on online computer terminal. All persons hedging their
transaction exposures or speculating on price movement, need not e and for that
matter cannot e memers of futures or options exchange. A non#memer has to
deal in futures exchange through memer only. This provides a memer the role of
a roker. Ais existence as a roker takes the enefits of the futures and options
exchange to the entire economy all transactions are done in the name of the
memer who is also responsile for final settlement and delivery. This activity of a
memer is price risk free ecause he is not taking any position in his account, ut
his other risk is clients default risk. Ae cannot default in his oligation to the clearing
house, even if client defaults. /o, this risk premium is also inuilt in rokerage
recharges. %ore and more involvement of non#memers in hedging and speculation
in futures and options market will increase rokerage usiness for memer and
more volume in turn reduces the rokerage. Thus more and more participation of
traders other than memers gives li2uidity and depth to the futures and options
market. %emers can attract involvement of other y providing efficient services at a
reasonale cost. In the asence of well functioning roking houses, the futures
exchange can only function as a clu.
%.E /ARBET /ABERS AND FO,,ERS <
20
-ven in organised futures exchange, every deal cannot get the
counter party immediately. It is here the 1oer or market maker plays his role. They
are the memers of the exchange who takes the purchase or sale y other
memers in their ooks and then s2uare off on the same day or the next day. They
2uote their id#ask rate regularly. The difference etween id and ask is known as
id#ask spread. !hen volatility in price is more, the spread increases since 1oers
price risk increases. In less volatile market, it is less. 5enerally, 1oers carry limited
risk. -ven y incurring loss, they s2uare off their position as early as possile. /ince
they decide the market price considering the demand and supply of the commodity
or asset, they are also known as market makers. Their role is more important in the
exchange where outcry system of trading is present. A uyer or seller of a particular
futures or option contract can approach that particular 1oing counter and 2uotes
for executing deals. In automated screen ased trading est uy and sell rates are
displayed on screen, so the role of 1oer to some extent. In any case, 1oers
provide li2uidity and volume to any futures and option market.
C.( INSTITUTIONA: FRA/E>ORB :
&.E E6CHAN=E <
-xchange provides uyers and sellers of futures and option contract
necessary infrastructure to trade. In outcry system, exchange has trading pit where
memers and their representatives assemle during a fixed trading period and
execute transactions. In online trading system, exchange provide access to
memers and make availale real time information online and also allow them to
execute their orders. "or derivative market to e successful exchange plays a very
important role, there may e separate exchange for financial instruments and
commodities or common exchange for oth commodities and financial assets.
C.E C:EARIN= HOUSE <
A clearing house performs clearing of transactions executed in futures
and option exchanges. &learing house may e a separate company or it can e a
21
division of exchange. It guarantees the performance of the contracts and for this
purpose clearing house ecomes counter party to each contract. Transactions are
etween memers and clearing house. &learing house ensures solvency of the
memers y putting various limits on him. "urther, clearing house devises a good
managing system to ensure performance of contract even in volatile market. This
provides confidence of people in futures and option exchange. Therefore, it is an
important institution for futures and option market.
D.E CUSTODIAN G >ARE HOUSE <
"utures and options contracts do not generally result into delivery ut
there has to e smooth and standard delivery mechanism to ensure proper
functioning of market. In stock index futures and options which are cash settled
contracts, the issue of delivery may not arise, ut it would e there in stock futures
or options, commodity futures and options and interest rates futures. In the asence
of proper custodian or warehouse mechanism, delivery of financial assets and
commodities will e a cumersome task and futures prices will not reflect the
e2uilirium price for convergence of cash price and futures price on maturity,
custodian and warehouse are very relevant.
$.E ,ANB FOR FUND /OVE/ENTS <
"utures and options contracts are daily settled for which large fund
movement from memers to clearing house and ack is necessary. This can e
smoothly handled if a ank works in association with a clearing house. ;ank can
make daily accounting entries in the accounts of memers and facilitate daily
settlement a routine affair. This also reduces a possiility of any fraud or
misappropriation of fund y any market intermediary.
1H.E RE=U:ATOR* FRA/E>ORB <
A regulator creates confidence in the market esides providing Devel
playing field to all concerned, for foreign exchange and money market, $;I is the
22
regulatory authority so it can take initiative in starting futures and options trade in
currency and interest rates. "or capital market, /-;I is playing a lead role, along
with physical market in stocks, it will also regulate the stock index futures to e
started very soon in India. The approach and outlook of regulator directly affects the
strength and volume in the market. "or commodities, "orward %arket &ommission
is working for settling up national .ational &ommodity -xchange.
2.% RO:E OF DERIVATIVES :
Derivative markets help investors in many different ways O
23
1.E RISB /ANA=E/ENT <
"utures and options contract can e used for altering the risk of
investing in spot market. "or instance, consider an investor who owns an asset. Ae
will always e worried that the price may fall efore he can sell the asset. Ae can
protect himself y selling a futures contract, or y uying a 0ut 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. /imilarly, if the spot price falls
elow the exercise price, the put option can always e exercised.
Derivatives markets help to reallocate risk among investors. A person
who wants to reduce risk, can transfer some of that risk to a person who wants to
take more risk. &onsider a risk#averse individual. Ae can oviously reduce risk y
hedging. !hen he does so, the opposite position in the market may e taken y a
speculator who wishes to take more risk. /ince people can alter their risk exposure
using futures and options, derivatives markets help in the raising of capital. As an
investor, you can always invest in an asset and then change its risk to a level that is
more acceptale to you y using derivatives.
2.E PRICE DISCOVER* <
0rice discovery refers to the markets aility to determine true
e2uilirium prices. "utures prices are elieved to contain information aout 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.
<ptions markets provide information aout the volatility or risk of the underlying
asset.
).E OPERATIONA: ADVANTA=ES <
24
As opposed to spot markets, derivatives markets involve lower
transaction costs. /econdly, they offer greater li2uidity. Darge spot transactions can
often lead to significant price changes. Aowever, futures markets tend to e more
li2uid than spot markets, ecause herein you can take large positions y depositing
relatively small margins. &onse2uently, 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. "inally, it is easier to take a short position
in derivatives markets than it is to sell short in spot markets.
?.E /ARBET EFFICIENC* <
The availaility of derivatives makes markets more efficient+ spot,
futures and options markets are inextricaly linked. /ince it is easier and cheaper to
trade in derivatives, it is possile to exploit aritrage opportunities 2uickly and to
keep prices in alignment. Aence these markets help to ensure that prices reflect true
values.
%.E EASE OF SPECU:ATION <
Derivative markets provide speculators with a cheaper alternative to
engaging in spot transactions. Also, the amount of capital re2uired to take a
comparale position is less in this case. This is important ecause facilitation of
speculation is critical for ensuring free and fair markets. /peculators 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.
CHAPTER )
25
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HO> ,ANBS USE DERIVATIVES :
ASSET :IA,I:IT* /ANA=E/ENT 7
;anks have traditionally taken deposits from their customers and put those
deposits to work as loans. ;ecause the deposits and the loans are dominated in the
same currency, this activity has no associated foreign exchange risk. ;ut it does
limit anks to lending to customers which need to orrow in the currencies which the
anks have availale on deposits.
If a ank is asked to lend to a customer in a currency other than one of those
it has on deposits it creates a currency exposure for the ank. /uppose a customer
wants to orrow -:$</ from a :/ ;ank for , years and that the :/ ank has no
natural source of -:$</. It is possile for the anks to cover this exposure in the
forward market y selling -:$</ forwards and uying :/ dollars. The transaction
costs associated with this, in particular the id L offer spread in the medium term
foreign exchange forward market, would make the resultant cost of the loan
prohiitively expensive for the orrower.
&urrency swaps provide an economic alternative to this prolem for anks. In
order to cover the exposure created y a loan to a customer in -:$</ funded y a
anks deposit in :/ dollar, a ank could receive fixed rate :/ dollars in a currency
swap and pay fixed rate -:$</.
<ne of the conse2uences of the development of the currency swap market is
that anks now often make much more competitive medium term forward foreign
exchange prices than they used to. %ost anks 2uote forward foreign exchange and
currency swap prices from the same desk and increases li2uidity in the latter has
improved li2uidity in the former. ;anks therefore, need no longer restrict their
lending activities to the currencies in which they have natural deposits. They are
26
free to fund themselves in the most competitively priced currency and to lend to their
customers in the currency of the customers preference, using a currency swap as
an asset and liaility matching tool
The I.ormal yield curveJ, reflects that it is much easier for anks to orrow at
the short end of the curve than the long end. This means that anks can fund
themselves much more effectively in the inter ank market in maturities such as the
overnight, tom L next 3overnight from tomorrow, or tomorrow to the next day4, spot L
next, one week, one month, three months and six months than they can in
maturities such as five years or >* years.
!ith the development of the swaps market it is possile for anks to satisfy their
customers demands for fixed rate funding while ensuring that the anks assets and
liailities are matched. /uppose a ank has a customer who needs , years fixed
rate funds. Det us say that the ank finances in this loan in the interank market at B
month DI;<$. The ank now has a B month liaility and a , year asset 3"igure '4.
The ank is short floating rate interest at B month DI;<$ and long fixed rate
interest at the rate at which it lends to its customer. This is called the asset liaility
mismatch. /o in order to hedge its position the anks needs to match its exposure
to B month DI;<$ y receiving on a floating rate asis in an interest rate swap, and
27
match its exposure on a fixed rate asis y paying a fixed rate in a interest rate
swap. This is a hedge which is ideally suited to an interest rate swap which the ank
receives a floating rare of interest and pays a fixed rare 3"igure >4.
This structure has the enefit for the ank that it eliminates the anks
exposure to interest rate risk. The ank can no longer profit from a fall in interest
rates ut it cannot lose money on its asset and liaility mismatch as a result of an
increase in rates. The ank will make or lose money ased on its pricing of the
credit risk in the transaction and its overall loan exposure rather than on its aility to
forecast interest rates. Aence the interest rate swaps provide anks with an
opportunity to change their risks from interest rate to credit.
28
CHAPTER ?
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-
O,FECTIVE OF THE STUD* :
The main objectives behind the study of deivatives ae!
To understand the scope and growth of derivatives in India.
To understand how the derivatives are used y anks.
To understand how derivatives can e used to hedge risk.
H*POTHESIS :
Derivative market in India is undeveloped.
;anks are successful in using derivatives to hedge the risk.
29
CHAPTER %
---------------------------------------------------------------------------------------------------------------
-
ANA:*SIS :
Q. Income range of investors who investing in derivative market.

"ncome an#e $o. of %esu&t
be&o' 1(50(000 1
1(50(000-3(00(000 9
3(00(000-5(00(000 14
above 5(00(000 26
Q. What is your primary investment purpose?
Q. Why people do not invest in derivative market?
30
Reasons No.of result
)ac* of *no'&ed#e + undestandin# 27
"ncease s,ecu&ation 2
%is*y + hi#h&y &evea#ed 17
-ounte ,aty is* 4
Q. What is the purpose of investing in derivative market?
urpose of investment No. of Result
.ed#e thei fund 27
%is* conto& 9
/oe stab&e 1
0iect investment 'ithout buyin# + ho&din# assets 13
1. 2ou ,atici,ate in deivative ma*et as
articipation as No. of Result
31
investo 23
3,ecu&ato 2
4o*e50ea&e 8
.ed#e 17
1. "n 'hich of the fo&&o'in# 'ou&d you &i*e to ,atici,ate6
articipate in No. of Result
3toc* inde7 futues 19
3toc* inde7 8,tions 13
9utue on individua& stoc* 6
-uency futues 9
8,tions on individua& stoc* 3
CHAPTER &
---------------------------------------------------------------------------------------------------------------
-
32
RECO//ENDATIONS
$;I should play a greater role in supporting derivatives.
Derivatives market should e developed in order to keep it at par with
other derivative markets in the world.
/peculation should e discouraged.
There must e more derivative instruments aimed at individual
investors.
/-;I should conduct seminars regarding the use of derivatives to
educate individual investors.
33
!I"I#$I#%N& %' &#()*
+. !I"I#,) #I",:
The time avai&ab&e to conduct the study 'as on&y ha&f months. "t bein# a 'ide to,ic( had
a &imited time..
-. !I"I#,) R,&%(R.,&:
)imited esouces ae avai&ab&e to co&&ect the infomation about the commodity tadin#
/. 0%!$#$!I#*:
3hae ma*et is so much vo&ati&e and it is difficu&t to foecast anythin# about it 'hethe
you tade thou#h on&ine o off&ine
1. $&,.#& .%0,R$2,:
3ome of the as,ects may not be coveed in my study.
34
CONC:USION
Derivative securities markets play an important role y allowing
investors who do not want the risks associated with holding an asset to
transfer it to those who do. Aowever, ecause they are markets for risk
as opposed to physical assets, derivatives markets can e very
dangerous places for unsophisticated investors. 0eople who reduce
their risk y entering a derivative market are called hedgers, and those
who increase their risk are called speculators.
The derivative securities markets play a vital role in the modern financial
systems, and without them many common usiness transactions would
e rendered much riskier or practically impossile.
Derivatives were utili6ed in the financial markets around the world
from 2uite a long time whose origin can e traced ack to =th century
;.&. !ith the passage of time, the need of these instruments increased
among various sections of the society for hedging purposes. Dater, the
speculative motive of the investors also surfaced and led to its
popularity.
35
,I,:IO=RAPH* :
,OOBS
"utures markets G /unil. @. 0arameswaran
:nderstanding futures market G $oert. !. @lo
Derivatives %arket in India G /usan Thomas
"inancial Derivatives G H. @. ;halla
"inancial /ervices and %arkets G Dr. /. 5uruswamy
"utures and <ptions G D. &. 5ardner
INTERNET
www.cxotoday.com
www.indiainfoline.com
www.indiamart.com
36
;UESTIONNAIRE
SURVE* ;UESTIONNAIRE OF INVESTORS FOR PERCEPTION
TO>ARDS INVEST/ENT IN DERIVATIVE /ARBET
1. :ducationa& 1ua&ification
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect =nde#aduate
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect Baduate
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect <ost Baduate
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect <ofessiona& 0e#ee .o&de
2. "ncome %an#e!
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4e&o' 1(50(000
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 1(50(000 C 3(00(000
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3(00(000 C 5(00(000
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect @bove 5(00(000
3. $oma&&y 'hat ,ecenta#e of you month&y househo&d income cou&d be avai&ab&e fo
investment6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4et'een 5D to 10D
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4et'een 11D to 15D
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4et'een 16D to 20D
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4et'een 21D to 25D
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect /oe than 25D
4. Ehat is you ,imay investment ,u,ose6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect %etiement <&annin#
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4ui&din# u, a co,us fo
chaity donations
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3u,,otin# futue education
of you chi&den
37
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 8the F3,ecifyG
HHHHHHHHHHHHHHHHHHHHH
5. Ehat *ind of is* do you ,eceive 'hi&e investin# in the stoc* ma*et6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect =ncetainty of etuns
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3&um, in stoc* ma*et
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 9ea of bein# 'indu, of
com,any ;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 8the
F3,ecifyG HHHHHHHHHHHHHHHHH
6. Ehy ,eo,&e do not invest in deivative ma*et6 F%an* you ,efeence 1-4G
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect )ac* of *no'&ed#e and
difficu&ty in undestandin#
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect "ncease s,ecu&ation
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect Iey is*y and hi#h&y
&evea#ed instument
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect -ounte ,aty is*
7. Ehat is the ,u,ose of investin# in deivative ma*et6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect To hed#e thei fund
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect %is* conto&
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect /oe stab&e
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 0iect investment 'ithout
buyin# and ho&din# assets
8. 2ou ,atici,ate in deivative ma*et as!
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect "nvesto
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3,ecu&ato
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4o*e50ea&e
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect .ed#e
9. 9om 'hee you ,efe to ta*e advice befoe investin# in deivative ma*et6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 4o*ea#e houses
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect %eseach ana&yst
38
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect Eebsites
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect $e's $et'o*s
10. "n 'hich of the fo&&o'in# 'ou&d you &i*e to ,atici,ate6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3toc* "nde7 9utues
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3toc* "nde7 8,tions
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 9utue on individua& stoc*
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 8,tions on individua& stoc*
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect -uency futues
11. Ehat contact matuity ,eiod 'ou&d inteest you fo tadin# in6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 1 month
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 2 month
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3 month
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 6 month
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 9 month
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 12 month
12. .o' often do you invest in deivative ma*et6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 1-10 times in a yea
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 11-50 times
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect /oe than 50 times
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect %e#u&a&y
13. Ehich of the fo&&o'in# statements best descibes you ovea&& a,,oach to invest as a
mean of achievin# you #oa&s6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect .avin# a e&ative &eve& of
stabi&ity in my ovea&& investment ,otfo&io.
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect /odeate&y inceasin# my
investment va&ue 'hi&e minimiJin# ,otentia& fo &oss of
,inci,a&.
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect <usue investment #o'th(
acce,tin# modeate to hi#h &eve&s of is* and
,inci,a& f&uctuation.
39
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 3ee* ma7imum &on#-tem
etuns( acce,tin# ma7imum is* 'ith ,inci,a&
f&uctuation.
14. Ehat 'as the esu&t of you investment6
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect Beat esu&ts
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect /odeate but acce,tab&e
;"$<=T T2<:>? %@0"8 A /@-%84=TT8$ .T/)0iect 0isa,,ointed
40