A

Project Study Report

On

Training Undertaken at

IDBI
FINANCIAL DERIVATIVES MYTHS AND REALITIES

Submitted in partial fulfillment for the

Award of degree of

Master of Business Administration

Submitted By: - Submitted To:-

Mr. MOHIT SHARMA
 PREFACE

Derivatives are defined as financial instruments whose value derived from the prices of one or
more other assets such as equity securities, fixed-income securities, foreign currencies, or
commodities. Derivatives are also a kind of contract between two counterparties to exchange
payments linked to the prices of underlying assets. Derivative can also be defined as a
financial instrument that does not constitute ownership, but a promise to convey ownership.
Examples are options and futures. The simplest example is a call option on a stock. In the
case of a call option, the risk is that the person who writes the call (sells it and assumes the
risk) may not be in business to live up to their promise when the time comes. In standardized
options sold through the Options Clearing House, there are supposed to be sufficient
safeguards for the small investor against this.

I the student of SHRINATHJI INSTITUTE OF MANAGEMENT, ODAN have done

research work on subject.
 Acknowledgement

I express my sincere thanks to my project guide, Mr.MOHIT SIR, Designation Assistance

professor, Deptt SITE, for guiding me right form the inception till the successful completion
of the project. I sincerely acknowledge him for extending their valuable guidance, support
for literature, critical reviews of project and the report and above all the moral support
he/she/they had provided to me with all stages of this project

I would also like to thank the supporting staff Department, for their help and cooperation
throughout our project.

(Signature of Student)
Executive Summary
Derivatives have had a long presence in India. The commodity derivative market
has been functioning in India since the nineteenth century with organized trading in cotton
through the establishment of Cotton Trade Association in 1875. Since then contracts on
various other commodities have been introduced as well.’

Exchange traded financial derivatives were introduced in India in June 2000 at the two
major stock exchanges, NSE and BSE. There are various contracts currently traded on
these exchanges.The National Stock Exchange of India Limited (NSE) commenced trading
in derivatives with the launch of index futures on June 12, 2000. The futures contracts are
based on the popular benchmark S&P CNX Nifty Index.The Exchange introduced trading in
Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange
to launch trading in options on individual securities from July 2, 2001. Futures on individual
securities were introduced on November 9, 2001. Futures and Options on individual
securities are available on 227 securities stipulated by SEBI.The Exchange provides trading
in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY
MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and options)
contracts on S&P CNX Nifty index w.e.f. January 1,2008.National Commodity & Derivatives
Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform
for commodities trading.The derivatives market in India has grown exponentially, especially
at NSE. Stock Futures are the most highly traded contracts.
 CONTENTS
UNIT 1

INTRODUCTION OF FINANCIAL DERIVATIVES

DERIVATIVE MARKET

DEVLOPMENT OF DERIVATIVE MARKET IN INDIA

RISKS INVOLVED IN TRADING IN DERIVATIVES CONTRACTS

REGULATORY FRAMEWORK FOR DERIVATIVES

UNIT 2

INTRODUCTION OF IDBI

MYTHS AND REALITIES OF DERIVATIVES

RESEARCH METHODILOGY:-
Title of study
Durations of study
Objective of study
Type of research
Sample size and method of selecting sample
Limitation of study
DATA ANALYSIS AND INTERPRETATION

CONCLUSION

RECOMMENDATION AND SUGGESTION

APPENDIX

BIBLIOGRAPHY
FINANCIAL DERIVATIVES

INTRODUCTION

Derivatives are defined as financial instruments whose value derived from the prices of one
or more other assets such as equity securities, fixed-income securities, foreign currencies,
or commodities. Derivatives are also a kind of contract between two counterparties to
exchange payments linked to the prices of underlying assets. Derivative can also be defined
as a financial instrument that does not constitute ownership, but a promise to convey
ownership. Examples are options and futures. The simplest example is a call option on a
stock. In the case of a call option, the risk is that the person who writes the call (sells it and
assumes the risk) may not be in business to live up to their promise when the time comes.
In standardized options sold through the Options Clearing House, there are supposed to be
sufficient safeguards for the small investor against this. The most common types of
derivatives that ordinary investors are likely to come across are futures, options, warrants
and convertible bonds. Beyond this, the derivatives range is only limited by the imagination
of investment banks. It is likely that any person who has funds invested an insurance policy
or a pension fund that they are investing in, and exposed to, derivatives-wittingly or
unwittingly.

HISTORY OF DERIVATIVE

The history of derivatives is surprisingly longer than what most people think. Some texts
even find the existence of the characteristics of derivative contracts in incidents of
Mahabharata. Traces of derivative contracts can even be found in incidents that date back
to the ages before Jesus Christ.However, the advent of modern day derivative contracts is
attributed to the need for farmers to protect themselves from any decline in the price of their
crops due to delayed monsoon, or verproduction.The first 'futures' contracts can be traced
to the Yodoya rice market in Osaka, Japan around 1650. These were evidently
standardized contracts, which made them much like today's futures.The Chicago Board of
Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where
forward contracts on various commodities were standardised around 1865. From then on,
futures contracts have remained more or less in the same form, as we know them today.

Derivatives have had a long presence in India. The commodity derivative market
has been functioning in India since the nineteenth century with organized trading in cotton
through the establishment of Cotton Trade Association in 1875. Since then contracts on
various other commodities have been introduced as well.’

Exchange traded financial derivatives were introduced in India in June 2000 at the two
major stock exchanges, NSE and BSE. There are various contracts currently traded on
these exchanges.The National Stock Exchange of India Limited (NSE) commenced trading
in derivatives with the launch of index futures on June 12, 2000. The futures contracts are
based on the popular benchmark S&P CNX Nifty Index.The Exchange introduced trading in
Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange
to launch trading in options on individual securities from July 2, 2001. Futures on individual
securities were introduced on November 9, 2001. Futures and Options on individual
securities are available on 227 securities stipulated by SEBI.The Exchange provides trading
in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY JUNIOR, CNX 100 and NIFTY
MIDCAP 50 indices. The Exchange is now introducing mini derivative (futures and options)
contracts on S&P CNX Nifty index w.e.f. January 1,2008.National Commodity & Derivatives
Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform
for commodities trading.The derivatives market in India has grown exponentially, especially
at NSE. Stock Futures are the most highly traded contracts.
 The size of the derivatives market has become important in the last 15 years or so. In
2007 the total world derivatives market expanded to $516 trillion.With the opening of the
economy to multinationals and the adoption of the liberalized economic policies, the
economy is driven more towards the free market economy. The complex nature of
financial structuring itself involves the utilization of multi currency transactions. It exposes
the clients, particularly corporate clients to various risks such as exchange rate risk, interest
rate risk, economic risk and political risk.With the integration of the financial markets and
free mobility of capital, risks also multiplied. For instance, when countries adopt floating
exchange rates, they have to face risks due to fluctuations in the exchange rates.
Deregulation of interest rate cause interest risks. Again, securitization has brought with it the
risk of default or counter party risk. Apart from it, every asset—whether commodity or metal
or share ocurrency—is subject to depreciation in its value. It may be due to certain inherent
factors and external factors like the market condition, Government’s policy, economic and
political condition prevailing in the country and so on. In the present state of the economy,
there is an imperative need of the corporate clients to protect there operating profits by
shifting some of the uncontrollable financial risks to those who are able to bear and manage
them. Thus, risk management becomes a must for survival since there is a high volatility in
the present financial markets In this context, derivatives occupy an important place as risk
reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In
fact, the financial service companies can play a very dynamic role in dealing with such risks.
They can ensure that the above risks are hedged by using derivatives like forwards, future,
options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to he
financial service companies. This really protects the clients from unforeseen risks and helps
them to get there due operating profits or to keep the project well within the budget costs.
To hedge the various risks that one faces in the financial market today, derivatives are
absolutely essential.

SCOPE OF DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital
market. The National Stock Exchange has been planning to introduce index-based futures.
A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to
enroll for such trading. But, it has not yet received the necessary permission from the
securities and Exchange Board of India.In the forex market, there are brighter chances of
introducing derivatives on a large scale. Infact, the necessary groundwork for the
introduction of derivatives in forex market was prepared by a high-level expert committee
appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee’s report was already
submitted to the Government in 1995. As it is, a few derivative products such as interest
rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a
limited scale. It is easier to introduce derivatives in forex market because most of these
products are OTC products (Over-the-counter) and they are highly flexible. These are
always between two parties and one among them is always a financial intermediary.
However, there should be proper legislations for the effective implementation of derivative
contracts. The utility of derivatives through Hedging can be derived, only when, there is
transparency with honest dealings. The players in the derivative market should have a
sound financial base for dealing in derivative transactions. What is more important for the
success of derivatives is the prescription of proper capital adequacy norms, training of
financial intermediaries and the provision of well-established indices. Brokers must also be
trained in the intricacies of the derivative-transactions. Now, derivatives have been
introduced in the Indian Market in the form of index options and index futures. Index options
and index futures are basically derivate tools based on stock index. They are really the risk
management tools. Since derivates are permitted legally, one can use them to insulate his
equity portfolio against the vagaries of the market

Every investor in the financial area is affected by index fluctuations. Hence, risk
management using index derivatives is of far more importance than risk management using
individual security options. Moreover, Portfolio risk is dominated by the market risk,
regardless of the composition of the portfolio. Hence, investors would be more interested in
using index-based derivative products rather than security based derivative products. There
are no derivatives based on interest rates in India today. However, Indian users of hedging
services are allowed to buy derivatives involving other currencies on foreign markets. India
has a strong dollar- rupee forward market with contracts being traded for one to six month
expiration. Daily trading volume on this forward market is around $500 million a day. Hence,
derivatives available in India in foreign exchange area are also highly beneficial to the
users.

FACTORS CONTRIBUTED TOWARDS THE GROWTH OF DERIVATIVES:-

1) Increased Volatility in asset prices in financial markets.

2) Increased integration of national financial markets with the international markets,

3) Marked improvement in communication facilities and sharp decline in their costs,

4) Development of more sophisticated risk management tools, providing economic agents a

, wider choice of risk management strategies.

Innovations in the derivatives markets, which optimally combine the risks and returns over a
large number of financial assets, leading to higher returns, reduced risk as well as
transaction costs as compared to individual financial assets.

The need for a derivatives market :-

1) They help in transferring risks from risk adverse people to risk oriented people

2) They help in the discovery of future as well as current prices.

3) They increase the volume traded in markets because of participation of risk adverse

People in greater numbers. They increase savings and investment in the long run.

TYPES OF DERIVATIVES:-

There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.

The most commonly used derivatives contracts are Forward, Futures and Options.
 FORWARD:-

A forward contract is an agreement between two parties – a buyer and a seller to

purchase or sell something at a later date at a price agreed upon today. Forward
contracts, sometimes called forward commitments, are very common in everyone life. For
example, an apartment lease is a forward commitment. By signing a one-year lease, the
tenant agrees to purchase the service – use of the apartment – each month for the next
twelve months at a predetermined rate. Like-wise, the landlord agrees to provide the
service each month for the next twelve months at the agreed-upon rate. Now suppose that
six months later the tenant finds a better apartment and decides to move out. The forward
commitment remains in effect, and the only way the tenant can get out of the contract is to
sublease the apartment. Because there is usually a market for subleases, the lease is
even more like a futures contract than a forward contract. Any type of contractual
agreement that calls for the future purchase of a good or service at a price agreed upon
today and without the right of cancellation

FUTURES:-

The future contract is an agreement to buy or sell an asset at a certain time in the future for
a certain price. Equities, bonds, hybrid securities and currencies are the commodities of the
investment business. They are traded on organized exchanges in which a clearing. house
interposes itself between buyer and seller and guarantees all transactions, so that the identity
of the buyer or seller is a matter of indifference to the opposite party.

Futures contracts protect those who use these commodities in their business. Future contract
based on financial investment or a financial index are known as:-financial futures. Financial
futures can be classified in three categories which is as follows:-

a) stock index futures ;

b) interest rate futures

c) currency futures.
 SWAPS:-

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

OPTION:-

An option is a contract whereby one party (the holder or buyer) has the right, but not
the obligation, to exercise the contract (the option) on or before a future date (the exercise
date or expiry). The other party (the writer or seller) has the obligation to honour the
specified feature of the contract. Since the option gives the buyer a right and the seller an
obligation, the buyer has received something of value. The amount the buyer pays the seller
for the option is called the option premium. Because this is a security whose value is
determined by an underlying asset, it is classified as a derivative.

Types of Options:-

There are two main types of options:

a. American options can be exercised at any time between the date of purchase and the
expiration date.

b. European options can only be exercised at the end of their lives.

c. Long-Term Options are options with holding times of one, two or multiple years, which
may be more appealing for long-term investors, which are called long-term equity
anticipation securities (LEAPS).
DERIVATIVE MARKET

The Derivatives Market is meant as the market where exchange of derivatives takes
place. Derivatives are one type of securities whose price is derived from the underlying
assets. And value of these derivatives is determined by the fluctuations in the underlying
assets. These underlying assets are most commonly stocks, bonds, currencies, interest
rates, commodities and market indices. As Derivatives are merely contracts between two or
more parties, anything like weather data or amount of rain can be used as underlying
assets.

PARTICIPANTS OF THE DERIVATIVE MARKET

Market participants in the future and option markets are many and they perform multiple
roles, depending upon their respective positions. A trader acts as a hedger when he
transacts in the market for price risk management. He is a speculator if he takes an open
position in the price futures market or if he sells naked option contracts. He acts as an
arbitrageur when he enters in to simultaneous purchase and sale of a commodity, stock or
other asset to take advantage of misruling. He earns risk less profit in this activity. Such
opportunities do not exist for long in an efficient market. Brokers provide services to others,
while market makers create liquidity in the market.

a)Hedgers
Hedgers are the traders who wish to eliminate the risk (of price change) to which they are
already exposed. They may take a long position on, or short sell, a commodity and would,
therefore, stand to lose should the prices move in the adverse direction. hedgers want to
eliminate an exposure to movements in the price of an asset. Hedging with financial futures
is an art as well as a science. By future hedging, we mean to take a position in futures
contracts that offset some of the risk associated with some given market commitment. The
essence of hedging is the adoption of a future position that, on average, generates profits
when the market value of the commitment is higher than expected. The notion of designing
a futures strategy to generate losses under certain circumstances may seem quixotic to
some. . One must keep in mind the well-repeated adage:” There are no free lunches”.

One cannot expect trading profits as well as risk reduction (although that sometimes
happens). The key is to coordinate losses in futures with gains elsewhere, and vice versa.
How does one achieve that kind of coordination? Such futures are not an answer to all
investment management problems, but they do provide the finance manager with new
means to act upon market decisions. An understanding of the futures contracts and how the
futures markets operate is critical to designing a successful hedge strategy. As with any
innovative technique, potential hedgers need to take the time to study the markets and
determine the risk/return potential for each application In order to profit from a spread
transaction the trader attempts to determine whether the size of the difference between the
prices of the two contracts will increase or decrease. A spread earns a profit if the correct
direction of the price difference is forecasted and the appropriate spread transaction is set
up in conjunction with the changing price structure of the future contracts.

b) Speculators

If hedgers are the people who wish to avoid the price risk, speculators are those who
are willing to take such risk. These people take position in the market and assume risk to
profit from fluctuations in prices. In fact, speculators consume information, make forecasts
about the prices and put their money in these forecasts. In this process, they feed
information into prices and thus contribute to market efficiency. By taking position, they are
betting that a price would go up or they are betting that it would go down.The speculators in
the derivative markets may be either day trader or position traders. The day traders
speculate on the price movements during one trading day, open and close position many
times a day and do not carry any position at the end of the day.They monitor the prices
continuously and generally attempt to make profit from just a few ticks per trade. On the
other hand, the position traders also attempt to gain from price fluctuations but they keep
their positions for longer durations may is for a few days, weeks or even months.
Speculators wish to take a position in the market. Either they are betting that a price will go
up or they are betting that it will go down. In other words, a speculative position can be
either a long or a short. A long position occurs when the futures contract is purchased;
profits arise when prices increase. A short position when its futures contract is sold, a short
trader profits when prices decrease. Speculative futures positions are very profitable for
those who are able to forecast correctly both market direction and the extent of the market
move. This profitability is enhanced because the speculator needed to put up only a small
percentage of the value of the underlying cash instrument for margin, there by allowing a
significant degree of leverage.

Of course, if a speculator forecasts incorrectly, then the mark-to-market rules cause a cash
outflow as the future position deteriorates. Consequently, a speculator needs forecasting
ability and substantial knowledge of the underlying cash markets, plus sufficient funds to
overcome a short-term (or permanent) loss of funds from losing trades.

There is an important difference between speculating using forward markets and

speculating by buying the underlying asset in the spot market.Buying a certain amount of
the underlying asset in the spot market requires an initial cash payment equal to the total
value of what is bought. Entering into a forward contract on the same amount of the asset
requires no initial cash payment. Speculating using forward markets therefore provide an
investor with a much higher level of leverage than speculating using spot markets. In the
highly leveraged futures markets, minimums are set to ensure that the speculators can
afford any potential losses. For this very reason a levy of 15 percent margin on the contract
price has been suggested in the Bombay Stock Exchange plans to introduce futures trading
on the exchange parallel to cash transactions on the market. The percentage of margin is to
be constant throughout the contract but the amount of margin will vary based on the mark to
market price. Members are to pay margins on all futures contracts on a gross basis.

In a volatile market, the speculator needs to establish realistic goals for trades. After
reaching these goals, it is best to cover the trade. If a speculator becomes emotionally
involved in a position (which generates greed and fear), the ability to make a realistic
decision about covering a position is impaired. Some speculators attempt to circumvent
such emotional considerations by Placing special trading orders with the broker so that the
trader is automatically removed from a disadvantageous situation. Although such orders are
useful for speculators who are not in constant contact with the market and have specific
forecasts of market movements, many active traders believe that recognizing the current
trend in the market and then adapting to that trend is more important than mechanical
position trading.

c) Arbitrageurs

Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a given

commodity, or other item, that sells for different prices in different markets. The Institute of
Chartered Accountant of India, the word “ARBITRAGE” has been defines as
follows:-“Simultaneous purchase of securities in one market where the price there of is low
and sale thereof in another market, where the price thereof is comparatively higher. These
are done when the same securities are being quoted at different prices in the two markets,
with a view to make profit and carried on with conceived intention to derive advantage from
difference in prices of securities prevailing in the two different markets”Thus, arbitrage
involves making risk-less profits by simultaneously entering into transactions in two or more
markets.

Arbitrage exists when a trader is able to obtain risk-free profits by taking one position in the
cash market and an exact opposite position in the futures market. The arbitrage position is
covered later by delivering the cash security into the futures position. The arbitrageur can
close the position prior to delivery if the profit potential has been achieved; this situation
occurs principally in the stock index futures market because of the price swings. Arbitrage
keeps the futures and cash prices in line with one another.

This relationship between the cash and fair futures prices is expressed by the simple cost
of carry pricing. This pricing shows that the fair futures prices are the set of buying the cash
asset now and financing this asset until delivery into the futures contract. If the current
futures price is higher than the fair price dictated by the cost of carry pricing, then arbitrage
is possible by buying the cheaper instrument (the cash) and selling the more expensive
instrument (the futures). Alternatively, if the current futures price is less than the fair price,
then the arbitrageur purchases futures and sells the cash short. This activity forces the
prices of the cash and futures instruments back into their appropriate relationship.

THE TREND OF DERIVATIVE MARKET IN INDIA

Derivative products made a debut in the Indian market during 1998 and overall progress
of derivatives market in India has indeed been impressive. The Indian equity derivatives
market has registered an "explosive growth" and is expected to continue its dream run in the
years to come with the various pieces that are crucial for the market's growth slowly falling
in place.

Over the counter derivatives market in Interest Rate and Foreign Exchange has also
witnessed impressive growth with RBI allowing the local banks to run books in Indian Rupee
Interest Rate and FX derivatives.

The complexity of market continues to increase as clients have become savvier,

demanding more fine tuned solution to meet their risk management objectives, rather than
using the vanilla roducts.Besides Rupee derivatives offered by the local players, RBI has
also allowed the client to use more exotic products like barrier options. These products are
offered by the local bank on back-to-back basis, wherein they buy similar product from
market maker from the offshore markets.

The complexity of derivatives market has increased, but the growth in deployment of
risk management systems required to manage such complex business has not grown at the
same pace.

The reason being, the very high cost of such system and absence of any local player
who could offer the solution, which could compete with product offered by the international
vendors.

DERIVATIVE MARKET GROWTH

The Derivatives Market Growth was about 30% in the first half of 2008 when it reached
a size of $US 370 trillion. This growth was mainly due to the increase in the participation of
the bankers, investors and different companies. The derivative market instruments are used
by them to hedge risks as well as to satisfy their speculative needs

The derivative market growth for different derivative market instruments may be
discussed under the following heads.

a) Derivative Market Growth for the Exchange-traded-Derivatives

The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the
futures and options market grew by 38 % while the interest rate futures grew by 42%.
Hence the derivative market size for the futures and the options market was $49 trillion.
 b) Derivative Market Growth for the Global Over-the-Counter Derivatives

The contracts traded through Over-the-Counter market witnessed a 24 % increase in its

face value and the over-the -counter derivative market size reached $70,000 billion. This
shows that the face value of the derivative contracts has multiplied 30 times the size of the
US economy. Notable increases were recorded for foreign exchange, interest rate, equity
and commodity based derivative following an increase in the size of the Over-the Counter
derivative market.

The Derivative Market Growth does not necessitate an increase in the risk taken by the
different investors. Even then, the overshoot in the face value of the derivative contracts
shows that these derivative instruments played a pivotal role in the financial market of
today.

c) Derivative Market Growth for the Credit Derivatives

The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market
growth is attributed to the increase in the trading in the synthetic collateral Debt
obligations and also to the electronic trading systems that have come into existence. The
Bank of International Settlements measures the size and the growth of the derivative
market. the derivative market growth in the over the counter derivative market witnessed
a slump in the second half of 2008.

Although the credit derivative market grew at a rapid pace, such growth was made offset
by a slump somewhere else. The notional amount of the Credit Default Swap witnessed a
growth of 42%. Credit derivatives grew by 54%. The single name contracts grew by 36%.
The interest derivatives grew by 11%. The OTC foreign exchange derivatives slowed by
5%, the OTC equity derivatives slowed by 10%. Commodity derivatives also experienced
crawling growth pattern.
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 24–member 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 pre–
conditions 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 real–
time monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include
derivatives within the ambit of ‘securities’ and the regulatory framework was developed for
governing derivatives trading. The act also made it clear that derivatives shall be legal and
valid only if such contracts are traded on a recognized stock exchange, thus precluding
OTC derivatives The government also rescinded in March 2000, the three– decade old
notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval
to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges,
NSE and BSE, and their clearing house/corporation to commence trading and settlement in
approved derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by
approval for trading in options based on these two indexes and options on individual
securities

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options
on individual securities commenced in July 2001. Futures contracts on individual stocks
were launched in November 2001. The derivatives trading on NSE commenced with S&P
CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on
June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001.

The index futures and options contract on NSE are based on S&P CNX Trading and
settlement in derivative contracts is done in accordance with the rules, byelaws, and
regulations of the respective exchanges and their clearing house/corporation duly approved
by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are
permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE
report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O segment. It
constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to
this phenomenon is that traders are comfortable with single-stock futures than equity
options, as the former closely resembles the erstwhile badla system.

• On relative terms, volumes in the index options segment continues to remain poor. This
may be due to the low volatility of the spot index. Typically, options are considered more
valuable when the volatility of the underlying (in this case, the index) is high. A related issue
is that brokers do not earn high commissions by recommending index options to their
clients, because low volatility leads to higher waiting time for round-trips.

• Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from2.86 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 aless risky
alternative (read substitute) to generate profits from the stock price movements. The fact
that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall,
while puts rise when Satyam falls intraday. 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.

Commodity Derivatives

Futures contracts in pepper, turmeric, guar (jaggery), hessian (jute fabric), jute sacking,
castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18
commodity exchanges located in various parts of the country. Futures trading in other edible
oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities,
especially in edible oils, is expected to commence in the near future. The sugar industry is
exploring the merits of trading sugar futures contracts.

The policy initiatives and the modernisation programme include extensive training,
structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and
the thrust towards the establishment of a national commodity exchange. The Government of
India has constituted a committee to explore and evaluate issues pertinent to the
establishment and funding of the proposed national commodity exchange for the nationwide
trading of commodity futures contracts, and the other institutions and institutional processes
such as warehousing and clearinghouses.

With commodity futures, delivery is best affected using warehouse receipts (which are like
dematerialized securities). Warehousing functions have enabled viable exchanges to
augment their strengths in contract design and trading.

The viability of the national commodity exchange is predicated on the reliability of the
warehousing functions. The program for establishing a system of warehouse receipts is in
progress. The Coffee Futures Exchange India (COFEI) has operated a system of
warehouse receipts since 1998. There are two exchanges for commodity in India:

1) National Commodity & Derivatives Exchange Limited-(Herein referred to as ‘NCDEX’ or

‘Exchange’),

2) Multi Commodity Exchange ( MCX)

Foreign Exchange Derivatives

The Indian foreign exchange derivatives market owes its origin to the important step that the
RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange; as a
consequence, the stipulation of maintaining square or near square position was to be
complied with only at the close of each business day.

This was followed by use of products like cross-currency options, interest rate and currency
swaps, caps/collars and forward rate agreements in the international foreign exchange
market; development of a rupee-foreign currency swap market; and introduction of
additional hedging instruments such as foreign currency-rupee options.

Cross-currency derivatives with the rupee as one leg were introduced with some restrictions
in the April 1997 Credit Policy by the RBI. In the April 1999 Credit Policy, Rupee OTC
interest rate derivatives were permitted using pure rupee benchmarks, while in April 2000,
Rupee interest rate derivatives were permitted using implied rupee benchmarks.

In 2001, a few select banks introduced Indian National Rupee (INR) Interest Rate
Derivatives (IRDs) using Government of India security yields as floating benchmarks.
Interest rate futures (long bond and t-bill) were introduced in June 2003 and Rupee-foreign
exchange options were allowed in July 2003.

Fixed income derivatives

Scheduled Commercial Banks, Primary Dealers (PDs) and FIs have been allowed by RBI
since July 1993 to write Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAs)
as products for their own asset liability management(ALM) or for market making (risk
trading) purposes. Since October 2000, IRS can be written on benchmarks in domestic
money or debt market (e.g. NSE MIBOR, Reuter Mibor, GoI Treasury Bills) or on implied
foreign currency interest rates [e.g. Mumbai Interbank Forward Offer Rate (MIFOR),
Mumbai Interbank Tom Offer Rate (MITOR)].
 IRS based on MIFOR/MITOR could well be written on a stand-alone basis, and need not be
a part of a Cross Currency Interest Rate Swap (CC-IRS). This enables corporates to
benchmark the servicing cost on their rupee liabilities to the foreign currency forward yield
curve.

There is now an active Over-The-Counter (OTC) IRS and FRA market in India. Yet, the bulk
of the activity is concentrated around foreign banks and some private sector banks (new
generation) that run active derivatives trading books in their treasuries. The presence of
Public Sector Bank (PSB) majors (such as SBI, BoB, BoI, PNB, amongst others) in the
rupee IRS market is marginal, at best. Most PSBs are either unable or unwilling to run a
derivatives trading book enfolding IRS or FRAs.

Further, most PSBs are not yet actively offering IRSs or FRAs to their corporate customers
on a “covered” basis with back-to-back deals in the inter-institutional market. The
consequence is a paradox.

On the one side you have foreign banks and new generation private sector banks that run a
derivatives trading book but do not have the ability to set significant counter party (credit)
limits on a large segment of corporate customers of PSBs. And, on the other side are PSBs
who have the ability and willingness to set significant counter party (credit) limits on
corporate customers, but are unable or unwilling to write IRS or FRAs with them. Thereby,
the end user corporates are denied access through this route to appropriate hedging and
yield enhancing products, to better manage the assetliability portfolio. This inability or
unwilling of PSB majors seemingly stems from the following key impediments they are yet to
overcome:

1. Inadequate technological and business process readiness of their treasuries to run

a derivatives trading book, and manage related risks.

2. Inadequate readiness of human resources/talent in their treasuries to run a derivatives

trading book, and manage related risks.
3. Inadequate willingness of bank managements to the “risk” being held accountable for
bona-fide trading losses in the derivatives book, and be exposed to subsequent onerous
investigative reviews, in a milieu where there is no penal consequence for lost opportunity
profit

4.Inadequate readiness of their Board of Directors to permit the bank to run a derivatives
trading book, partly for reasons cited above, and partly due to their own “discomfort of the
unfamiliar.”s

Interest rate options and futures:

The RBI is yet to permit banks to write rupee (INR) interest rate options.Indeed, for banks to
be able to write interest rate options, a rupee interest rate futures market would need to first
exist, so that the option writer can delta hedge the risk in the interest rate options positions.
And, according to one school of thought, perhaps the policy dilemma before RBI is: how to
permit an interest rate futures market when the current framework does not permit short
selling of sovereign securities. Further, even if short selling of sovereign securities were to
be permitted, it may be of little consequence unless lending and borrowing of sovereign
securities is first permitted.

RISKS INVOLVED IN TRADING IN DERIVATIVES CONTRACTS

Effect of "Leverage" or "Gearing"

The amount of margin is small relative to the value of the derivatives contract so the
transactions are 'leveraged' or 'geared'.

Derivatives trading, which is conducted with a relatively small amount of margin, provides
the possibility of great profit or loss in comparison with the principal investment amount. But
transactions in derivatives carry a high degree of risk.
You should therefore completely understand the following statements before actually trading
in derivatives trading and also trade with caution while taking into account one's
circumstances, financial resources, etc. move against you, you may lose a part of or whole
margin equivalent to the principal investment amount in a relatively short period of time.
Moreover, the loss may exceed the original margin amount.

A. Futures trading involve daily settlement of all positions. Every day the open positions are
marked to market based on the closing level of the index. If the index has moved against
you, you will be required to deposit the amount of loss (notional) resulting from such
movement. This margin will have to be paid within a stipulated time frame, generally before
commencement of trading next day.

B. If you fail to deposit the additional margin by the deadline or if an outstanding debt
occurs in your account, the broker/member may liquidate a part of or the whole position or
substitute securities. In this case, you will be liable for any losses incurred due to such
close-outs.

C. Under certain market conditions, an investor may find it difficult or impossible to execute
transactions. For example, this situation can occur due to factors such as illiquidity i.e. when
there are insufficient bids or offers or suspension of trading due to price limit or circuit
breakers etc.

D. In order to maintain market stability, the following steps may be adopted: changes in the
margin rate, increases in the cash margin rate or others. These new measures may be
applied to the existing open interests. In such conditions, you will be required to put up
additional margins or reduce your positions.

E. You must ask your broker to provide the full details of the derivatives contracts you plan
to trade i.e. the contract specifications and the associated obligations.

1) Risk-reducing orders or strategies

The placing of certain orders (e.g., "stop-loss" orders, or "stop-limit" orders) which are
intended to limit losses to certain amounts may not be effective because market conditions
may make it impossible to execute such orders. Strategies using combinations of
positions, such as "spread" positions, may be as risky as taking simple "long" or "short"
positions

2) Suspension or restriction of trading and pricing relationships

Market conditions (e.g., illiquidity) and/or the operation of the rules of certain markets (e.g.,
the suspension of trading in any contract or contact month because of price limits or "circuit
breakers") may increase the risk of loss due to inability to iquidate/offset positions

3) Deposited cash and property

You should familiarise yourself with the protections accorded to the money or other property
you deposit particularly in the event of a firm insolvency or bankruptcy. The extent to which
you may recover your money or property may be governed by specific legislation or local
rules. In some jurisdictions, property which has been specifically identifiable as your own will
be pro-rated in the same manner as cash for purposes of distribution in the event of a
shortfall. In case of any dispute with the member, the same shall be subject to arbitration as
per the byelaws/regulations of the Exchange

. 4) Risk of Option holders

1. An option holder runs the risk of losing the entire amount paid for the option in a relatively
short period of time. This risk reflects the nature of an option as a wasting asset which
becomes worthless when it expires. An option holder who neither sells his option in the
secondary market nor exercises it prior to its expiration will necessarily lose his entire
investment in the option. If the price of the underlying does not change in the anticipated
direction before the option expires to the extent sufficient to cover the cost of the option, the
investor may lose all or a significant part of his investment in the option.
. 2. The Exchange may impose exercise restrictions and have authority to restrict the
exercise of options at certain times in specified circumstances.

5) Risks of Option Writers

1. not well understood is, in itself, a risk factor. While this is not to suggest that combination
strategies should not be If the price movement of the underlying is not in the anticipated
direction the option writer runs the risks of losing substantial amount.

2. The risk of being an option writer may be reduced by the purchase of other options on the
same underlying interest-and thereby assuming a spread position-or by acquiring other
types of hedging positions in the options markets or other markets. However, even where
the writer has assumed a spread or other hedging position, the risks may still be significant.
A spread position is not necessarily less risky than a simple 'long' or 'short' position.

3. Transactions that involve buying and writing multiple options in combination, or buying or
writing options in combination with buying or selling short the underlying interests, present
additional risks to investors. Combination transactions, such as option spreads, are more
complex than buying or writing a single option. And it should be further noted that, as in any
area of investing, a complexity considered, it is advisable, as is the case with all
investments in options, to consult with someone who is experienced and knowledgeable
with respect to the risks and potential rewards of combination transactions under various
market circumstances.

6) Commission and other charges

Before you begin to trade, you should obtain a clear explanation of all commission, fees and
other charges for which you will be liable. These charges will affect your net profit (if any) or
increase your loss.
7) Trading facilities

The Exchange offers electronic trading facilities which are computerbased systems for
order-routing, execution, matching, registration or clearing of trades. As with all facilities and
systems, they are vulnerable to temporary disruption or failure. Your ability to recover
certain losses may be subject to limits on liability imposed by the system provider, the
market, the clearing house and/or member firms. Such limits may vary; you should ask the
firm with which you deal for details in this respect.

This document does not disclose all of the risks and other significant aspects involved in
trading on a derivatives market. The constituent should therefore study derivatives trading
carefully before becoming involved in it.

REGULATORY FRAMEWORK FOR DERIVATIVES THE GUIDING

PRINCIPLES

Regulatory objectives

1. The Committee believes that regulation should be designed to achieve specific, well-
defined goals. It is inclined towards positive regulation designed to encourage healthy
activity and behaviour. It has been guided by the following objectives :

a).Investor Protection: Attention needs to be given to the following four

aspects:

b). Fairness and Transparency: The trading rules should ensure that trading is
conducted in a fair and transparent manner. Experience in other countries shows that in
many cases, derivative brokers/dealers failed to disclose potential risk to the clients. In this
context, sales practices adopted by dealers for derivatives would require specific
regulation. In some of the most widely reported mishaps in the derivatives market
elsewhere, the underlying reason was inadequate internal control system at the user-firm
itself so that overall exposure was not controlled and the use of derivatives was for
speculation rather than for risk hedging. These experiences provide useful lessons for us for
designing regulations.

c). Safeguard for clients' moneys: Moneys and securities deposited by clients with
the trading members should not only be kept in a separate clients' account but should also
not be attachable for meeting the broker's own debts. It should be ensured that trading by
dealers on own account is totally segregated from that for clients.

d). Competent and honest service: The eligibility criteria for trading members
should be designed to encourage competent and qualified personnel so that
investors/clients are served well. This makes it necessary to prescribe qualification for
derivatives brokers/dealers and the sales persons appointed by them in terms of a
knowledge base.

e). Market integrity: The trading system should ensure that the market's integrity is
safeguarded by minimising the possibility of defaults. This requires framing appropriate
rules about capital adequacy, margins, clearing corporation, etc.

Quality of markets: The concept of "Quality of Markets" goes well beyond market
integrity and aims at enhancing important market qualities, such as cost-efficiency, price-
continuity, and price-discovery. This is a much broader objective than market integrity.

Innovation: While curbing any undesirable tendencies, the regulatory framework should
not stifle innovation which is the source of all economic progress, more so because financial
derivatives represent a new rapidly developing area, aided by advancements in information
technology.

Major issues concerning regulatory framework

The Committee's attention had been drawn to several important issues in connection with
derivatives trading. The Committee has considered such issues, some of which have a
direct bearing on the design of the regulatory framework. They are listed below :

a. Should a derivatives exchange be organised as independent and separate from an

existing stock exchange?

b. What exactly should be the division of regulatory responsibility, including both framing
and enforcing the regulations, between SEBI and the derivatives exchange?

c. How should we ensure that the derivatives exchange will effectively fulfill its regulatory
responsibility?

d. What criteria should SEBI adopt for granting permission for derivatives trading to an
exchange?

e. What conditions should the clearing mechanism for derivatives trading satisfy in view of
high leverage involved?

f. What new regulations or changes in existing regulations will have to be introduced by

SEBI for derivatives trading?

Should derivatives trading be conducted in a separate exchange?

1. A major issue raised before the Committee for its decision was whether regulations
should mandate the creation of a separate exchange for derivatives trading, or allow an
existing stock exchange to conduct such trading.
 The Committee has examined various aspects of the problem. It has also reviewed the
position prevailing in other countries. Exchange-traded financial derivatives originated in
USA and were subsequently introduced in many other countries.

Organisational and regulatory arrangements are not the same in all countries. Interestingly,
in U.S.A., for reasons of history and regulatory structure, a future trading in financial
instruments, including currency, bonds and equities, was started in early 1970s, under the
auspices of commodity futures markets rather than under securities exchanges where the
underlying bonds and equities were being traded.

This may have happe ned partly because currency futures, which had nothing to do with
securities markets, were the first to emerge among financial derivatives in U.S.A. and partly
because derivatives were not "securities" under U.S. laws.

Cash trading in securities and options on securities were under the Securities and
Exchange Commission (SEC) while futures trading were under the Commodities Futures
Trading Commission (CFTC). In other countries, the arrangements have varied.

2. The Committee examined the relative merits of allowing derivatives trading to be

conducted by an existing stock exchange vis-a-vis a separate exchange for derivatives.
The arguments for each are summarised below.

Arguments for allowing existing stock exchanges to start futures trading:

a. The weightiest argument in this regard is the advantage of synergies arising from the
pooling of costs of expensive information technology networks and the sharing of expertise
required for running a modern exchange. Setting-up a separate derivatives exchange will
involve high costs and require more time.

b. The recent trend in other countries seems to be towards bringing futures andcash trading
under coordinated supervision. The lack of coordination was recognised as an important
problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level
supervisory coordination between futures and cash markets is greatly facilitated if both are
parts of the same exchange.

Arguments for setting-up separate futures exchange:

a. The trading rules and entry requirements for futures trading would have to be different
from those for cash trading.

b. The possibility of collusion among traders for market manipulation seems to be greater if
cash and futures trading are conducted in the same exchange.

c. A separate exchange will start with a clean slate and would not have to restrict the entry
to the existing members only but the entry will be thrown open to all potential eligible
players.

Recommendation

From the purely regulatory angle, a separate exchange for futures trading seems to be a
neater arrangement. However, considering the constraints in infrastructure facilities, the
existing stock exchanges having cash trading may also be permitted to trade derivatives
provided they meet the minimum eligibility conditions as indicated below:

1. The trading should take place through an online screen-based trading system, which
also has a disaster recovery site. The per-half-hour capacity of the computers and the
network should be at least 4 to 5 times of the anticipated peak load in any half hour, or of
the actual peak load seen in any half-hour during the preceding six months. This shall be
reviewed from time to time on the basis of experience.

2. The clearing of the derivatives market should be done by an independent clearing

corporation, which satisfies the conditions listed in a later chapter of this report.

3. The exchange must have an online surveillance capability which monitors positions,
prices and volumes in realtime so as to deter market manipulation. Price and position limits
should be used for improving market quality.

4. Information about trades, quantities, and quotes should be disseminated by the exchange
in realtime over at least two information vending networks which are accessible to investors
in the country.

5. The Exchange should have at least 50 members to start derivatives trading.

6. If derivatives trading are to take place at an existing cash market, it should be done in a
separate segment with a separate membership; i.e., all members of the existing cash
market would not automatically become members of the derivatives market.

7. The derivatives market should have a separate governing council which shall

not have representation of trading/clearing members of the derivatives Exchange beyond

whatever percentage SEBI may prescribe after reviewing the working of the present
governance system of exchanges.

8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a

member of the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not
carry on any Broking or Dealing Business on any Exchange during his tenure as Chairman.

9. The exchange should have arbitration and investor grievances redressal mechanism
operative from all the four areas/regions of the country.

10. The exchange should have an adequate inspection capability.

 11. No trading/clearing member should be allowed simultaneously to be on the

governing council of both the derivatives market and the cash market.

12. If already existing, the Exchange should have a satisfactory record of monitoring its
members, handling investor complaints and preventing irregularities in trading

Working of Derivatives markets in India

Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for
derivative trading in India. SEBI has also framed suggestive byelaw for Derivative
Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions
for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the
Derivative Segment of the Exchanges and their Clearing Corporation/House have to be
framed in line with the suggestive Bye-laws.

SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its
Clearing Corporation/House. The eligibility conditions have been framed to ensure that
Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading
environment, safety & integrity and provide facilities for redressal of investor grievances.
Some of the important eligibility conditions are- Derivative trading to take place through an
on-line screen based Trading System.

The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor

positions, prices, and volumes on a real time basis so as to deter market manipulation.
The Derivatives Exchange/ Segment should have arrangements for dissemination of
information about trades, quantities and quotes on a real time basis through atleast two
information vending networks, which are easily accessible to investors across the country.

The Derivatives Exchange/Segment should have arbitration and investor grievances

redressal mechanism operative from all the four areas / regions of the country.The
Derivatives Exchange/Segment should have satisfactory system of monitoring investor
complaints and preventing irregularities in trading.

The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
The Clearing Corporation/House shall perform full notation, i.e., The Clearing
Corporation/House shall interpose itself between both legs of every trade, becoming the
legal counterparty to both or alternatively should provide an unconditional guarantee for
settlement of all trades. 

The Clearing Corporation/House shall have the capacity to monitor the overall position of
Members across both derivatives market and the underlying securities market for those
Members who are participating in both. The level of initial margin on Index Futures
Contracts shall be related to the risk of loss on the position. The concept of value-at-risk
shall be used in calculating required level of initial margins. The initial margins should be
large enough to cover the one-day loss that can be encountered on the position on 99% of
the days.

The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT)
for swift movement of margin payments. In the event of a Member defaulting in meeting its
liabilities, the Clearing Corporation/House shall transfer client positions nd assets to another
solvent Member or close-out all open positions. The Clearing co- rporation/House should
have capabilities to segregate initial margins deposited by Clearing Members for trades on
their own account and on account of his client.

The Clearing Corporation/House shall hold the clients’ margin money in trust for the client
purposes only and should not allow its diversion for any other purpose.The Clearing
Corporation/House shall have a separate Trade Guarantee Fund for the trades executed
on Derivative Exchange / Segment. Presently, SEBI has permitted Derivative Trading on the
Derivative Segment of BSE and the F&O Segment of NSE.
Membership categories in the Derivatives Market

The various types of membership in the derivatives market are as follows:

1. Professional Clearing Member (PCM):

PCM means a Clearing Member, who is permitted to clear and settle trades on his own
account, on account of his clients and/or on account of trading members and their lients.

2. Custodian Clearing Member (CCM):

CCM means Custodian registered as Clearing Member, who may clear and settle trades on
his own account, on account of his clients and/or on account of trading members and their
clients.

3. Trading Cum Clearing Member (TCM):

A TCM means a Trading Member who is also a Clearing Member and can clear and settle
trades on his own account, on account of his clients and on account of associated Trading
Members and their clients.

4. Self Clearing Member (SCM):

A SCM means a Trading Member who is also Clearing Member and can clear and settle
trades on his own account and on account of his clients.

5. Trading Member (TM):

A TM is a member of the Exchange who has only trading rights and whose trades are
cleared and settled by the Clearing Member with whom he is associated.
6. Limited Trading Member (LTM):

A LTM is a member, who is not the members of the Cash Segment of the Exchange, and
would like to be a Trading Member in the Derivatives Segment at BSE. An LTM has only the
trading rights and his trades are cleared and settled by the Clearing Member with whom he
is associated. As on January 31, 2002, there are 1 Professional Clearing Member, 3
Custodian Clearing Members, 75 trading cum Clearing Members, 93 Trading Members and
17 Limited Trading Members in the Derivative Segment of the Exchange.

Financial Requirement for Derivatives Membership:

The most basic means of controlling counterparty credit and liquidity risks is to deal only
with creditworthy counterparties. The Exchange seeks to ensure that their members are
creditworthy by laying down a set of financial requirements for membership.

The members are required to meet, both initially and on an ongoing basis, minimum
networth requirement. Unlike Cash Segment membership where all the trading members
are also the clearing members, in the Derivatives Segment the trading and clearing rights
are segregated.

In other words, a member may opt to have both clearing and trading rights or he may opt
for trading rights only in which case his trades are cleared and settled by the Clearing
Member with whom he is associated. Accordingly, the networth requirement is based on the
type of membership and is as under:
Networth requirement is based on the type of membership:

Type of Membership Networth

Requirement

Professional Clearing Member, Custodian Clearing 300 lakhs

Member and Trading cum Clearing Member

Self Clearing Member 100 lakhs

Trading Member 25 lakhs

Limited Trading Member 25 lakhs

Limited Trading Member ( for members of other stock 10 lakhs

exchange whose Clearing Member is a subsidiary company

of a Regional Stock Exchange)

 Requirements to be a member of the derivatives exchange/ clearing corporation Balance
Sheet Networth Requirements: SEBI has prescribed a networth requirement of Rs. 3 crores
for clearing members. The clearing members are required to furnish an auditor's certificate
for the networth every 6 months to the exchange. The networth requirement is Rs. 1 crore
for a self-clearing member.

SEBI has not specified any networth requirement for a trading member. Liquid Networth
Requirements: Every clearing member (both clearing members and self-clearing members)
has to maintain atleast Rs. 50 lakhs as Liquid Networth with the exchange / clearing
corporation. Certification requirements:

The Members are required to pass the certification programme approved by SEBI. Further,
every trading member is required to appoint atleast two approved users who have passed
the certification programme. Only the approved users are permitted to operate the
derivatives trading terminal.

Requirements for a Member with regard to the conduct of his business

The derivatives member is required to adhere to the code of conduct specified under
the SEBI Broker Sub-Broker regulations. The following conditions stipulations have been
laid by SEBI on the regulation of sales practices:

 Sales Personnel: The derivatives exchange recognizes the persons recommended by

the Trading Member and only such persons are authorized to act as sales personnel of the
TM. These persons who represent the TM are known as Authorised Persons.

 Know-your-client: The member is required to get the Know-your-client form filled by

every one of client. Risk disclosure document: The derivatives member must educate his
client on the risks of derivatives by providing a copy of the Risk disclosure document to the
client. Member-client agreement: The Member is also required to enter into the Member-
client agreement with all his clients.
Derivative contracts that are permitted by SEBI

Derivative products have been introduced in a phased manner starting with Index Futures
Contracts in June 2000. Index Options and Stock Option were introduced in june 2001 and
July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for
derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill
priced off ZCYC have been introduced in June 2003 and exchange traded interest rate
futures on a notional bond priced off a basket of Government Securities were permitted for
trading in January 2004.

Eligibility criteria for stocks on which derivatives trading may be

permitted

A stock on which stock option and single stock future contracts are proposed to be
introduced is required to fulfill the following broad eligibility criteria:-

The stock shall be chosen from amongst the top 500 stock in terms of average daily market
capitalization and average daily traded value in the previous six month on a rolling basis.

The stock’s median quarter-sigma order size over the last six months shall be not less than
Rs.1 Lakh. A stock’s quarter-sigma order size is the mean order size (in value terms)
required to cause a change in the stock price equal to one-quarter of a standard deviation.
The market wide position limit in the stock shall not be less than Rs.50 crores.

A stock can be included for derivatives trading as soon as it becomes eligible. However, if
the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted
to derivatives trading, then derivative contracts on such a stock would be discontinued.
Minimum contract size

The Standing Committee on Finance, a Parliamentary Committee, at the time of

recommending amendment to Securities Contract (Regulation) Act, 1956 had
recommended that the minimum contract size of derivative contracts traded in the Indian
Markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has
specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the
time of introducing the contract in the market. In February 2004, the Exchanges were
advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakhs.
Subsequently, the Exchanges were authorized to align the contracts sizes as and when
required in line with the methodology prescribed by SEBI.

Lot size of a contract

Lot size refers to number of underlying securities in one contract. The lot size is determined
keeping in mind the minimum contract size requirement at the time of introduction of
derivative contracts on a particular underlying.

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum

contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be

200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
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 Fund Management (Managing Clients' Assets-Pension/PF Fund Managers)
 Research Group
IDBI Capital is highly regarded for safety and trust and enjoys a credit rating of “AAA” by
CARE for its medium-term borrowings and P1+ by ICRA for its short-term borrowings.

IDBI Capital Market Services Limited

IDBI Capital Market Services Ltd. (head quartered in Mumbai), is a leading provider of financial
services and is a 100% subsidiary of IDBI Bank Ltd.

The company was set up in 1993 with the objective of catering to specific financial
requirements of financial institutions, banks, mutual funds and corporate houses. The company
provides a complete range of financial products and services that includes:

• Stock Broking-Institutional and Retail

• Derivatives Trading
• Distribution of Mutual Funds

Financial Advisory

Financial Advisory has been considered as a strategic function requiring innovative and distinct
financial solutions both long and short term focused on delivering greater shareholder value.
IDBI Capital Market Services Limited occupies a leading position being a wholly owned
subsidiary of IDBI Bank in the Corporate Finance Market place. We support our clients by
offering those creative ideas and solutions that facilitates in enhancing the value.

We broadly advise on the following on the Financial Advisory space:

 Business Valuation
 Financial & Commercial Due Diligence
 Merchant Financial Appraisal
 Joint Venture & Contract
 Bid Process Management
 Disinvestments
 Infrastructure Advisory
  Financial / Debt Restructuring

Structured Finance & Securitisation

Capital Markets

IDBI Capital as an institutional player provides the entire gamut of Capital Market services
encompassing:

1. Public Offerings
2. Qualified Institutional Placements
3. Buyback
4. Takeover
5. Preferential Allotments
6. External Commercial Borrowings, FCCBs, etc.

The above activities entails liasioning with institutional investors such as treasury departments
of Domestic Institutions, Banks and corporates, fund managers of mutual funds, private equity
firms, FIIs, HNIs.

IPO / FPO / RIGHT ISSUES

IDBI Capital Market Services Ltd. (ICMS), as a Securities and Exchange Board of India (SEBI)
registered Merchant Banker, provides the following services:

 Public issue of Equity and Debt Instruments in Indian markets through Initial Public
Offering (IPO), Follow on Public Offering (FPO) and Rights Issue
 Acts as a Book Running Lead Manager, a Lead Manager, a Co-Manager or an Advisor
to the Issue.
 Underwrites Issues of Equity and Debt Instruments.
  Markets various instruments with Qualified Institutional Buyers (QIBs), High Networth
Individuals (HNIs), Corporate and Retail investors.
 Prepares all documents like Prospectus / Letter of Offer and assists the Issuer in
complying with legal and statutory requirements of SEBI, Stock Exchanges, Registrar of
Companies (ROC) and authorities under various corporate laws and economic laws for
issue of securities.

Advisory services on structuring of capital and debt, timing for raising the same, choice of
agencies to assist in the process of raising funds, etc.

Takeover

IDBI Capital helps corporate and institutional clients to carry out successful takeovers on the
Exchange listed companies. IDBI Capital helps carry out the Due Diligence exercise in
accordance with relevant SEBI Rules / Regulations / Guidelines followed by the preparation of
legal documentation connected with Buybacks and Take-overs.

Buyback of Securities

IDBI Capital is active in assisting its clients in buy-back programmes. With the presence of a
strong Broking services, the Company is in a position to offer comprehensive solutions to
accomplish buy-back programmes.

Qualified Institutional Placement

IDBI Capital adds value to QIP issues which can be done only by listed Companies to raise
additional equity from Qualified Institutional Buyers (QIBs). The strong relationship of IDBI
Capital with the different categories of QIB, FIIs, Fis, Mutual Funds, Banks etc., makes a
difference to the QIP placement programmes of the Companies. This is backed by a strong
research support.
Private Equity

We have developed strong expertise across different industries, which enable us to structure
the transaction in that context. In Private Equity (PE), we focus on sectors ranging from
Infrastructure, Power, Telecom, Healthcare & Life Sciences, Pharmaceuticals, Hospitality,
Banking, Logistics, Media, Auto Ancillaries / Components, Cement, Steel, etc to name a few.
Our strength in Private Equity advisory is on account of:

 Strong relationships with PE funds and their key decision makers

 Strong execution team gives an edge on optimal structuring and efficient closure of
transactions
 Value addition on entire structure of activities

Our PE transaction doesn’t come to an end with the transfer of funds but also cater to entire
gamut of Investment Banking needs. IDBI Capital enables strong growth oriented companies
raise capital through;

• Preparation of Business and Financial Plans

• Preparation of the Information Memorandum
• Discussions and Negotiations with prospective investors

Deal closure and Execution

INVESTMENT BANKING

Our Clients
We represent Government organizations, Public Sector Enterprises and Indian Corporates
covering sectors such as Steel and other metals, Mines, Minerals, Chemicals, Healthcare,
Hospitality, Financial Services and other Core Sectors.

Our Team
We have a combination of professionals with varied background who shares our values of
truthfulness, objectivity, innovation and analytical accuracy. The professional qualification of
our team provide a rock solid foundation for giving consulting services and our depth of
experience ranges from young management graduates from premier business schools to
experienced finance professional and qualified chartered accountants as well.

PROJECT ADVISORY

IDBI Capital has considerable expertise in Project Advisory / Finance. We advise our clients
right from the project conception stage followed by preparation of the Project Report and its
Techno-Commercial Appraisal with the support of accredited institutions with optimal financial
structuring. These reports pave the way for contracting project loans for green-field as well as
expansion projects.

Our Project Advisory would also include turnkey advisory services on financial structuring,
implementation and documentation aspects of Green-field Projects, Brown Field Projects and
Public Private Partnership Projects. The scope of work ranges from negotiations with Banks,
Financial Institutions and Multilateral agencies for obtaining the final loan sanctions. Our Project
Advisory Services broadly include:

 Overview of the promoting company / SPV

 Review of the Project Structure and Project Costs including various assumptions.
 Capital Structuring
 Real Estate Advisory
 Identification and evaluation of various sources of finance
 Financial modeling
 Risk Analysis and Allocation
 Development of a Security Package

Corporate Advisory
IDBI Capital Market Services Limited support Promoters and Senior Management
professionals of Corporate to acquire new perspectives and dimensions on Competitive
Strategy that will give Competitive Advantage. Our deliverables and advice focuses on
delivering timely and researched information for the ultimate decision-making. Our financial
and strategic advisory and analysis will provide necessary inputs to key stake holder (s) for
taking decisions for enhancing shareholder value. Our key advisory areas are:

a. Mergers and Acquisitions

b. Strategic Advisory

MERGERS & ACQUISTIONS

There are several means a Corporate adopt to improve shareholder value e.g. increased
revenue, market share, geographical expansion, diversification, economies of scale; or to
integrate through Merger & Acquisition. Broadly speaking, M&A drivers could be customer
acquisition and top line growth, new market entry or competence building. IDBI Capital’s M&A
Advisory services covers right from the initial negotiation stage to the final deal conclusion. We
address the following while taking up Mergers and Acquisitions;

 Business valuations and managing the entire merger process

 Assisting companies in acquisitions as sell off as joint ventures
 Assisting the Company in financing the deal
 Managing Open Offers
 Evaluating bids on the basis of the evaluation criteria set out
 Assisting in closing the deal

Post Merger Integration

STRATEGIC ADVISORY
Strategic Planning provides the framework for all the major business decisions of an
enterprises-decision on businesses, products & markets, manufacturing facilities, investments
& organizational structure. It is indeed act as a pathfinder to various business opportunities.

IDBI Capital assists clients in formulating strategy, developing solutions and successfully
managing results. We work with clients to define their business strategy and implement
interactive solutions that redefine relationships with customers, suppliers and employees. We
help clients improve business performance by delivering a complete, business-focused menu
of end-to-end business solutions. We broadly cover:

 Business and Strategic Planning

 Business Restructuring
 Entry Strategy
 Policy Advisory
 Organization Restructuring
 Bid Process Management

Process Consulting

INSTITUTIONAL BROKING & DISTRIBUTION

Institutions and Corporates have surplus funds to manage on daily basis as well as investible
surplus for a defined period. The risk differs for Institution and Corporates subject to their
preferences. The reward by way of return is always in proportion to the risk taken. IDBI Capital
define, advise and manage the same by blending caution with aggression in the desired
proportion to teach client. The range of services include from Equity Broking with customized
research, advisory and distribution services for investment in Mutual Funds, Debt/Bonds,
Equity IPOs to placement of Equities etc

EQUITY SALES & DEALING

  The Institutional Broking Desk offers the Clients with a dealing platform for trading in
NSE and BSE. The parameters on market conditions with an astute technical analysis
from the Dealing Desk enable the clients to take an apt decision. The intra day analysis
and reports are also available to clients on customized basis.
 Further the Institutional Clients are provided with the Derivatives Trading desk for
Futures and Option. The Institutional Clients are updated with fresh research Ideas on
the happening Scrip and Sectors.
 Being well connected with the global market Via Bloomberg, the updates are shared
from time to time.
 The interpreted brief report on the Futures and Option positions before the Expiry is
published for Client’s Circulation.

Daily market information is disseminated to the clients under ‘Heard on Street’ News heads.

EQUITY RESEARCH

We have research desks covering all aspects of the equities. Our equities research desk
publishes high quality research on all major sectors of the industry and covers a wide spectrum
of companies listed on the Indian stock exchanges. Our derivatives research team publishes
daily/monthly reports on the trends in the equity derivatives markets.

Our objective, uncomplicated and reliable research reports on global markets and equity
empower institutional investors and make it possible for them to make informed investment
decisions. Our research teams have made a name for themselves in a very short time.

MUTUAL FUND SALES & DEALING

Several factors need to be taken into account when choosing an instrument for investment –
among these being safety, liquidity & return related to the risk undertaken. Coming to the
choice of instruments, we have equity, debt, money market, commodity based or even global
equities. Mutual funds provide all this and more.
Mutual funds offer an investment portfolio which can be either diversified in nature or specific
in category with risk skewed towards debt to equity in varying proportions, all in one under one
umbrella. Mutual Funds cater to the specific requirement of the Investor be it Institutional or
Individual.

IDBI Capital Market Services Ltd. is into Mutual Fund Distribution, Advisory and Fund
Management. We address the needs of any type of investor from corporate, banks, trusts,
firms, and societies to NRIs, HNIs and individual retail clients

We have been recognized as among the best financial advisers in the country, and have been
conferred with the CNBC TV 18 Financial Advisor Awards as the Best Performing National
Financial Advisor –Institutional segment in India for the past two consecutive years.

As a distributor registered with almost all the SEBI Registered Mutual Funds in India, we have
also started offering Mutual funds to our retail customers, both off-line and on-line.

MUTUAL FUND RESEARCH

The degree of risk in a Mutual Fund varies with the diversity in portfolio and the combination of
assets. Add to this the different classes of instruments. Judging the best investments avenues
calls for astute incisive knowledge on markets and individual companies.

The research desk of IDBI Capital Market Ltd. publishes a number of detailed research
Reports on the Mutual Fund Industry viz.
(i) Daily Report – detailing the NAV and growth of the schemes on various periods
(ii) MF Monthly – with coverage on the Equity, Debt and Mutual Fund market
(iii) Customised Sector Reports and
(iv) Scheme Reports for Special Clients.

Customized Reports are provided to specific institutional / corporate clients. The universe for
every category is selected from the entire industry and rigorous analysis undertaken including
peer comparison. Various tools and techniques are used, from studying the Alpha of every
scheme with Standard Deviation to Beta Analysis to Tryenor and Sortino.

RETAIL BROKING & DISTRIBUTION

In addition to offering corporate, institutional clients, IDBI Capital also offers a gamut of
financial products and services that cater to a varied cross section of investors.
IDBI Capital also offers to financial planners, retail intermediaries and consumers to deliver
lasting, innovative solutions.

Looking at the opportunities in our market and the growth of our country, we believe it is high
time investors are educated about the nuances of investments. The knowledge and awareness
gained will empower investors and help them create wealth. We firmly believe brokers, media
and regulators have a pivotal role in assisting the individuals to become wealthy. We will go
extra mile to empower the investors in managing their wealth to ensure a more rewarding future.

IDBI Capital aims to provide a single-point source for retail investors in their requirements for
trading and investment products.

ONLINE INVESTING

Online investing provides investors with a convenient method to take part in today’s financial
markets. With our commitment to enhancing investor education and awareness as a
foundation stone, we have created an online investing website www.idbipaisabuilder.in for
trading and depository services. This platform enables easy and informed investing in Equity
shares, Futures & Options (F&O), IPO’s and Mutual Funds, for the retail investors with a
wealth of information, news, analysis and tools sourced from the best in the industry. It also
brings a large database of information about companies which will assist them in making an
informed investment decision.

We strive to empower you with information that helps you make informed decisions and bank
upon the right opportunity. We bring you lots of useful information by way of our varied market
research reports on equity, derivatives, and mutual funds

We offer an integrated three-in-one account linking savings account, trading account and the
demat account. Now investing in Equity, Mutual funds and IPO’s is just a click away.

IPO DISTRIBUTION

Investment Banking Activities

We have in the last financial year successfully lead managed public/rights issues mobilizing
more than Rs.900 crores. Some of the notable examples were the Central Bank of India ‘s IPO
and Varun Industries Ltd fixed price issue. The responses to our issues have been heartening.

Initial Public Offerings (IPO)

We are reaching out to the investors thru

 10,000 sub-brokers/agents spread across the country.

 Our 40 thousands online investors.
 and our own 25 branches.

We market and distribute IPOs of all lead investment bankers, including our owned lead
managed issues. In IPO distribution, the marketing effort is the key, which enables us to carry
out the vigorous exercise of

 Putting the banners of the IPO on our portal and all across our branches.
 Sending the emails to all our investors about the impending IPOs and the product note.
 Sending SMS to all of them.
 Making available the IPO application forms, in all our branches.

All our branches are in marketing & distribution of IPO application forms, where we accept and
bid the application forms to the exchange.
Our Credentials
We are a leading full service securities house, offering a complete suite of financial products
and services to individual, institutional and corporate clients:
  Wholly owned subsidiary of IDBI Bank Ltd.
 A well-capitalized financial position - networth of over Rs.350 crores as on 31st March
2008.
 A private equity fund of Rs.100 crores for investment in Mid Cap and SME Growth
Companies
 A leading player in Private Placement of Tier II bonds and debentures for institutions,
banks and corporates.

We manage Provident and Pension Funds of more than Rs.8,250 crores

MUTUAL FUND DISTRIBUTION

Several factors need to be taken into account when choosing an instrument for investment –
among these being safety, liquidity & return related to the risk undertaken. Coming to the
choice of instruments, we have equity, debt, money market, commodity based or even global
equities. Mutual funds provide all this and more.
Mutual funds offer an investment portfolio which can be either diversified in nature or specific
in category with risk skewed towards debt to equity in varying proportions, all in one under one
umbrella. Mutual Funds cater to the specific requirement of the Investor be it Institutional or
Individual.

IDBI Capital Market Services Ltd. is into Mutual Fund Distribution, Advisory and Fund
Management. We address the needs of any type of investor from corporate, banks, trusts,
firms, and societies to NRIs, HNIs and individual retail clients

We have been recognized as among the best financial advisers in the country, and have been
conferred with the CNBC TV 18 Financial Advisor Awards as the Best Performing National
Financial Advisor –Institutional segment in India for the past two consecutive years.
As a distributor registered with almost all the SEBI Registered Mutual Funds in India, we have
also started offering Mutual funds to our retail customers, both off-line and on-line.

We distribute and advise on the schemes of all the Mutual Fund Houses registered with SEBI.

FUND MANAGEMENT

IDBI Capital Market Services Ltd. (ICMS) is a leading Fund Manager in the country for
Provident, Pension and Retirement Benefit Funds. The Company is a SEBI registered Portfolio
Manager and manage its Client’s assets under both discretionary and non-discretionary
mandates. These services are provided to various public and private sector undertakings and
their provident, pension, retirement benefit and surplus funds. The Company’s client base
includes leading pension and provident funds in the country.

IDBI capital has been advising institutions, banks and corporates for their investment in Debt,
Mutual Funds and Equities over several years. Its services include managing Client Assets--
Pension & Provident Funds, Surplus fund Management, Equity Portfolio Management and
Mutual Fund Advisory.

The funds have continuously yielded superior returns, which are significantly higher than the
benchmark.

ISO Certification 9001:2000

Keeping in view the importance of standardized processes and service levels, the Company

has gone in for ISO Certification for Fund Management, and is the only company to have done
so in this sector. Being a public sector, the Company is also audited by Comptroller and
Auditor General (CAG) office and follows transparent practices.

Regulatory Approval
IDBI Capital is a registered Portfolio Manager with Securities and Exchange Board of India
(SEBI) since 1998 and is authorised to undertake Funds Management activities (Debt &
Equity) for clients. These activities would be governed by Securities and Exchange Board of
India (Portfolio Managers) Rules and Regulations, 1993. SEBI Regisration No. of IDBI Capital
is INP000000209, valid till the year 2010.

The Key strengths of IDBI capital Market Services in the areas of Debt Fund
Management are:

1. Fund Management experience of 10 years

2. Expertise in managing large corpus
3. Expertise in both Debt & Equity Market
4. IDBI Capital is the only Portfolio Manager in the Country to achieve ISO 9001: 2000
Standard for Quality Management Systems in Fund Management operations, with
certification from TUV NORD an accredited German standards firm
5. Substantial Returns Over Benchmark
6. IDBI Capital is a SEBI registered Portfolio Manager
7. Minimum Idle Days
8. Our fund management skill covers Portfolio Analysis that includes ALM, Asset
Allocation, Risk Analysis, Maturity Analysis and Yield Analysis
9. Transparency of Operations
10. Strict adherence to Compliance Procedures
11. Highly Rated Debt Research
12. Presence in All Segment/ Asset of the Financial Services: IDBI Capital deals in Equity
and Equity related products and is one of the highly rated Mutual Fund Distributor (won
two consecutive CNBC TV18 Institutional Financial Advisor Award). In Investment
Banking and Debt Capital Market- Rated in Top 15 by Prime Database
13. Group Strength in Debt Market: IDBI Capital is one of the leading players in debt market
with presence in primary dealership since July 2007. The current operations of primary
dealership is conducted by a group company, IDBI Gilts

INFRASTRUCTURE

 Experienced Fund Management Team: The Fund Management team comprises of

experienced professionals (experience ranges between 2 years to 15 years) in Portfolio
 Management with requisite exposure in the fixed income and equity segment and
qualifications
 Experienced Back-Office: The Clearing and Settlement Operations are manned by
experienced personnel with requisite exposure to capital market and particularly debt
market. The process is standardized as per the regulatory and other specific norms and
mainly technology driven in most areas Accounting: Real time accounting of
Remittances, Investments, Interest and Redemption proceeds ensures accurate
reconciliation
 Professional Custodian: Member of NSDL for demat services and offers Constituent
SGL Account facility for Government securities through IDBI Gilts Ltd.
 Functional Separation of Front and Back Office: Separate personnel handle the front
and back office functions to ensure transparency and complete regulatory compliance
 Internal Controls: Adequate Risk Management systems in place to ensure complete
regulatory compliance
 Audit Systems: Audit of all transactions and reports by an independent firm of
chartered accountants. The accounts and transactions are also subject to CAG audit
and other regulators

Belongs to IDBI Group: IDBI is a leading bank, classified under ‘Other Public Sector Bank’.
Established in 1964 by Government of India under an Act of Parliament, IDBI has essayed a
significant role in the country’s industrial and economic progress for over 40 years – first as
apex Development Financial Institution (DFI) and now as a full service commercial bank.
.

MYTHS AND REALITIES ABOUT DERIVATIVES

In our fast-changing financial services industry, coercive regulations intended to restrict
banks' activities will be unable to keep up with financial innovation. As the lines of
demarcation between various types of financial service providers continues to blur, the
bureaucratic leviathan responsible for reforming banking regulation must face the fact that
fears about derivatives have proved unfounded. New regulations are unnecessary. Indeed,
access to risk-management instruments should not be feared but, with caution, embraced to
help firms manage the vicissitudes of the market.

In this paper 10 common misconceptions about financial derivatives are explored. Believing
just one or two of the myths could lead one to advocate tighter legislation and regulatory
measures designed to restrict derivative activities and market participants. A careful review
of the risks and rewards derivatives offer, however, suggests that regulatory and legislative
restrictions are not the answer. To blame organizational failures solely on derivatives is to
miss the point. A better answer lies in greater reliance on market forces to control
derivative-related risk taking.
Financial derivatives have changed the face of finance by creating new ways to understand,
measure, and manage risks. Ultimately, financial derivatives should be considered part of
any firm's risk-management strategy to ensure that value-enhancing investment
opportunities are pursued. The freedom to manage risk effectively must not be taken away.

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?

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial Products Myth
Number 2: Derivatives Are Purely Speculative, Highly Leveraged Instruments

Myth Number 3: The Enormous Size of the Financial Derivatives Market Dwarfs Bank
Capital, Thereby Making Derivatives Trading an Unsafe and Unsound Banking Practice

Myth Number 4: Only Large Multinational Corporations and Large Banks Have a Purpose
for Using Derivatives

Myth Number 5: Financial Derivatives Are Simply the Latest Risk-Management Fad

Myth Number 6: Derivatives Take Money Out of Productive Processes and Never Put
Anything Back.

Myth Number 7: Only Risk-Seeking Organizations Should Use Derivatives

 Myth Number 8: The Risks Associated with Financial Derivatives Are New and Unknown

Myth Number 9: Derivatives Link Market Participants More Tightly Together, Thereby
Increasing Systemic Risks

Myth Number 10: Because of the Risks Associated with Derivatives, Banking Regulators
Should Ban Their Use by Any Institution Covered by Federal Deposit Insurance

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial

Products Created by Wall Street's Rocket Scientists

Financial derivatives are not new; they have been around for years. A description of the first
known options contract can be found in Aristotle's writings. He tells the story of Thales, a
poor philosopher from Miletus who developed a "financial device, which involves a principle
of universal application." People reproved Thales, saying that his lack of wealth was proof
that philosophy was a useless occupation and of no practical value. But Thales knew what
he was doing and made plans to prove to others his wisdom and intellect.

Thales had great skill in forecasting and predicted that the olive harvest would be
exceptionally good the next autumn. Confident in his prediction, he made agreements with
area olive-press owners to deposit what little money he had with them to guarantee him
exclusive use of their olive presses when the harvest was ready.
Thales successfully negotiated low prices because the harvest was in the future and no one
knew whether the harvest would be plentiful or pathetic and because the olive-press owners
were willing to hedge against the possibility of a poor yield.

Aristotle's story about Thales ends as one might guess: "When the harvest-time came, and
many [presses] were wanted all at once and of a sudden, he let them out at any rate which
he pleased, and made a quantity of money.

Thus he showed the world that philosophers can easily be rich if they like, but that their
ambition is of another sort." So Thales exercised the first known options contracts some
2,500 years ago. He was not obliged to exercise the options. If the olive harvest had not
been good, Thales could have let the option contracts expire unused and limited his loss to
the original price paid for the options. But as it turned out, a bumper crop came in, so Thales
exercised the options and sold his claims on the olive presses at a high profit.

Options are just one type of derivative instrument. Derivatives, as their name implies, are
contracts that are based on or derived from some underlying asset, reference rate, or index.
Most common financial derivatives, described later, can be classified as one, or a
combination, of four types: swaps, forwards, futures, and options that are based on interest
rates or currencies.

Most financial derivatives traded today are the "plain vanilla" variety--the simplest form of a
financial instrument. But variants on the basic structures have given way to more
sophisticated and complex financial derivatives that are much more difficult to measure,
manage, and understand. For those instruments, the measurement and control of risks can
be far more complicated, creating the increased possibility of unforeseen losses.

Wall Street's "rocket scientists" are continually creating new, complex, sophisticated financial
derivative products. However, those products are all built on a foundation of the four basic
types of derivatives.

Most of the newest innovations are designed to hedge complex risks in an effort to reduce
future uncertainties and manage risks more effectively. But the newest innovations require a
firm understanding of the tradeoff of risks and rewards.

To that end, derivatives users should establish a guiding set of principles to provide a
framework for effectively managing and controlling financial derivative activities. Those
principles should focus on the role of senior management, valuation and market risk
management, credit risk measurement and management, enforceability, operating systems
and controls, and accounting and disclosure of risk-management positions. [4]

Myth Number 2: Derivatives Are Purely Speculative, Highly Leveraged

Instruments

Put another way, this myth is that "derivatives" is a fancy name for gambling. Has
speculative trading of derivative products fueled the rapid growth in their use? Are
derivatives used only to speculate on the direction of interest rates or currency exchange
rates? Of course not. Indeed, the explosive use of financial derivative products in recent
years was brought about by three primary forces: more volatile markets, deregulation, and
new technologies.

The turning point seems to have occurred in the early 1970s with the breakdown of the
fixed-rate international currency exchange regime, which was established at the 1944
conference at Bretton Woods and maintained by the International Monetary Fund. Since
then currencies have floated freely. Accompanying that development was the gradual
removal of government-established interest-rate ceilings when Regulation Q interest-rate
restrictions were phased out. Not long afterward came inflationary oil-price shocks and wild
interest-rate fluctuations. In sum, financial markets were more volatile than at any time since
the Great Depression.

Banks and other financial intermediaries responded to the new environment by developing
financial risk-management products designed to better control risk. The first were simple
foreign-exchange forwards that obligated one counterparty to buy, and the other to sell, a
fixed amount of currency at an agreed date in the future.

By entering into a foreign-exchange forward contract, customers could offset the risk that
large movements in foreign-exchange rates would destroy the economic viability of their
overseas projects. Thus, derivatives were originally intended to beused to effectively hedge
certain risks; and, in fact, that was the key that unlocked their explosive development.

Beginning in the early 1980s, a host of new competitors accompanied the deregulation of
financial markets, and the arrival of powerful but inexpensive personal computers ushered
in new ways to analyze information and break down risk into component parts. To serve
customers better, financial intermediaries offered an ever-increasing number of novel
products designed to more effectively manage and control financial risks. New technologies
quickened the pace of innovation and provided banks with superior methods for tracking
and simulating their own derivatives portfolios.

From the simple forward agreements, financial futures contracts were developed. Futures
are similar to forwards, except that futures are standardized by exchange clearinghouses,
which facilitates anonymous trading in a more competitive and liquid market. In addition,
futures contracts are marked to market daily, which greatly decreases counterparty risk--the
risk that the other party to the transaction will be unable to meet its obligations on the
maturity date.
Around 1980 the first swap contracts were developed. A swap is another forward-based
derivative that obligates two counterparties to exchange a series of cash flows at specified
settlement dates in the future. Swaps are entered into through private negotiations to meet
each firm's specific risk-management objectives. There are two principal types of swaps:
interest-rate swaps and currency swaps.

Today interest-rate swaps account for the majority of banks' swap activity, and the fixed-for-
floating-rate swap is the most common interest-rate swap. In such a swap, one party agrees
to make fixed-rate interest payments in return for floating-rate interest payments from the
counterparty, with the interest-rate payment calculations based on a hypothetical amount of
principal called the notional amount.

Myth Number 3: The Enormous Size of the Financial Derivatives Market

Dwarfs Bank Capital, Thereby Making Derivatives Trading an Unsafe and
Unsound Banking Practice

The financial derivatives market's worth is regularly reported as more than $20 trillion. That
estimate dwarfs not only bank capital but also the nation's $7 trillion annual gross domestic
product. Those often-quoted figures are notional amounts. For derivatives, notional principal
is the amount on which interest and other payments are based. Notional principal typically
does not change hands; it is simply a quantity used to calculate payments.

While notional principal is the most commonly used volume measure in derivatives markets,
it is not an accurate measure of credit exposure. A useful proxy for the actual exposure of
derivative instruments is replacement-cost credit exposure. That exposure is the cost of
replacing the contract at current market values should the counterparty default before the
settlement date.

For the 10 largest derivatives players among U.S. bank holding companies, derivative credit
exposure averages 15 percent of total assets. The average exposure is 49 percent of
assets for those banks' loan portfolios. In other words, if those 10 banks lost 100 percent on
their loans, the loss would be more than three times greater than it would be if they had to
replace all of their derivative contracts.

Derivatives also help to improve market efficiencies because risks can be isolated and sold
to those who are willing to accept them at the least cost. Using derivatives breaks risk into
pieces that can be managed independently. Corporations can keep the risks they are most
comfortable managing and transfer those they do not want to other companies that are
more willing to accept them. From a market-oriented perspective, derivatives offer the free
trading of financial risks.

The viability of financial derivatives rests on the principle of comparative advantage--that is,
the relative cost of holding specific risks. Whenever comparative advantages exist, trade
can benefit all parties involved. And financial derivatives allow for the free trading of
individual risk components.

Myth Number 4: Only Large Multinational Corporations and Large Banks

Have a Purpose for Using Derivatives

Very large organizations are the biggest users of derivative instruments. However, firms of
all sizes can benefit from using them. For example, consider a small regional bank (SRB)
[5]
with total assets of $5 million (Figure 1). The SRB has a loan portfolio composed primarily
of fixed-rate mortgages, a portfolio of government securities, and interest-bearing deposits
that are often repriced. Two illustrations of how SRBs can use derivatives to hedge risks
follow.
First, rising interest rates will negatively affect prices in the SRB's $1 million securities
portfolio. But by selling short a $1 million Treasury-bond futures contract, the SRB can
effectively hedge against that interest-rate risk and smooth its earnings stream in a volatile
market. If interest rates went higher, the SRB would be hurt by a drop in value of its
securities portfolio, but that loss would be offset by a gain from its derivative contract.
Similarly, if interest rates fell, the bank would gain from the increase in value of its securities
portfolio but would record a loss from its derivative contract. By entering into derivatives
contracts, the SRB can lock in a guaranteed rate of return on its securities portfolio and not
be as concerned about interest-rate volatility.

The economic benefits of derivatives are not dependent on the size of the institution trading
them. The decision about whether to use derivatives should be driven, not by the company's
size, but by its strategic objectives. The role of any risk-management strategy should be to
ensure that the necessary funds are available to pursue value-enhancing investment
opportunities.

However, it is important that all users of derivatives, regardless of size, understand how
their contracts are structured, the unique price and risk characteristics of those instruments,
and how they will perform under stressful and volatile economic conditions. A prudent risk-
management strategy that conforms to corporate goals and is complete with market
simulations and stress tests is the most crucial prerequisite for using financial derivative
products

Myth Number 5: Financial Derivatives Are Simply the Latest Risk-

Management Fad

Financial derivatives are important tools that can help organizations to meet their specific
risk-management objectives. As is the case with all tools, it is important that the user
understand the tool's intended function and that the necessary safety precautions be taken
before the tool is put to use.
Builders use power saws when they construct houses. And just as a power saw is a useful
tool in building a house--increasing the builder's efficiency and effectiveness--so financial
derivatives can be useful tools in helping corporations and banks to be more efficient and
effective in meeting their risk-management objectives. But power saws can be dangerous
when not used correctly or when used blindly.

If users are not careful, they can seriously injure themselves or ruin the project. Likewise,
when financial derivatives are used improperly or without a plan, they can inflict pain by
causing serious losses or propelling the organization in the wrong direction so that it is ill
prepared for the future.

When used properly, financial derivatives can help organizations to meet their risk-
management objectives so that funds are available for making worthwhile investments.
Again, a firm's decision to use derivatives should be driven by a risk-management strategy
that is based on broader corporate objectives.

The most basic questions about a firm's risk-management strategy should be addressed:
Which risks should be hedged and which should remain unhedged? What kinds of
derivative instruments and trading strategies are most appropriate? How will those
instruments perform if there is a large increase or decrease in interest rates? How will those
instruments perform if there are wild fluctuations in exchange rates?

Without a clearly defined risk-management strategy, use of financial derivatives can be

dangerous. It can threaten the accomplishment of a firm's long-range objectives and result
in unsafe and unsound practices that could lead to the organization's insolvency. But when
used wisely, financial derivatives can increase shareholder value by providing a means to
better control a firm's risk exposures and cash flows.
Clearly, derivatives are here to stay. We are well on our way to truly global financial markets
that will continue to develop new financial innovations to improve risk-management
practices. Financial derivatives are not the latest risk-management fad; they are important
tools for helping organizations to better manage their risk exposures.

Myth Number 6: Derivatives Take Money Out of Productive Processes

and Never Put Anything Back

Financial derivatives, by reducing uncertainties, make it possible for corporations to initiate

productive activities that might not otherwise be pursued. For example, an Italian company
may want to build a manufacturing facility in the United States but is concerned about the
project's overall cost because of exchange-rate volatility between the lira and the dollar.

To ensure that the company will have the necessary cash available when it is needed for
investment, the Italian manufacturer should devise a prudent risk-management strategy that
is in harmony with its broader corporate objective of building a manufacturing facility in the
United States. As part of that strategy, the Italian firm should use financial derivatives to
hedge against foreign-exchange risk. Derivatives used as a hedge can improve the
management of cash flows at the individual firm level.

To ensure that productive activities are pursued, corporate finance and treasury groups
should transform their operations from mundane bean counting to activist financial risk
management. They should integrate a clear set of risk-management goals and objectives
into the organization's overall corporate strategy. The ultimate goal is to ensure that the
organization has the necessary funds at its disposal to pursue investments that maximize
shareholder value. Used properly, financial derivatives can help corporations to reduce
uncertainties and promote more productive activities.

Myth Number 7: Only Risk-Seeking Organizations Should Use Derivatives

Financial derivatives can be used in two ways: to hedge against unwanted risks or to
speculate by taking a position in anticipation of a market movement. The olive-press
owners, by locking in a guaranteed return no matter how good or bad the harvest, hedged
against the risk that the next season's olive harvest might not be plentiful. Thales speculated
that the next season's olive harvest would be exceptionally good and therefore paid an up-
front premium in anticipation of that event.

Similarly, organizations today can use financial derivatives to actively seek out specific risks
and speculate on the direction of interest-rate or exchange-rate movements, or they can use
derivatives to hedge against unwanted risks. Hence, it is not true that only risk-seeking
institutions use derivatives. Indeed, organizations should use derivatives as part of their
overall risk-management strategy for keeping those risks that they are comfortable
managing and selling those that they do not want to others who are more willing to accept
them. Even conservatively managed institutions can use derivatives to improve their cash-
flow management to ensure that the necessary funds are available to meet broader
corporate objectives. One could argue that organizations that refuse to use financial
derivatives are at greater risk than are those that use them.

When using financial derivatives, however, organizations should be careful to use only
those instruments that they understand and that fit best with their corporate risk-
management philosophy. It may be prudent to stay away from the more exotic instruments,
unless the risk/reward tradeoffs are clearly understood by the firm's senior management and
its independent risk-management review team. Exotic contracts should not be used unless
there is some obvious reason for doing so.

Myth Number 8: The Risks Associated with Financial Derivatives Are New
and Unknown

The kinds of risks associated with derivatives are no different from those associated with
traditional financial instruments, although they can be far more complex. There are credit
risks, operating risks, market risks, and so on.

Risks from derivatives originate with the customer. With few exceptions, the risks are man-
made, that is, they do not readily appear in nature. For example, when a new homeowner
negotiates with a lender to borrow a sum of money, the customer creates risks by the type
of mortgage he chooses--risks to himself and the lending company. Financial derivatives
allow the lending institution to break up those risks and distribute them around the financial
system via secondary markets. Thus, many risks associated with derivatives are actually
created by the dealers' customers or by their customers' customers. Those risks have been
inherent in our nation's financial system since its inception.

Banks and other financial intermediaries should view themselves as risk managers--
blending their knowledge of global financial markets with their clients' needs to help their
clients anticipate change and have the flexibility to pursue opportunities that maximize their
success. Banking is inherently a risky business. Risk permeates much of what banks do.
And, for banks to survive, they must be able to understand, measure, and manage financial
risks effectively.

The types of risks faced by corporations today have not changed; rather, they are more
complex and interrelated. The increased complexity and volatility of the financial markets
have paved the way for the growth of numerous financial innovations that can enhance
returns relative to risk. But a thorough understanding of the new financial-engineering tools
and their proper integration into a firm's overall risk-management strategy and corporate
philosophy can help turn volatility into profitability.

Risk management is not about the elimination of risk; it is about the management of risk:
selectively choosing those risks an organization is comfortable with and minimizing those
that it does not want. Financial derivatives serve a useful purpose in fulfilling risk-
management objectives. Through derivatives, risks from traditional instruments can be
efficiently unbundled and managed independently. Used correctly, derivatives can save
costs and increase returns.

Myth Number 9: Derivatives Link Market Participants More Tightly

Together, Thereby Increasing Systemic Risks

Financial derivative participants can be divided into two groups: end-users and dealers. As
end-users, banks use derivatives to take positions as part of their proprietary trading or for
hedging as part of their asset/liability management. As dealers, banks use derivatives by
quoting bids and offers and committing capital to satisfy customers' needs for managing
risk.

In the developmental years of financial derivatives, dealers, for the most part, acted as
brokers, finding counterparties with offsetting requirements. Then dealers began to offer
themselves as counterparties to intermediate customer requirements. Once a position was
taken, a dealer immediately either matched it by entering into an opposing transaction or
"warehoused" it--temporarily using the futures market to hedge unwanted risks--until a
match could be found.

Today dealers manage portfolios of derivatives and oversee the net, or residual, risk of their
overall position. That development has changed the focus of risk management from
individual transactions to portfolio exposures and has substantially improved dealers' ability
to accommodate a broad spectrum of customer transactions. Because most active
derivatives players today trade on portfolio exposures, it appears that financial derivatives
do not wind markets together any more tightly than do loans. Derivatives players do not
match every trade with an offsetting trade; instead, they continually manage the residual risk
of the portfolio. If a counterparty defaults on a swap, the defaulted party does not turn
around and default on some other counterparty that offset the original transaction. Instead,
a derivatives default is very similar to a loan default. That is why it is important that
derivatives players perform with due diligence in determining the financial strength and
default risks of potential counterparties.

For banking supervisors in the United States, probably the most important question today is,
What could go wrong to engender systemic risk--the danger that a failure at a single bank
could cause a domino effect, precipitating a banking crisis? Because financial derivatives
allow different risk components to be isolated and passed around the financial system,
those who are willing and able to bear each risk component at the least cost will become the
risk holders. That clearly reduces the overall cost of risk bearing and enhances economic
efficiency.
Furthermore, a major shock that would jolt financial markets in the absence of derivatives
would also affect financial markets in which the use of derivatives was widespread. But
because the holders of various risks would be different, the impact would be different and
presumably not as great because the holders of the risks should be better able to absorb
potential losses.

Myth Number 10: Because of the Risks Associated with Derivatives,

Banking Regulators Should Ban Their Use by Any Institution

The problem is not derivatives but the perverse incentives banks have under the current
system of federal deposit guarantees. Deposit insurance and other deposit reforms were
first introduced to address some of the instabilities associated with systemic risk. Through
federally guaranteed deposit insurance, the U.S. government attempted to avoid, by
increasing depositor confidence, the experience of deposit runs that characterized banking
crises before the 1930s.

The current deposit guarantee structure has, indeed, reduced the probability of large-scale
bank panics, but it has also created some new problems. Deposit insurance effectively
eliminates the discipline provided by the market mechanism that encourages banks to
maintain appropriate capital levels and restrict unnecessary risk taking. Therefore, banks
may wish to pursue higher risk strategies because depositors have a diminished incentive to
monitor banks. Further, federal deposit insurance may actually encourage banks to use
derivatives as speculative instruments to pursue higher risk strategies, instead of to hedge,
or as dealers.

Since federal deposit insurance discourages market discipline, regulators have been put in
the position of monitoring banks to ensure that they are managed in a safe and sound
manner. Given the present system of federal deposit guarantees, regulatory proposals
involving financial derivatives should focus on market-oriented reforms as opposed to laws
that might eliminate the economic risk-management benefits of derivatives.

To that end, banking regulators should emphasize more disclosure of derivatives positions
in financial statements and be certain that institutions trading huge derivatives portfolios
have adequate capital. In addition, because derivatives could have implications for the
stability of the financial system, it is important that users maintain sound risk-management
practices.

Regulators have issued guidelines that banks with substantial trading or derivatives activity
should follow. Those guidelines include active board and senior management oversight of
trading activities; establishment of an internal risk-management audit function that is
independent of the trading function; thorough and timely audits to identify internal control
weaknesses; and risk-measurement and risk-management information systems that include
stress tests, simulations, and contingency plans for adverse market movements.

It is the responsibility of a bank's senior management to ensure that risks are effectively
controlled and limited to levels that do not pose a serious threat to its capital position.
Regulation is an ineffective substitute for sound risk management at the individual firm level.

Should Company Use Derivatives?

Financial derivatives should be considered for inclusion in any corporation's risk-control

arsenal. Derivatives allow for the efficient transfer of financial risks and can help to ensure
that value-enhancing opportunities will not be ignored. Used properly, derivatives can
reduce risks and increase returns.

Derivatives also have a dark side. It is important that derivatives players fully understand the
complexity of financial derivatives contracts and the accompanying risks. Users should be
certain that the proper safeguards are built into trading practices and that appropriate
incentives are in place so that corporate traders do not take unnecessary risks.

The use of financial derivatives should be integrated into an organization's overall risk-
management strategy and be in harmony with its broader corporate philosophy and
objectives. There is no need to fear financial derivatives when they are used properly and
with the firm's corporate goals as guides.
What Should Regulators Do?

Believing the 10 myths presented here, indeed, believing just one or two of them, could lead
[9]
one to advocate legislative and regulatory measures to restrict the use of derivatives.
Derivatives-related disasters, such as the Orange County bankruptcy and the collapse of
Barings, have led to questions about the ability of individual derivatives participants to
internally manage their trading operations. In addition, concerns have surfaced about
regulators' ability to detect and control potential derivatives losses.

But regulatory and legislative restrictions on derivatives activities are not the answer,
primarily because simple, standardized rules most likely would only impair banks' ability to
manage risk effectively. A better answer lies in greater reliance on market forces to control
derivatives-related risk taking, together with more emphasis on government supervision, as
opposed to regulation.

The burden of managing derivatives activities must rest squarely on trading organizations,
not the government. Such an approach will promote self-regulation and improve
organizations' internal controls through the discipline of market mechanisms. Government
guarantees will serve only to strengthen moral-hazard behavior by derivatives traders.

The best regulations are those that guard against the misuse of derivatives, as opposed to
those that severely restrict, or even ban, their use. Derivatives-related losses can typically
be traced to one or more of the following causes: an overly speculative investment strategy,
a misunderstanding of how derivatives reallocate risk, an ineffective internal risk-
management audit function, and the absence of systems that simulate adverse market
movements and help develop contingency solutions. To address those concerns,
supervisory reforms should focus on increasing disclosure of derivatives holdings and the
strategies underlying their use, appropriate capital adequacy standards, and sound risk-
management guidelines.
 For the most part, however, policymakers should leave derivatives alone. Derivatives have
become important tools that help organizations manage risk exposures. The development of
derivatives was brought about by a need to isolate and hedge against specific risks.
Derivatives offer a proven method of breaking risk into component pieces and managing
those components independently.

Almost every organization--whether a corporation, a municipality, or an insured commercial

bank--has inherent in its business and marketplace a unique risk profile that can be better
managed through derivatives trading. The freedom to manage risks effectively must not be
taken away.

RESEARCH METHODOLOGY

Research Methodology: An Introduction

Research in common parlance refers to a search for knowledge. Once can also define
research as scientific and systematic search for pertinent information on a specific topic. In fact,
research is a base of scientific investigation. The Advanced Learner's Dictionary of Current
English lays down the leaning of research as "a careful investigation or inquiry especially
through search for new facts in. branch of knowledge." Redman and Mory define research as a
"systematized effort to gain knowledge." Some people consider research as a movement, a
movement from the known to unknown. It is actually a voyage of discovery. We all possess the
vital instinct of in quantitative-ness . When the unknown confronts us, we wonder and our
inquisitiveness makes us probe and attain and fuller understanding of the unknown. This
inquisitiveness is the mother of all knowledge and method, which mean employs for obtaining
the knowledge of whatever the unknown, can be ed as research.

Research is an academic activity and as such, the term should be used in a technical sense.
According to Clifford Woody, research comprises defining and redefining problems, formulating
thesis or suggested solutions; collecting, organising and evaluating data; making deductions
and Drawing conclusions; and at last carefully testing the conclusions to determine whether
they fit the stipulating hypothesis. D. Slesinger and M. Stephenson in the Encyclopaedia of
Social Sciences - e research as "the manipulation of things, concepts or symbols for the
purpose of generalising to d, correct or verify knowledge, whether that knowledge aids in
construction of theory or in the . e of an art."3 Research is, thus, an original contribution to the
existing stock of knowledge ° g for its advancement. It is the pursuit of truth with the help of
study, observation, comparison - experiment. In short, the search for knowledge through
objective and systematic method of solution to a problem is research. Such the term 'research'
refers to the systematic method

The purpose of research is to discover answers to questions through the application of

scientific procedures. The main aim of research is to find out the truth which is hidden and
which has not been discovered as yet. Though each research study has its own specific
purpose, we may think of research objectives as falling into a number of following broad
groupings:

1. To gain familiarity with a phenomenon or to achieve new insights into it (studies with this
object in view are termed as exploratory or formulates research studies);
2. To portray accurately the characteristics of a particular individual, situation or a group
(studies with this object in view are known as descriptive research studies);
3. To determine the frequency with which something occurs or with which it is associated
 with something else (studies with this object in view are known as diagnostic research
studies);
4. To test a hypothesis of a causal relationship between variables (such studies are known
as hypothesis-testing research studies).

Types of Research

(i) Descriptive vs. Analytical: Descriptive research includes surveys and fact-finding enquirie of
different kinds. The major purpose of descriptive research is description of the state 0 affairs
as it exists at present. In social science and business research we quite often use the term Ex
post facto research for descriptive research studies. The main characteristic of this method is
that the researcher has no control over the variables; he can only report what has happened or
what is happening. Most ex post facto research projects are used for descriptive studies in
which the researcher seeks to measure such items as, for example, frequency of shopping,
preferences of people, or similar data. Ex post facto studies also include attempts by
researchers to discover causes even when they cannot control the variables. The methods of
research utilized in descriptive research are survey methods of all kinds, including comparative
and correlation methods. In analytical research, on the other hand, the researcher has to use
facts or information already available, and analyze these to make a critical evaluation of the
material.

(ii) Applied vs. Fundamental: Research can either be applied (or action) research or
fundamental (to basic or pure) research. Applied research aims at finding a solution for an
immediate problem facing a society or an industrial/business organisation, whereas
fundamental research is mainly concerned with generalisations and with the formulation of a
theory. "Gathering knowledge for knowledge's sake is termed 'pure' or 'basic' research."4
Research concerning some natural phenomenon or relating to pure mathematics are examples
of fundamental research. Similarly, research studies, concerning human behaviour carried on
with a view to make generalisations about human behaviour, are also examples of
fundamental research, but research aimed at certain conclusions (say, a solution) facing a
concrete social or business problem is an example of applied research. Research to identify
social, economic or political trends that may affect a particular institution or the copy research
(research to find out whether certain communications will be read and understood) or the
marketing research or evaluation research are examples of applied research. Thus, the central
aim of applied research is to discover a solution for some pressing practical problem, whereas
basic research is directed towards finding information that has a broad base of applications
and thus, adds to the already existing organized body of scientific knowledge.

(iii) Quantitative vs. Qualitative: Quantitative research is based on the measurement of quantity
or amount. It is applicable to phenomena that can be expressed in terms of quantity.
Qualitative research, on the other hand, is concerned with qualitative phenomenon, i.e.,
phenomena relating to or involving quality or kind. For instance, when we are interested in
investigating the reasons for human behaviour (i.e., why people think or do certain things), we
quite often talk of 'Motivation Research', an important type of qualitative research. This type of
research aims at discovering the underlying motives and desires, using in depth interviews for
the purpose. Other techniques of such research are word association tests, sentence
completion tests, story completion tests and similar other projective techniques. Attitude or
opinion research i.e., research designed to find out how people feel or what they think about a
particular subject or institution is also qualitative research. Qualitative research is specially
important in the behavioural sciences where the aim is to discover the underlying motives of
human behaviour. Through such research we can analyse the various factors which motivate
people to behave in a particular manner or which make people like or dislike a particular thing.
It may be stated, however, that to apply qualitative research in

practice is relatively a difficult job and therefore, while doing such research, one should seek
guidance from experimental psychologists.

(iv) Conceptual vs. Empirical: Conceptual research is that related to some abstract idea(s) or
theory. It is generally used by philosophers and thinkers to develop new concepts or to
reinterpret existing ones. On the other hand, empirical research relies on experience or
observation alone, often without due regard for system and theory. It is data-based research,
coming up with conclusions which are capable of being verified by observation or experiment.
We can also call it as experimental type of research. In such a research it is necessary to get
at facts firsthand, at their source, and actively to go about doing certain things to stimulate the
production of desired information. In such a research, the researcher must first provide himself
with a working hypothesis or guess as to the probable results. He then works to get enough
facts (data) to prove or disprove his hypothesis. He then sets up experimental designs which
he thinks will manipulate the persons or the materials concerned so as to bring forth the
desired information. Such research is thus characterised by the experimenter's control over the
variables under study and his deliberate manipulation of one of them to study its effects.
Empirical research is appropriate when proof is sought that certain variables affect other
variables in some way. Evidence gathered through experiments or empirical studies is today
considered to be the most powerful support possible for a given hypothesis.

(v) Some Other Types of Research: All other types of research are variations of one or more of
the above stated approaches, based on either the purpose of research, or the time required to
accomplish research, on the environment in which research is done, or on the basis of some
other similar factor. Form the point of view of time, we can think of research either as one-time
research or longitudinal research. In the former case the research is conformed to a single
time-period, whereas in the latter case the research is carried on over several time-periods.
Research can be field-setting research or laboratory research or simulation research,
depending upon the environment in which it is to be carried out. Research can as· well be
understood as clinical or diagnostic research. Such research follows case-study methods or in-
depth approaches to reach the basic causal relations. Such studies usually go deep into the
causes of things or events that interest us, using very small samples and very deep probing
data gathering devices. The research may be exploratory or it may be formalized. The
objective of exploratory research is the development of hypotheses rather than their testing,
whereas formalized research studies are those with substantial structure and with specific
hypotheses to be tested. Historical research is that which utilizes historical sources like
documents, remains, etc. to study events or ideas of the past, including the philosophy of
persons and groups at any remote point of time. Research can also be classified as
conclusion-oriented and decision-oriented. While doing conclusion oriented research, a
researcher is free to pick up a problem, redesign the enquiry as he proceeds and is prepared
to conceptualize as he wishes. Decision-oriented research is always for ten need of a decision
maker and the researcher in this case is not free to embark upon research according to his
own inclination. Operations research is an example of decision oriented research since it is a
scientific method of providing executive departments with a quantitative basis for decisions
regarding operations under their control.
Research Problem

A research problem, in general, refers to some difficulty which a researcher experiences in

context of either a theoretical or practical situation and wants to obtain a solution for the same.
Usually we say that a research problem does exist if the following conditions are met with:

(i) There must be an individual (or a group or an organisation), let us call it 'I,' to whom problem
can be attributed. The individual or the organisation, as the case may be, occupies an
environment, say 'N', which is defined by values of the uncontrolled variables, Y.

(ii) There must be at least two courses of action, say C, and C2, to be pursued. A course action
is defined by one or more values of the controlled variables. For example, the number of items
purchased at a specified time is said to be one course of action.

(iii) There must be at least two possible outcomes, say 0, and 02' of the course of action which
one should be preferable to the other. In other words, this means that there must be at least
one outcome that the researcher wants, i.e., an objective.

(iv) The courses of action available must provides some chance of obtaining the objective they
cannot provide the same chance, otherwise the choice would not matter

Research De
sign

The formidable problem that follows the task of defining the research problem is the
preparation of the research project, popularly known jis the "research design". Decisions
regarding where, when, how much, by what means concerning an inquiry or a research study
constitute a research design. "A research design is the arrangement of condition and anal sis
of data in a manner that aim’s combine relevance to the research purpose with economy. In
procedure." The research design is the conceptual structure within which research is
conducted; it constitutes the blueprint for the collection, measurement and analysis of data. As
such the design includes an e of what the researcher will do from writing the hypothesis and its
operational implications to the analysis of data. More explicitly, the design decisions happen to
be in respect of:
 i) What is the study about?
ii) Why is the study being made?
iii) Where will the study be carried out?
iv) What type of data is required?
v) Where can the required data be found?
vi) What periods of time will the study include?
vii) What will be the sample design?
viii) What techniques of data collection will be used?
ix) How will the data be analysed?
x) In what style will the report be prepared?

Data collection

Data collection begins after a research problem has been defined and research design. While
deciding about the method of data collection to be used for the study, they should keep in mind
two types of data viz., primary and secondary. The primary data are collected afresh and for
the first time, and thus happen to be original in character. Secondary data, on the other hand,
are those which have already been collected by someone & have already been passed
through the statistical process. The researcher would have h sort of data he would be using
(thus collecting) for his study and accordingly he will one or the other method of data
collection. The methods of collecting primary and secondary data differ since primary data are
to be originally collected, while in case of secondary of data collection work is merely that of
compilation. We describe the different collection, with the pros and cons of each method.

Primary data during the course of doing experiments in an experimental research but in order
to the descriptive type and perform surveys, whether sample surveys or census Scan obtain
primary data either through observation or through direct communication in one form Or
another or through personal interviews.' This, in other words, means refers to an investigation
in which a factor or variable under test is isolated and its effect(s) measured. . Investigator
measures the effects of an experiment which he conducts intentionally. Survey refers to
information concerning phenomena under study from all or a selected number of respondents
of ere. In a survey,' the investigator examines those phenomena which exist in the universe"
independent of deference between an experiment.
there are several methods of collecting primary data,· particularly in surveys and the
researches. Important ones are: (i) observation method, (ii) interview method, (iii) through
questionnaire (iv) through schedules, and (v) other methods which include (a) warranty cards;
(b) discount audits; (c) pantry audits; (d) consumer panels; (e) using mechanical devices; (f)
through pro· techniques; (g) depth interviews, and (h) content analysis. We briefly take up each
method

Observation Method

The observation method is the most commonly used method specially in studies relating to
behavioural sciences. In a way we all observe things around us, but this sort of observation is
not observation. Observation becomes a scientific tool and the method of data collection for
the re when it serves a formulated research purpose, is systematically planned and recorded
and is s to checks and controls on validity and reliability. Under the observation method, the
info sought by way of investigator's own direct observation without asking from the respond
instance, in a study relating to consumer behaviour, the investigator instead of , asking the
wrist watch used by the respondent, may himself look at the watch. The main advantage
method is that subjective bias is eliminated, if observation is done accurately. Secondly, the
information obtained under this method relates to what is currently happening; iris not
complicated by i.e., past behaviour or future intentions or attitudes. Thirdly, this method is
independent of rest willingness to respond and as such is relatively less demanding of active
cooperation on the respondents as happens to be the case in the interview or the
questionnaire method. This particularly suitable in studies which deal with subjects (i.e.,
respondents) who are not e giving verbal reports of their feelings for one reason or the other
However, observation method has various limitations. Firstly, it is an expensive method. the
information provided by this method is very limited. Thirdly, sometimes unforeseen interfere
with the observational task. At times, the fact that some people are rarely ace direct
observation creates obstacle for this method to collect data effectively.

While using this method, the researcher should keep in mind things like: What should be how
the observations should be recorded? Or how the accuracy of observation can be e case the
observation is characterised by a careful definition of the units to be observed, recording the
observed information, standardised conditions of observation and the selection data of
observation, then the observation is called as structured observation. But when is to take place
without these characteristics to be thought of in advance, the same is unstructured
observation. Structured observation is considered appropriate in descriptive. Whereas in an
exploratory study the observational procedure is most likely to be relatively

We often talk about participant and non-participant types of observation in the context
particularly of social sciences, This distinction depends upon the observer's sharing or the life
~f the group he is observing. If the observer observes by making himself, more member of the
group he is observing so that he can experience what the members of experience, the
observation is called as the participant observation. But when the observe as a detached
emissary without any attempt on his part to experience through patrician others feel, the
observation of this type is often termed as non-participant observation. observer is observing in
such a manner that his presence may be unknown to the observing, such an observation is
described as disguised observation.)

Their are several merits of the participant type of observation: (i) the researcher is enabled to
--'" natural behaviour of the group. (ii) The researcher can even gather information which
specially be obtained if he observes in a disinterested fashion. (iii) The researcher can even
give the statements made by informants in the context of a questionnaire or a schedule. But
there are also certain demerits of this type of observation viz., the observer may lose the
objectivity he participates emotionally; the problem of observation-control is not solved; and it
may narrow down the researcher's range of experience.

We talk of controlled and uncontrolled observation. If the observation takes place setting, it
may be termed as uncontrolled observation, but when observation takes place 5'0 definite pre-
arranged plans, involving experimental procedure, the same is then termed derivation. In non-
controlled observation, no attempt is made to use precision instruments. The major aim of this
type of observation is to get a spontaneous picture of life and persons. It has a tendency to
supply naturalness and completeness of behaviour, allowing sufficient time for observing
controlled observation, we use mechanical (or precision) instruments as aids to accuracy
desertion. Such observation has a tendency to supply formalised data upon which . ones can
be built with some degree of assurance. The main pitfall of non-controlled i that of subjective
interpretation. There is also the danger of having the feeling that we _ about the observed
phenomena than we actually do. Generally, controlled observation " in various experiments
that are carried out in a laboratory or under controlled conditions, ~controlled observation is
resorted to in case of exploratory researches .

The method of collecting data involves presentation of oral-verbal stimuli and reply in verbal
responses. This method can be used through personal interviews and, if possible, through
telephonic interviews.

Personnel interviews: Personal interview method requires a person known as the interviewer.
Ones generally in a. face-to face contact. to the other person or persons. yet times they may
also ask certain questions and the interviewer responds to these, but usually the interviewer
initiates the interview and collects the information.) This sort of interview may be in the foam of
personal investigation or it may be indirect oral investigation. In the case of direct investigation
the interviewer has to collect the information personally from the sources He has to be on the
spot and has to meet people from whom data have to be collected particularly suitable 'for
intensive investigations. But in certain cases it may not be worthwhile to contact directly the
persons concerned or on account of the extensive dairy, the direct personal investigation
technique may not be used. In such cases an exanimation can be conducted under which the
interviewer has to cross-examine other are supposed to have knowledge about the problem
under investigation and the trained is recorded. Most of the commissions and committees
appointed by government investigations make use of this method.

Data collection begins after a research problem has been defined and research design. While
deciding about the method of data collection to be used for the study, they should keep in mind
two types of data viz., primary and secondary. The primary data are collected afresh and for
the first time, and thus happen to be original in character. Secondary data, on the other hand,
are those which have already been collected by someone & have already been passed
through the statistical process. The researcher would have h sort of data he would be using
(thus collecting) for his study and accordingly he will one or the other method of data
collection. The methods of collecting primary and secondary data differ since primary data are
to be originally collected, while in case of secondary of data collection work is merely that of
compilation. We describe the different collection, with the pros and cons of each method.

Primary data during the course of doing experiments in an experimental research but in order
to the descriptive type and perform surveys, whether sample surveys or census Scan obtain
primary data either through observation or through direct communication in one form Or
another or through personal interviews.' This, in other words, means refers to an investigation
in which a factor or variable under test is isolated and its effect(s) measured. . Investigator
measures the effects of an experiment which he conducts intentionally. Survey refers to
information concerning phenomena under study from all or a selected number of respondents
of ere. In a survey,' the investigator examines those phenomena which exist in the universe"
independent of deference between experiments.

There are several methods of collecting primary data,· particularly in surveys and the
researches. Important ones are: (i) observation method, (ii) interview method, (iii) through
questionnaire (iv) through schedules, and (v) other methods which include (a) warranty cards;
(b) discount audits; (c) pantry audits; (d) consumer panels; (e) using mechanical devices; (f)
through pro· techniques; (g) depth interviews, and (h) content analysis. We briefly take up each
method

Observation Method

The observation method is the most commonly used method specially in studies relating to
behavioural sciences. In a way we all observe things around us, but this sort of observation is
not observation. Observation becomes a scientific tool and the method of data collection for
the re when it serves a formulated research purpose, is systematically planned and recorded
and is s to checks and controls on validity and reliability. Under the observation method, the
info sought by way of investigator's own direct observation without asking from the respond
instance, in a study relating to consumer behaviour, the investigator instead of , asking the
wrist watch used by the respondent, may himself look at the watch. The main advantage
method is that subjective bias is eliminated, if observation is done accurately. Secondly, the
information obtained under this method relates to what is currently happening; iris not
complicated by i.e., past behaviour or future intentions or attitudes. Thirdly, this method is
independent of rest willingness to respond and as such is relatively less demanding of active
cooperation on the respondents as happens to be the case in the interview or the
questionnaire method. This particularly suitable in studies which deal with subjects (i.e.,
respondents) who are not e giving verbal reports of their feelings for one reason or the other
However, observation method has various limitations. Firstly, it is an expensive method. the
information provided by this method is very limited. Thirdly, sometimes unforeseen fa interferes
with the observational task. At times, the fact that some people are rarely ace direct
observation creates obstacle for this method to collect data effectively.

While using this method, the researcher should keep in mind things like: What should be How
the observations should be recorded? Or how the accuracy of observation can be e case the
observation is characterised by a careful definition of the units to be observed, recording the
observed information, standardised conditions of observation and the selection data of
observation, then the observation is called as structured observation. But when is to take place
without these characteristics to be thought of in advance, the same is unstructured
observation. Structured observation is considered appropriate in descriptive. Whereas in an
exploratory study the observational procedure is most likely to be relatively

We often talk about participant and non-participant types of observation in the context
particularly of social sciences, this distinction depends upon the observer's sharing or the life
of the group he is observing. If the observer observes by making himself, more member of the
group he is observing so that he can experience what the members of experience, the
observation is called as the participant observation. But when the observe as a detached
emissary without any attempt on his part to experience through practical others feel, the
observation of this type is often termed as non-participant observation. Observer is observing
in such a manner that his presence may be unknown to the observing, such an observation is
described as disguised observation.)

Their are several merits of the participant type of observation: (i) the researcher is enabled to
know about natural behaviour of the group. (ii) The researcher can even gather information
which specially be obtained if he observes in a disinterested fashion. (iii) The researcher can
even give the statements made by informants in the context of a questionnaire or a schedule.
But there are also certain demerits of this type of observation viz., the observer may lose the
objectivity he participates emotionally; the problem of observation-control is not solved.

We talk of controlled and uncontrolled observation. If the observation takes place setting, it
may be termed as uncontrolled observation, but when observation takes place 5'0 definite pre-
arranged plans, involving experimental procedure, the same is then termed derivation. In non-
 controlled observation, no attempt is made to use precision instruments. The major aim of this
type of observation is to get a spontaneous picture of life and persons. It has a tendency to
supply naturalness and completeness of behaviour, allowing sufficient time for observing
controlled observation, we use mechanical (or precision) instruments as aids to accuracy
desertion. Such observation has a tendency to supply formalised data upon which. ones can
be built with some degree of assurance. The main pitfall of non-controlled i that of subjective
interpretation. There is also the danger of having the feeling that we _ about the observed
phenomena than we actually do. Generally, controlled observation " in various experiments
that are carried out in a laboratory or under controlled conditions, ~controlled observation is
resorted to in case of exploratory researches .

The method of collecting data involves presentation of oral-verbal stimuli and reply in verbal
responses. This method can be used through personal interviews and, if possible, through
telephonic interviews.

1. Personnel interviews: Personal interview method requires a person known as the

interviewer. Ones generally in a. face-to face contact. to the other person or persons. yet times
they may also ask certain questions and the interviewer responds to these, but usually the
interviewer initiates the interview and collects the information.) This sort of interview may be in
the foam of personal investigation or it may be indirect oral investigation. In the case of direct
investigation the interviewer has to collect the information personally from the sources He has
to be on the spot and has to meet people from whom data have to be collected particularly
suitable 'for intensive investigations. But in certain cases it may not be worthwhile to contact
directly the persons concerned or on account of the extensive dairy, the direct personal
investigation technique may not be used. In such cases an exanimation can be conducted
under which the interviewer has to cross-examine other are supposed to have knowledge
about the problem under investigation and the trained is recorded. Most of the commissions
and committees appointed by government investigations make use of this method.

Method of collecting information through personal interviews is usually carried out in a

structured way. As such we call the interviews as structured interviews. Such interviews
involve the use of a set of predetermined questions and of highly standardised techniques of
recording; Thus, the interviewer in a structured interview follows a rigid procedure laid down,
asking question form and order prescribed. As against it, the unstructured interviews are
characterised by a flexibility of approach to-questioning. Unstructured interviews do not follow
a system of pre-determined questions and standardised techniques of recording information. In
a non-structured interview the interviewer is allowed much greater freedom to ask, in case of
need, supplementary question or at times he may omit certain questions if the situation so
requires. He may even change the sequence of questions. He has relatively greater freedom
while recording the responses to include se and exclude others. But this sort of flexibility
results in lack of comparability of one interview with another and the analysis of unstructured
responses becomes much more difficult and time consuming than that of the structured
responses obtained in case of structured interviews

We may as well talk about focussed interview, clinical interview and the non-directive
interviews. Focussed interview is meant to focus attention on the given experience of the
response effects. Under it the interviewer has the freedom to .decide the manner and
sequence the questions would be asked and has also the freedom to explore reasons and
motives. The interviewer in case of a focussed interview is to confine the respondent to it
discuss] with which he seeks conversance. Such interviews are used generally in the
development of the hypothesis and constitute a major type of unstructured interviews. The
clinical interview. With broad underlying feelings or motivations or with the course of
individual's life' experience. The method of eliciting information under it is generally left to the
interviewer's discretion. In case of non-directive interview, the interviewer's function is simply to
encourage the respondent to talk about the given topic with a bare minimum of direct
questioning. The interviewer of catalyst to a comprehensive expression of the respondents'
feelings and beliefs and of reference within which such feelings and beliefs take on personal
significance.

Despite the variations in interview-techniques, the major advantages and weaknesses

interviews can be enumerated in a general way. The chief merits of the interview ill follows:

(i) More information and that too in greater depth can be obtained.

(ii) Interviewer by his own skill can overcome the resistance, if any, of the despondence: the
interview method can be made to yield an almost perfect sample of the general population
(iii) There is greater flexibility under this method as the opportunity to restructure questions is
always there, specially in case of unstructured interviews.

(iv) Observation method can as well be applied to recording verbal answers to various
questions.

(v) Personal information can as well be obtained easily under this method.

(vi) Samples can be controlled more effectively as there arises no difficulty 0 returns; non-
response generally remains very low.

(vii) The interviewer can usually control which person(s) will answer the question possible in
mailed questionnaire approach. If so desired, group discussion held.

(viii) The interviewer may catch the informant off-guard and thus may secure the most
spontaneous reactions than would be the case if mailed questionnaire is used.

(ix) The language of the interview can be adapted to the ability or educational level of the
person interviewed and as such misinterpretations concerning questions can be avoided.

(x) The interviewer can collect supplementary information about the respondent's personal
characteristics and environment which is often of great value in interpreting results.

But their are also certain weaknesses of the interview method. Among the important
weaknesses, may be made of the following:

(i) It is a very expensive method, specially when large and widely spread geographical sample·
is taken.

(ii) There remains the possibility of the bias of interviewer as well as that of the respondent;
there also remains the headache of supervision and control of interviewers.

(iii) Certain types of respondents such as important officials or executives or people in high
income groups may not be easily approachable under this method and to that extent the data
may prove inadequate.
(iv) This method is relatively more-time-consuming, specially when the sample is large and
recalls upon the respondents are necessary.

(v)The presence of the interviewer on the spot may over-stimulate the respondent, sometimes
e en to the extent that he may give imaginary information just to make the interview·
interesting.

(vi) Under the interview method the organisation required for selecting, training and
supervising the field-staff is more complex with formidable problems.

Pre-requisites and basic tenets of interviewing: For successful implementation of the interview
method. Interviewers should be carefully selected, trained and briefed. They should be honest,
sincere, hardworking, and impartial and must possess the technical competence and
necessary practical experience. Occasional field checks should be made to ensure that
interviewers are neither cheating, nor deviating from instruction given to them for performing
their job efficiently. In addition, some provision should also be made in advance so that
appropriate action may be taken if some of the selected respondents cooperate or are not
available when an interviewer calls upon them.

In fact, interviewing is an art governed by certain scientific principles. Every effort should be
create friendly atmosphere of trust and confidence, so that respondents may feel at ease while
taking to and discussing with the interviewer. The interviewer must ask questions properly and
intelligently and must record the responses accurately and completely. At the same time, the
interviewer must answer legitimate question(s), if any, asked by the respondent and must clear
doubts.

(b) Telephonic interviews: This method of collecting information consists in contacting re on

telephonic itself. It is not a very widely used method, but plays important part in industry
particularly In developed regions. The chief merits of such a system are:

1. It is more flexible in comparison to mailing method.

2. It is faster than other methods i.e., a quick way of obtaining information.
3. It is cheaper than personal interviewing method; here the cost per response is relatively
low.
 4. Recall is easy; call backs are simple and economical.
5. There is a higher rate of response than what we have in mailing method; the non-
response is generally very low.

6. Replies can be recorded without causing embarrassment to respondents.

7. Interviewer can explain requirements more easily.
8. At times, access can be gained to respondents who otherwise cannot be contact reason
or the other.
9. No field staffs are required.
10. Representative and wider distribution of sample is possible.

But this system of collecting information is not free from demerits. Some of 'the highlighted.

1. Little time is given to respondents for considered answers; interview period is not likely
to exceed five minutes in most cases.
2. Surveys are restricted to respondents who have telephone facilities.
3. Extensive geographical coverage may get restricted by cost considerations.
4. It is not suitable for intensive surveys where comprehensive answers are required
questions.
5. Possibility of the bias of the interviewer is relatively more.
6. Questions have to be short and to the point; probes are difficult to handle.

COLLECTION OF DATA THROUGH THE QUESTIONNAIRES

This method of data collection is quite popular, particularly in case of big enquiries. It is be by
private individuals, research workers, private and public organisations and even by go In this
method a questionnaire is sent (usually by post) to the persons concerned with a request to
answer the questions and return the questionnaire. A questionnaire consists of a number ~
printed or typed in a definite order on a form or set of forms. The questionnaire is mailed to 1
who are expected to read and understand the questions and write down the reply in the space
ment for the purpose in the questionnaire itself. The respondents have to answer the
questionnaires on their own.

The method of collecting data by mailing the questionnaires to respondents is most employed
in various economic and business surveys. The merits claimed on behalf of this method are as
follows:

1 It is free from the bias of the interviewer; answers are in respondents' own words.

2. Respondents have adequate time to give well thought out answers.

3. Respondents, who are not easily approachable, can also be reached conveniently.

4 Large samples can be made use of and thus the results can be made more
dependable and reliable.

MAIN DEMARITS

1. Low rate of return of the duly filled in questionnaires; bias due to no-response is often
indeterminate.

2. It can be used only when respondents are educated and cooperating. The control over
questionnaire may be lost once it is sent.

3. There is inbuilt inflexibility because of the difficulty of amending the approach once
questionnaires have been despatched.

4. There is also the possibility of ambiguous replies or omission of replies altogether to

certain questions; interpretation of omissions is difficult.

5. It is difficult to know whether willing respondents are truly representative. - This method
is likely to be the slowest of all.

Main aspects of a questionnaire: Quite often questionnaire is considered as the heart of a

survey operation. Hence it should be very carefully constructed. If it is not properly set up, then
the survey is bound to fail. This fact requires us to study the main aspects of a questionnaire
viz., the general form, question sequence and question formulation and wording. Researcher
should note the. Following with regard to these three main aspects of a questionnaire:

1. General form: So far as the general form of a questionnaire is concerned, it can either be or
unstructured questionnaire. Structured questionnaires are those questionnaires in which their
are definite, concrete and pre-determined questions. The questions are presented with exactly
according and in the same order to all respondents. Resort is taken to this sort of
standardisation that all respondents reply to the same set of questions. The form of the
question may be either closed (i.e., of the type 'yes' or 'no') or open.(i.e., inviting free response)
but should be stated in advance and not constructed during questioning. Structured
questionnaires may also have fixed alternative question which responses of the informants are
limited to the stated alternatives. Thus a highly structured questionnaire is one in which all
questions and answers are specified and comments respondents own words are held to the
minimum. When these characteristics are not present in a questionnaire, it can be termed as
unstructured or non-structured questionnaire. More specifically, we can say that in an
unstructured questionnaire, the interviewer is provided with a general guide on the type of
information to be obtained, but the exact question formulation is largely his own responsibility.
And the replies are to be taken down in the respondent's own words to the extent possible; in
some - rape recorders may be used to achieve this goal. Structured questionnaires are simple
to administer and relatively inexpensive to anal provision of alternative replies, at times, helps
to understand the meaning of the question such questionnaires have limitations too. For
instance, wide range of data and that too in rest own words cannot be obtained with structured
questionnaires. They are usually considered in in investigations where the aim happens to be
to probe for attitudes and reasons for certain feelings. They are equally not suitable when a
problem is being first explored and working h sought. In such situations, unstructured
questionnaires may be used effectively. Then on the results obtained in protest (testing before
final use) operations from the use of us questionnaires, one can construct a structured
questionnaire for use in the main study.

2. Question sequence: In order to make the questionnaire effective and to ensure quality to the
replies' received, a researcher should pay attention to the question-sequence in preparing the
questionnaire. A proper sequence of questions reduces considerably the chances of individual
being misunderstood. The question-sequence must be clear and smoothly-moving, meaning
.that the relation of one question to another should be readily apparent to the respondent, with
that are easiest to answer being put in the beginning. The first few questions are particularly'
because they are likely to influence the attitude of the respondent and in seeking' his
cooperation. The opening questions should be such as to arouse human interest. The
following type of questions should generally be avoided as opening questions in a
questionnaire:

1. Questions that put too great a strain; on the memory or intellect of the respondent;

2...Questions of a personal character;

3. Questions related to personal wealth, etc.

Following the opening questions, we should have questions that are really vital to the problem
and a connecting thread should run through successive questions. Ideally, the sequence
should conform to the respondent's way of thinking. Knowing what information the researcher
can rearrange the order of the questions (this is possible in case of us questionnaire) to fit the
discussion in each particular case. But in a structured questionnaire that can be done is to
determine the question-sequence with the help of a Pilot Survey which' to produce good
rapport with most respondents. Relatively difficult questions must be towards the end so that
even if the respondent decides not to answer such questions, co. information would have
already been obtained. Thus, question-sequence should usually go general to the more
specific and the researcher must always remember that the answer to question is a function
not only of the question itself, but of all previous questions as well. For instance if one question
deals with the price usually paid for coffee and the next with reason for that particular brand,
the answer to this latter question may be couched largely in terms differences.

3. Question formulation and wording.' With regard to this aspect of questionnaire, the should
note that each question must be very clear for any sort o~ misunderstanding can do. Harm to a
survey. Question should also be impartial in order not to give a biased picture state of affairs.
Questions should be constructed with a view to their forming a logical part thought out
tabulation plan. In general, all questions should meet the following standards--- (be easily
understood; (b) should be simple i.e., should convey only one thought at a time; (be concrete
and should conform as much as possible to the respondent's way of thinking. for instead of
asking. "How many razor blades do you use annually?" The more realistic n would be to ask,
"How many razor blades did you use last week?"

Concerning the form of questions, we can talk about two principal forms, viz., multiple choice
questions and the open-end question. In the former the respondent selects one of the
alternative possible answers put to him, whereas in the latter he has to supply the answer in
his own words. The question in with only two possible answers (usually 'Yes' or 'No') can be
taken as a special case of the multiple choice question, or can be named as a 'closed
question.' There are some advantages and disadvantages of each possible form of question.
Multiple choice or closed questions have the · goes of easy handling, simple to answer, quick
and relatively inexpensive to analyse. They are enable-to statistical analysis. Sometimes, the
provision of alternative replies helps to make

COLLECTION OF DATA THROUGH SCHEDULE

This method of data collection is very much like the collection of data through little difference
which lies in the fact that schedules (perform containing a 1 being filled in by the enumerators
who are specially appointed for the purpose along with schedules, go to respondents, put to
them the questions from the proof questions are listed and record the replies in the space
meant for the same in the situations, schedules may be handed over to respondents and
enumerators may he their answers to various questions in the said schedules. Enumerators
explain the investigation and also remove the difficulties which any respondent may feel
implications of a particular question or the definition or concept of difficult term

This method requires the selection of enumerators for filling up schedules or a to fill up
schedules and as such enumerators should be very carefully selected should be trained to
perform their job well and the nature and scope of the explained to them thoroughly so that
they may well understand the implications 0 put in the schedule. Enumerators should be
intelligent and must possess the examination in order to find out the truth. Above all, they
should be honest, since] should have patience and perseverance.

This method of data collection is very useful in extensive enquiries and can lead to fairly
reliable results. It is, however, very expensive and is usually adopted in investigations
conducted by governmental agencies or by some big organisations. Population census all over
the world is conducted through this method.

Both questionnaire and schedule are popularly used methods of collecting data in research
survey. There is much resemblance in the nature of these two methods and this fact has made
many people to remark that from a practical point of view, the two methods can be taken to be
the same but for the technical point of view there is difference between the two. The important
points of the difference are as under:

1. The questionnaire is generally sent through mail to informants to be answered as specified

in covering letter but otherwise without further assistance from the sender. The schedule is
generally filled out by the research worker or the enumerator, who can interpret questions
when necessary.

2. To collect data through questionnaire is relatively cheap and economical since we have to
spend money only in preparing the questionnaire and in mailing the same to respond here no
field staff required. To collect data through schedules is relatively more experience
considerable amount of money has to be spent in appointing enumerators and in importing
training to them. Money is also spent in preparing schedules.

3. Non-response is usually high in case of questionnaire as many people do not respond many
return the questionnaire without answering all questions. Bias due to non-resp' often remains
indeterminate. As against this, non-response is generally very low in case of schedules
because these are filled by enumerators who are able to get answers to questions. But there
remains the danger of interviewer bias and cheating.

4. In case of questionnaire, it is not always clear as to who replies, but in case of schedule
identity of respondent is known.

5. The questionnaire method is likely to be very slow since many respondents do not re me
questionnaire in time despite several reminders, but in case of schedules the information.
Collected well in time as they are filled in by enumerators.

6. Personal contact is generally not possible in case of the questionnaire questionnaires are
sent to respondents by post who also in turn return the same by r 3ut in case of schedules
direct personal contact is established with respondents.

7. Questionnaire method can be used oi:J1y when respondents are literate and cooperative,
case of schedules the information can be gathered even when the respondents happen to
illiterate.
8. Wider and more representative distribution of sample is possible under the questionnaire
Method, but in respect of schedules there usually remains the difficulty in semi enumerators
over a relatively wider area.

9. Risk of collecting incomplete and wrong information is relatively more under the
questionnaire Method, particularly when people are unable to understand questions properly.
But in Schedules, the information collected is generally complete and accurate as enumerators
can remove the difficulties, if any, faced by respondents in correctly understanding questions.
As a result, the information collected through schedules is relatively more accurate' an that
obtained through questionnaires.

10. The success of questionnaire method lies more on the quality of the questionnaire itself,
me case of schedules much depends upon the honesty and competence of enumerators order
to attract the attention of respondents, the physical appearance of questionnaire, but be quite
attractive, but this may not be so in case of schedules as they are to be filled by enumerators
and not by respondents.

12. Along with schedules, observation method can also be used but such a thing is not
possible

Methodology Adopted

TITAL OF THE STUDY

The research methodology of present study is been designed for find out FINANCIAL
DERIVATIES MYTHS AND REALITIES.

TIME DURATION: the time taken for collecting the Data was one month.

OBJECTIVES

The purpose of research is to discover answer to questions through the application of

scientific procedures. Through each research study has its own specific purpose, we may
think of research objectives as falling into a number of following groups: -
 • To study myths and realties of financial derivatives

• To highlight realities of derivatives

Data Sources

The data collection process was carried out in various stages. These stages can be
clubbed under two major heads.

Primary Source Survey

Secondary Source

(A) Primary Source Survey:-

A small survey was carried out to collect opinions of the retail investor about myths and
realities from different parts of jaipur.This type of survey collected data is known as primary
data. The Primary data are those, which are collected afresh and for the first time and thus happen
to be original in character.

(B) Secondary Source:-

Data collected in this method is known as secondary data. Secondary data means data that
re already available i.e. they refer to the data which have already been collected and
segregated by someone else. The researcher has to determine the various sources of
obtaining secondary data. Secondary data may be published or unpublished in nature.

Published data are available in:-

1. Technical or trade journals

2. Books, magazines and newspapers and Internet

3. Public record, statistics, historical documents and sources of public information

 Data used for the project was the secondary and primary data.

SAMPLING SIZE: 50 Respondents

Data Collection Techniques

The Data was collected through questionnaire. The data was collected through open
and close ended questionnaire, in which questions were asked in a logical order. Each
question has a specific meaning. The data analysis is based on the data collected through
these questions.

Market Segmentation

The market segmentation was done keeping in mind that what types of customer were
available in the market. These segments are namely:

A. Business Class
B. Service Class

PLANNING AND SCOPE:

The planning and scope of present study is designed to cover Udaipur IDBI activities. This
relevant data can be downloaded from Net.

LIMITATIONS: -

Every research has its own limitation and present work is no exception to unit general rule.
The inherent limitation of the study is as under:Questionnaire method, can be used only
when respondents are literate and co-operative.Non-response by source of the
respondents.

The sample size was small as compared to the population size as the time period was
limited and large number of respondents cannot be assimilated in study.Study was
 geographically restricted to some part of jaipur Sampling error is an inherent error
associated with random sampling.

DATA ANALYSIS & INTERPRETATION

Analysis of the data was done by drawing inferences through what was collected as input
from the respondents.

. Quantitative analysis

Qualitative analysis

Thus analysis of data require a number of closely related operations such as establishment
of categories, the application of these categories into raw data through tabulation, chart and
then draw inferences. Analysis work is generally based on the computation of various
percentage, co-efficient etc. by applying various statistical formulae.

Analysis and interpretation are the central steps in the research process. The goal of
analysis is to summaries the collected data in such a way that they provide answer to
questions that triggered while research. Interpretation is the research for border, meaning
of research finding.

Hence, questionnaire was analyzed separately and interpretation was done to bring
meaning and implication of the study. Hence analysis could not be completed without
interpretation and interpretation cannot proceed without analysis.

Data Analysis & Interpretation: -

Myth Number 1: Derivatives Are New, Complex, High-Tech Financial Products.

Customer View Answer

Yes 55%

No 38%

Cant say 7%
 7%

38%
55%

Yes No Can't Say

It founds that 55% small investors are of the opinion that derivatives are new ,complex And
high tecth products .38% of the respondents said no and 7% investors couldnot answer the
question.

Myth Number 2: Derivatives Are Purely Speculative, Highly Leveraged

Instruments

Customer View Answer

Yes 62%

No 28%

Cant say 10%

 10%

28%

62%

Yes NO Can't Say

It founds that 62% small investors are of the opinion that derivatives are purely speculative,
high leveraged instruments 28% of the respondents said no and 10% investors couldnot
answer the question.

Myth Number 3: Only Large Multinational Corporations and Large Banks

Have a Purpose for Using Derivatives

Coustmer view Answer

Yes 49%

No 40%

Can’t say 11%

 11%

49%

40%

Yes No Can't Say

founds that 49%small investors are of the opinion that derivatives are Only Large
Multinational Corporations and Large Banks Have a Purpose for Using Derivatives 40% of
the respondents said no and 10% investors couldnot answer the question.

Myth Number4. Financial Derivatives Are Simply the Latest Risk-

Management Fad

Coustmer view Answer

Yes 50%

No 37%

Can’t say 13%

 13%

50%

37%

Yes No Can't Say

It founds that50%small investors are of the opinion that derivatives are Financial Derivatives
Are Simply the Latest Risk-Management Fad,37 % of the respondents said no and 13%
investors couldnot answer the question.

Myth Number5: Derivatives Take Money Out of Productive Processes and

Never Put Anything Back

Coustmer view Answer

Yes 39%

No 42%

Can’t say 19%

 19%

39%

42%

Yes No Can't Say

It founds that 39%small investors are of the opinion that derivatives Take Money Out of
Productive Processes and Never Put Anything Back,42 % of the respondents said no and
19% investors couldnot answer the question.

Myth Number 6: Only Risk-Seeking Organizations Should Use Derivatives

Coustmer view Answer

Yes 49%

No 36%

Can’t say 15%

 15%

49%

36%

Yes No Can't Say

It founds that 49%small investors are of the opinion that derivatives Only Risk-Seeking
Organizations Should Use Derivatives36% of the respondents said no and15% investors
couldnot answer the question.

Myth Number7: The Risks Associated with Financial Derivatives Are New and
Unknown

Coustmer view Answer

Yes 43%

No 38%

Can’t say 19%

 19%

43%

38%

Yes No Can't Say

It founds that 43%small investors are of the opinion that The Risks Associated with
Financial Derivatives Are New and Unknown 38% of the respondents said no and19%
investors couldnot answer the question.

Myth Number8: Derivatives Trading an Unsafe and Unsound Banking

Practice

Coustmer view Answer

Yes 56%

No 38%

Can’t say 6%
 6%

38%
56%

Yes No Can't Say

It founds that 56%small investors are of the opinion that Derivatives Trading an Unsafe and
Unsound Banking Practice 38% of the respondents said no and6% investors couldnot
answer the question.

Myth Number 9: Derivatives trading Increases Systemic Risks

Coustmer view Answer

Yes 53%

No 34%

Can’t say 13%

 13%

53%
34%

Yes No Can't Say

It founds that 53%small investors are of the opinion that Derivatives Trading Increases
Systemic Risks 34% of the respondents said no and13% investors couldnot answer the
question.

Myth Number 10: Because of the Risks Associated with Derivatives, Banking
Regulators Should Ban Their Use by Any Institution

Coustmer view Answer

Yes 31%

No 52%

Can’t say 17%

 17%

31%

52%

Yes No Can't Say

It founds that 25%small investors are of the opinion that the Risks Associated with
Derivatives, Banking Regulators Should Ban Their Use by Any Institution ,55% of the
respondents said no and20% investors couldnot answer the question.

CONCLUSION AND SUGGESTION

Believing that the 10 myths presented here just one or two of them could lead and
regulatory major to restrict the use of derivatives. Regulatory restriction on derivative
activities are not the answers because standardized rules most likely would only impact
ones ability to mange risk effectively. The best regulation are those that guard against the
miss use or derivatives, as opposed to that severely restrict or even ban there use.

Derivative related losses can typically be traced to one or more of the following causes:

1. Speculative investment strategy.

2. Misunderstanding of how derivative relocate risk.

 ANNEXURE

QUESTIONNAIRE

1.PERSONAL DETAILS :-

NAME

ADDRESS

AGE
a. Below 25 b. 25 to 40 c. 35 to 50

d. 50 to 60 e. Above 60 (years)

2. OCCUPATION:-
a. Business Profession Service
d. Student Other

3. Type of Business:-
Proprietorship Partnership Unlisted

Private ltd. Other

4.Are you dealing in f&o segment :-

yes no

If yes:-

Why did you choose this segment for investment:-

……………………………………………………………………………………………
……………………………………………………………………………………………
……
What bank you prefer for f&o trading:-

……………………………………………………………………………………………
……………………………………………………………………………………………
……

Why choosen this bank for f&o trading

……………………………………………………………………………………………
……………………………………………………………………………………………
……

5. Are derivatives new ,complex ,high tech financial product:-

Yes No Can’t Say

 6.Are derivatives purely speculative and highly leveraged
instruments:-

9 Yes No Can’t Say

7.Only large organizations have purpose for using

derivatives:-

9 Yes No Can’t Say

8.Are derivatives take money out of productive process and

never put
any things:-
9 Yes No Can’t Say

9.Are derivatives simply the latest risk management tool:-

Yes No Can’t Say

10.Should it used by only risk seeking organization:-

Yes No Can’t Say

11.Are the risk associated with derivatives new or unknown:-

Yes No Can’t Say

12.Is derivative trading unsafe and risky:-

Yes No Can’t Say

13.Is it increases systematic risk:-

Yes No Can’t Say

14.Should derivative trading ban by regulators for their use:-

Yes No Can’t Say

If NO:-

Why you are not dealing in this segment?

.................................................................................................................................
.................................................................................................................................

LEAD SHEETs
NAME:

ADDRESS:

CONTACT NO:

BIBLIOGRAPHY

www.wikipedia.com

www.cato.org
www.yahoo.com

www.google.com

www.idbi.co

www.idbi capital.com,

John c hull (third Indian print, 2004) options, future and other deritives, (5th ed) Pearson
education, India

Future and option-----N.D. vohra and B.R. bagri

Financial derivatives: options ICFAI press. (risk management series) (2003)

Thomas F siems. “10 myths about financial derivatives

Bseindia.com

Nseindia.com