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A REPORT
ON
DERIVATIVE MARKET
_____________________________________________________________
A report submitted in complete fulfillment of the requirements of PGDM program
of INSTITUTE OF TECHNOLOGY AND SCIENCE GHAZIABAD
SUBMITTED TO:
PROF. PRIYA
FACULTY
I.T.S GHAZIABAD
RAHUL KUMAR AGARWAL
ASM
IL&FS INVESTSMART SECURITIES LIMITED
E MAIL RAHULAGARWAL@hsbci.in
ACKNOWLEDGEMENT
The beatitude, bliss and euphoria that accompany the successful completion of any task
would not be complete without the expression of appreciation of simple virtues to the
people who made it possible.
The final project report is submitted to institute of technology and science, Ghaziabad
for partial fulfilment of diploma, post graduate diploma in management (PGDM).
This project is an attempt to study DERIVATIVE MARKET-INDIA
At IL&FS INVESTSMART SECURITIES LTD.(HSBC Group).
I would like to thanks to the Management of IL&FS INVESTSMART SECURITIES
LTD. (HSBC Group) for giving me the opportunity to do my two-month project training
in their esteemed organization. I am highly obliged to Mr. RAHUL KUMAR AGARWAL
sincerely thank my faculty guide PROF. PRIYA whose guidance has helped me to
Understand and complete my project in a timely and proper manner
MUKTA DHEER
DECLARATION
I do hereby declare that the project report is submitted as partial fulfilment of the
requirement of PGDM Program of INSTITUTE OF TECHNOLOGY AND SCIENCE,
GHAZIABAD.
The Project has been done under the guidance of Mr. RAHUL KUMAR AGARAWAL,
in Raj nagar branch ,Ghaziabad and PROF. PRIYA Faculty guide, INSTITUTE OF
TECHNOLOGY AND SCIENCE, Ghaziabad
No part of this report has not been published or submitted elsewhere for the fulfilment of
any degree or diploma for any institute or university.
MUKTA DHEER
EXECUTIVE SUMMARY
New ideas and innovations have always been the hallmark of progress made by mankind.
At every stage of development, there have been two core factors that drives man to ideas
and innovation. These are increasing returns and reducing risk, in all facets of life.
The financial markets are no different. The endeavour has always been to maximize
returns and minimize risk. A lot of innovation goes into developing financial products
centred on these two factors. It has spawned a whole new area called financial
engineering.
Derivatives are among the forefront of the innovations in the financial markets and aim to
increase returns and reduce risk. They provide an outlet for investors to protect
themselves from the vagaries of the financial markets. These instruments have been very
popular with investors all over the world.
Indian financial markets have been on the ascension and catching up with global
standards in financial markets. The advent of screen based trading, dematerialization,
rolling settlement have put our markets on par with international markets.
As a logical step to the above progress, derivative trading was introduced in the country
in June 2000. Starting with index futures, we have made rapid strides and have four types
of derivative products- Index future, index option, stock future and stock options. Today,
there are 30 stocks on which one can have futures and options, apart from the index
futures and options.
This market presents a tremendous opportunity for individual investors .The markets
have performed smoothly over the last two years and has stabilized. The time is ripe for
investors to make full use of the advantage offered by this market.
We have tried to present in a lucid and simple manner, the derivatives market, so that the
individual investor is educated and equipped to become a dominant player in the market
CONTENTS
PAGE NO.
INTRODUCTION TO PROJECT
COMPANY PROFILE
DERIVATIVES
a) Derivative defined
b) Types of market
c) History of derivatives
d) Indian derivative market
e) Need for derivatives in India today
f) Myths and realities about derivatives
g) Comparison of new system with existing system
h) Factor contributing to the growth of derivatives
i) Benefits of derivatives
13
15
25
27
28
28
31
36
39
41
NATIONAL EXCHANGES
45
RESEARCH OBJECTIVE
48
RESEARCH METHODOLOGY
48
51
62
BIBLIOGRAPHY
63
ANNEXURE
a) Questionnaire
b) Abbreviations
64
68
INTRODUCTION
A Derivative is a financial instrument whose value depends on other, more basic,
underlying variables. The variables underlying could be prices of traded securities
and stock, prices of gold or copper. Derivatives have become increasingly important
in the field of finance, Options and Futures are traded actively on many exchanges,
Forward contracts, Swap and different types of options are regularly traded outside
exchanges by financial intuitions, banks and their corporate clients in what are termed
as over-the-counter markets in other words, there is no single market place
organized exchanges. Interpretation
The study has been done to know the different types of derivatives and also to know
the derivative market in India. This study also covers the recent developments in the
derivative market taking into account the trading in past years.
Through this study I came to know the trading done in derivatives and their use in the
stock markets.
2. COMPANY PROFILE
IL&FS Investsmart securities Limited (IISL) is one of Indias leading financial
services organizations providing individuals and corporate with customized financial
management solutions. IL&FS investsmart limited( IIL) through its subsidiaries in India
and Singapore provide a wide range of investment products to its retail and institutional
client including equity broking investment banking, insurance broking and distribution,
mutual fund distribution and related financial services.
IILs 2000 employees provide a complete range of investment solution to over
138000 customers in India through its 88 branches and 190 franchised outlets from 133
cities. Company is having a market capitalization of approximately US $260 million.
Investsmart is listed on the national stock exchange (NSE) and the Bombay stock
exchange (BSE) and its global depository share are listed on the LUXEMBURG STOCK
EXCHANGE
At IISL, we believe in "Realizing your goals together". You will find in us - a trusted
investment partner to help you work towards achieving your financial goals. Our
institutional expertise, combined with a thorough understanding of the financial markets
results in appropriate investment solutions for you.
Our strong team of all your investment needs through a office near you. All you need
to do is drop in at the nearest branch or call us and well be happy to do the rest!
Investsmart recognized as National Relationship Managers, Customer Service
Executives, Advisory Managers and Research Analysts, offers efficient execution backed
by in-depth research, knowledge and expertise to customers across the country. With a
pan-India presence of over 300 offices, IISL is geared to meet Best Performing
Financial Advisor-Retail for two tear in a row (2006-07 and 2007-08) by CNBC
TV18.
Vision
To become a long term preferred long term financial to a wide base of customer whilst
optimizing Stake holder value.
Mission
To establish a base of 1 million satisfied customer by 2010 We will create this by
being a responsible trustworthy partner.
Corporate action
An approach to business that reflects responsibility, transparency and ethical
behaviour Respect for employee client and stake holder group.
10
Naina Lal Kidwai, Group General Manager and Chief Executive Officer, HSBC in India,
added: "Investsmart is a great addition to our current operations, which already constitute
the second largest foreign banking network in India. We look forward to working with
Investsmart's management team and growing this business."
HSBC was advised on the acquisition by the investment banking division of HSBC
Global Banking and Markets. The HSBC Group in India is represented by several entities
including The Hongkong and Shanghai Banking Corporation Limited which offers a
11
full range of banking and financial services to its over 2.8 million customers in India
through its 47 branches and 170 ATMs across 26 cities. HSBC is one of India's leading
financial services groups, with over 34,000 employees in its banking, investment banking
and capital markets, asset management, insurance broking, two global IT development
centres and six global resourcing operations in the country. The Bank is the founding and
a principal member of the HSBC Group which, with over 9,500 offices in 85 countries
and territories and assets of US$2,547 billion at 30 June 2008, is one of the world's
largest banking and financial services organizations.
In September 2008, HSBC Securities & Capital Markets (HSCI) and HSBC Violet
Investments (Mauritius) had acquired 29.35% and 43.85% stakes held by IL&FS and E
Trade in IL&FS Investsmart. Post the stake acquisition, HSCIs total holding in IL&FS
Investsmart increased to 50.01%, taking the total stake held by HSBC and HSCI together
in the company to 93.86%
HSBC Securities & capital markets (India) private limited
34,922,751
50.01 %
30,625,692
43.85 %
Others
4,287,830
6.14 %
Total
69836273
100 %
12
Currently HSBC group is having 93.86% of share in IL&FS investsmart securities limited.
HSBC securities and capital markets (INDIA) private limited has 50.01% HSBC violet
investment (maturities) limited has 43.85% in investsmart. Now the company is running under
the management of HSBC group.
13
3. INTRODUCTION TO DERIVATIVES
The origin of derivatives can be traced back to the need of farmers to protect themselves
against fluctuations in the price of their crop. From the time it was sown to the time it
was ready for harvest, farmers would face price uncertainty. Through the use of simple
derivative products, it was possible for the farmer to partially or fully transfer price risks
by locking-in asset prices. These were simple contracts developed to meet the needs of
farmers and were basically a means of reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he would
receive for his harvest in September. In years of scarcity, he would probably obtain
attractive prices. However, during times of oversupply, he would have to dispose off his
harvest at a very low price. Clearly this meant that the farmer and his family were
exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too would
face a price risk that of having to pay exorbitant prices during dearth, although favorable
prices could be obtained during periods of oversupply. Under such circumstances, it
clearly made sense for the farmer and the merchant to come together and enter into
contract whereby the price of the grain to be delivered in September could be decided
earlier. What they would then negotiate happened to be futures-type contract, which
would enable both parties to eliminate the price risk.
In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers
and merchants together. A group of traders got together and created the to-arrive
contract that permitted farmers to lock into price upfront and deliver the grain later. These
to-arrive contracts proved useful as a device for hedging and speculation on price
charges. These were eventually standardized, and in 1925 the first futures clearing house
came into existence.
14
3.1DERIVATIVES DEFINED
A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can be
equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of change in
price by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the underlying in this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures
contracts in commodities all over India. As per this the Forward Markets Commission
(FMC) continues to have jurisdiction over commodity futures contracts. However when
derivatives trading in securities was introduced in 2001, the term security in the
Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative
contracts in securities. Consequently, regulation of derivatives came under the purview of
Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities
for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of derivatives is
governed by the regulatory framework under the SCRA. The Securities Contracts
(Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract differences or any other form of security.
15
A contract which derives its value from the prices, or index of prices, of underlying
securities
Index Future
Index option
Stock option
Stock future
Interest
rate Futures
Derivatives
Future
Option16
Forward
Swaps
On the expiration date, the contract has to be settled by delivery of the asset.
If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
17
18
1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:
The underlying. This can be anything from a barrel of sweet crude oil to a short
term interest rate.
The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term interest
rate is traded, etc.
The grade of the deliverable. In case of bonds, this specifies which bonds can be
delivered. In case of physical commodities, this specifies not only the quality of
the underlying goods but also the manner and location of delivery. The delivery
month.
Other details such as the tick, the minimum permissible price fluctuation.
2. Margin:
Although the value of a contract at time of trading should be zero, its price constantly
fluctuates. This renders the owner liable to adverse changes in value, and creates a credit
risk to the exchange, who always acts as counterparty. To minimize this risk, the
exchange demands that contract owners post a form of collateral, commonly known as
Margin requirements are waived or reduced in some cases for hedgers who have physical
ownership of the covered commodity or spread traders who have offsetting contracts
balancing the position.
19
Initial margin: is paid by both buyer and seller. It represents the loss on that contract, as
determined by historical price changes, which is not likely to be exceeded on a usual
day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may exhaust the
initial margin, a further margin, usually called variation or maintenance margin, is
required by the exchange. This is calculated by the futures contract, i.e. agreeing on a
price at the end of each day, called the "settlement" or mark-to-market price of the
contract.
To understand the original practice, consider that a futures trader, when taking a position,
deposits money with the exchange, called a "margin". This is intended to protect the
exchange against loss. At the end of every trading day, the contract is marked to its
present market value. If the trader is on the winning side of a deal, his contract has
increased in value that day, and the exchange pays this profit into his account. On the
other hand, if he is on the losing side, the exchange will debit his account. If he cannot
pay, then the margin is used as the collateral from which the loss is paid.
3. Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways,
as specified per type of futures contract:
Physical delivery - the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the
buyers of the contract. In practice, it occurs only on a minority of contracts. Most
are cancelled out by purchasing a covering position - that is, buying a contract to
cancel out an earlier sale (covering a short), or selling a contract to liquidate an
earlier purchase (covering a long).
Cash settlement - a cash payment is made based on the underlying reference rate,
such as a short term interest rate index such as Euribor, or the closing value of a
stock market index. A futures contract might also opt to settle against an index
based on trade in a related spot market.
20
Expiry is the time when the final prices of the future are determined. For many equity
index and interest rate futures contracts, this happens on the Last Thursday of certain
trading month. On this day the t+2 futures contract becomes the t forward contract.
Pricing of future contract
In a futures contract, for no arbitrage to be possible, the price paid on delivery (the
forward price) must be the same as the cost (including interest) of buying and storing the
asset. In other words, the rational forward price represents the expected future value of
the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying
asset, the value of the future/forward,
value
at time to maturity
This relationship may be modified for storage costs, dividends, dividend yields, and
convenience yields. Any deviation from this equality allows for arbitrage as follows.
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today (on the
spot market) with borrowed money.
2. On the delivery date, the arbitrageur hands over the underlying, and receives the
agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.
In the case where the forward price is lower:
1. The arbitrageur buys the futures contract and sells the underlying today (on the
spot market); he invests the proceeds.
2. On the delivery date, he cashes in the matured investment, which has appreciated
at the risk free rate.
3. He then receives the underlying and pays the agreed forward price using the
matured investment. [If he was short the underlying, he returns it now.]
21
22
FORWARD CONTRACT
FUTURE CONTRACT
Operational
Mechanism
Contract
Exists.
Specifications
Counter-party
risk
Liquidation
as
contracts
are
Profile
standardized
Not efficient, as markets are Efficient, as markets are centralized and all
scattered.
Examples
23
24
OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy
or sell the underlying asset at a price, called the strike price, during a period or on a
specific date in exchange for payment of a premium is known as option. Underlying
asset refers to any asset that is traded. The price at which the underlying is traded is
called the strike price.
There are two types of options i.e., CALL OPTION AND PUT OPTION.
CALL OPTION:
A contract that gives its owner the right but not the obligation to buy an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as
a Call option. The owner makes a profit provided he sells at a higher current price and
buys at a lower future price.
b. PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as
a Put option. The owner makes a profit provided he buys at a lower current price and
sells at a higher future price. Hence, no option will be exercised if the future price does
not increase.
Put and calls are almost always written on equities, although occasionally preference
shares, bonds and warrants become the subject of options.
25
4. SWAPS Swaps are transactions which obligates the two parties to the contract to exchange a
series of cash flows at specified intervals known as payment or settlement dates. They
can be regarded as portfolios of forward's contracts. A contract whereby two parties agree
to exchange (swap) payments, based on some notional principle amount is called as a
SWAP. In case of swap, only the payment flows are exchanged and not the principle
amount. The two commonly used swaps are:
INTEREST RATE SWAPS:
Interest rate swaps is an arrangement by which one party agrees to exchange his series of
fixed rate interest payments to a party in exchange for his variable rate interest payments.
The fixed rate payer takes a short position in the forward contract whereas the floating
rate payer takes a long position in the forward contract.
CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and the interest on
loan in one currency are swapped for the principle and the interest payments on loan in
another currency. The parties to the swap contract of currency generally hail from two
different countries. This arrangement allows the counter parties to borrow easily and
cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are
determined at the spot rate at a time when swap is done. Such cash flows are supposed to
remain unaffected by subsequent changes in the exchange rates.
FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to access one
market and then exchange the liability for another type of liability. It also allows the
investors to exchange one type of asset for another type of asset with a preferred income
stream.
26
The other kind of derivatives, which are not, much popular are as follows:
5. BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are
most popular form of baskets.
6. LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange
may introduce option contracts with a maturity period of 2-3 years. These long-term
option contracts are popularly known as Leaps or Long term Equity Anticipation
Securities.
7. WARRANTS Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
8. SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the expiry of
the options. Thus a swaption is an option on a forward swap. Rather than have calls and
puts, the swaptions market has receiver swaptions and payer swaptions. A receiver
swaption is an option to receive fixed and pay floating. A payer swaption is an option to
pay fixed and receive floating.
27
The history of derivatives is quite colourful and surprisingly a lot longer than most people
think. Forward delivery contracts, stating what is to be delivered for a fixed price at a
specified place on a specified date, existed in ancient Greece and Rome. Roman emperors
entered forward contracts to provide the masses with their supply of Egyptian grain.
These contracts were also undertaken between farmers and merchants to eliminate risk
arising out of uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.
The first organized commodity exchange came into existence in the
early 1700s in Japan. The first formal commodities exchange, the Chicago Board of
Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk
and to provide centralised location to negotiate forward contracts. From forward trading
in commodities emerged the commodity futures. The first type of futures contract was
called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT
listed the first exchange traded derivatives contract, known as the futures contracts.
Futures trading grew out of the need for hedging the price risk involved in many
commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT,
was formed in 1919, though it did exist before in 1874 under the names of Chicago
Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first
financial futures to emerge were the currency in 1972 in the US. The first foreign
currency futures were traded on May 16, 1972, on International Monetary Market
(IMM), a division of CME. The currency futures traded on the IMM are the British
Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the
Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest
rate futures. Interest rate futures contracts were traded for the first time on the CBOT on
October 20, 1975. Stock index futures and options emerged in 1982. The first stock index
futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The
first of the several networks, which offered a trading link between two exchanges, was
28
formed between the Singapore International Monetary Exchange (SIMEX) and the
CME on September 7, 1984.
Options are as old as futures. Their history also dates back to ancient Greece and Rome.
Options are very popular with speculators in the tulip craze of seventeenth century
Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a
high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb
options. There was so much speculation that people even mortgaged their homes and
businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as
there was no mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an American financier,
Russell Sage, in 1872. These options were traded over the counter. Agricultural
commodities options were traded in the nineteenth century in England and the US.
Options on shares were available in the US on the over the counter (OTC) market only
until 1973 without much knowledge of valuation. A group of firms known as Put and Call
brokers and Dealers Association was set up in early 1900s to provide a mechanism for
bringing buyers and sellers together.
On April 26, 1973, the Chicago Board options Exchange (CBOE) was
set up at CBOT for the purpose of trading stock options. It was in 1973 again that black,
Merton, and Scholes invented the famous Black-Scholes Option Formula. This model
helped in assessing the fair price of an option which led to an increased interest in trading
of options. With the options markets becoming increasingly popular, the American Stock
Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in
options in 1975.
The market for futures and options grew at a rapid pace in the eighties and nineties. The
collapse of the Bretton Woods regime of fixed parties and the introduction of floating
rates for currencies in the international financial markets paved the way for development
29
DERIVATIVES MARKET
Starting from a controlled economy, India has moved towards a world where prices
fluctuate every day. The introduction of risk management instruments in India gained
momentum in the last few years due to liberalisation process and Reserve Bank of Indias
(RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation process to manage risk. NSE gauging the market requirements initiated the
process of setting up derivative markets in India. In July 1999, derivatives trading
commenced in India
Table Chronology of instruments
1991
Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for
11 May 1998
7 July 1999
index futures.
L.C.Gupta Committee submitted report.
RBI gave permission for OTC forward rate agreements (FRAs) and
24 May 2000
30
25 May 2000
9 June 2000
12 June 2000
25 September 2000
2 June 2001
31
Disasters prove that derivatives are very risky and highly leveraged instruments
Derivatives are complex and exotic instruments that Indian investors will find
difficulty in understanding
32
By providing investors and issuers with a wider array of tools for managing risks
and raising capital, derivatives improve the allocation of credit and the sharing of risk in
the global economy, lowering the cost of capital formation and stimulating economic
growth. Now that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global markets
increasing market liquidity and efficiency and facilitating the flow of trade and finance.
33
PRE-REQUISITES
Large market Capitalisation
INDIAN SCENARIO
India is one of the largest market-capitalised countries in
Asia with a market capitalisation of more than Rs.765000
crores.
High
Liquidity
in
underlying
Trade guarantee
the underlying.
The first clearing corporation guaranteeing trades has
become fully functional from July 1996 in the form of
National Securities
the clearing.
National Securities Depositories Limited (NSDL) which
started functioning in the year 1997 has revolutionalised
34
35
Figure 3.3a
Speculators
Existing
Approach
SYSTEM
New
Peril &Prize
1) Deliver based
1)Maximum
Trading, margin
loss to extent of
on delivery basis
loss possible
trading& carry
price change.
to premium
forward transactions.
by paying
paid
premium
36
Advantages
Figure 3.3b
Arbitrageurs
Existing
SYSTEM
Approach
New
Peril &Prize
1) Buying Stocks in
1) Make money
1) B Group more
promising as still
another exchange.
Market moves.
in weekly settlement
forward transactions.
2) Cash &Carry
2) If Future Contract
arbitrage continues
37
1) Risk free
game.
Figure 3.3c
Hedgers
Existing
Approach
1) Difficult to
SYSTEM
Peril &Prize
1) No Leverage
Approach
New
Peril &Prize
1) Additional
offload holding
available risk
cost is only
during adverse
reward dependant
premium.
market conditions
on market prices
as circuit filters
Advantages
Availability of Leverage
38
Figure 3.3d
Small Investors
Existing
Approach
1) If Bullish buy
stocks else sell it.
SYSTEM
New
Peril &Prize
implies unlimited
profit/loss.
1) Downside
remains
2) Hedge position if
protected &
holding underlying
upside
stock
unlimited.
Advantages
Losses Protected.
OTC derivative positions were the main cause of turbulence in financial markets in 1998.
These episodes of turbulence revealed the risks posed to market stability originating in
features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchanges self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market
stability.
The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic nature of
gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative
activities on available aggregate credit; (iv) the high concentration of OTC derivative
activities in major institutions; and (v) the central role of OTC derivatives markets in the
global financial system. Instability arises when shocks, such as counter-party credit
events and sharp movements in asset prices that underlie derivative contracts, occur
which significantly alter the perceptions of current and potential future credit exposures.
40
When asset prices change rapidly, the size and configuration of counter-party exposures
can become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However, the
progress has been limited in implementing reforms in risk management, including
counter-party, liquidity and operational risks, and OTC derivatives markets continue to
pose a threat to international financial stability. The problem is more acute as heavy
reliance on OTC derivatives creates the possibility of systemic financial events, which
fall outside the more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through the use of exchange traded derivatives. In
view of the inherent risks associated with OTC derivatives, and their dependence on
exchange traded derivatives, Indian law considers them illegal.
3.9 FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:
Factors contributing to the explosive growth of derivatives are price volatility,
globalisation of the markets, technological developments and advances in the financial
theories.
A.} PRICE VOLATILITY
A price is what one pays to acquire or use something of value. The objects having value
maybe commodities, local currency or foreign currencies. The concept of price is clear to
almost everybody when we discuss commodities. There is a price to be paid for the
purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of
another persons money is called interest rate. And the price one pays in ones own
currency for a unit of another currency is called as an exchange rate.
41
Prices are generally determined by market forces. In a market, consumers have demand
and producers or suppliers have supply, and the collective interaction of demand and
supply in the market determines the price. These factors are constantly interacting in the
market causing changes in the price over a short period of time. Such changes in the price
are known as price volatility. This has three factors: the speed of price changes, the
frequency of price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The break down of the BRETTON WOODS agreement
brought and end to the stabilising role of fixed exchange rates and the gold convertibility
of the dollars. The globalisation of the markets and rapid industrialisation of many
underdeveloped countries brought a new scale and dimension to the markets. Nations that
were poor suddenly became a major source of supply of goods. The Mexican crisis in the
south east-Asian currency crisis of 1990s has also brought the price volatility factor on
the surface. The advent of telecommunication and data processing bought information
very quickly to the markets. Information which would have taken months to impact the
market earlier can now be obtained in matter of moments. Even equity holders are
exposed to price risk of corporate share fluctuates rapidly.
These price volatility risks pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against adverse price
changes in commodity, foreign exchange, equity shares and bonds.
B.} GLOBALISATION OF MARKETS
Earlier, managers had to deal with domestic economic concerns; what happened in other
part of the world was mostly irrelevant. Now globalisation has increased the size of
markets and as greatly enhanced competition .it has benefited consumers who cannot
42
obtain better quality goods at a lower cost. It has also exposed the modern business to
significant risks and, in many cases, led to cut profit margins
In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis--vis depreciated currencies. Export of certain goods
from India declined because of this crisis. Steel industry in 1998 suffered its worst set
back due to cheap import of steel from south East Asian countries. Suddenly blue chip
companies had turned in to red. The fear of china devaluing its currency created
instability in Indian exports. Thus, it is evident that globalisation of industrial and
financial activities necessitates use of derivatives to guard against future losses. This
factor alone has contributed to the growth of derivatives to a significant extent.
C.} TECHNOLOGICAL ADVANCES
A significant growth of derivative instruments has been driven by technological break
through. Advances in this area include the development of high speed processors,
network systems and enhanced method of data entry. Closely related to advances in
computer
technology
are
advances
in
telecommunications.
Improvement
in
43
PRICE DISCOVERY
Price discovery refers to the markets ability to determine true equilibrium prices. Futures
prices are believed to contain information about future spot prices and help in
disseminating such information. As we have seen, futures markets provide a low cost
trading mechanism. Thus information pertaining to supply and demand easily percolates
into such markets. Accurate prices are essential for ensuring the correct allocation of
resources in a free market economy. Options markets provide information about the
volatility or risk of the underlying asset.
3.]
OPERATIONAL ADVANTAGES
44
MARKET EFFICIENCY
The availability of derivatives makes markets more efficient; spot, futures and options
markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is
possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence
these markets help to ensure that prices reflect true values.
5.]
EASE OF SPECULATION
The prices of derivatives converge with the prices of the underlying at the
expiration of derivative contract. Thus derivatives help in discovery of future as
well as current prices.
An important incidental benefit that flows from derivatives trading is that it acts
as a catalyst for new entrepreneurial activity.
45
Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
46
47
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):
segment. It constituted 70 per cent of the total turnover during June 2002. A primary
reason attributed to this phenomenon is that traders are comfortable with single-stock
futures than equity options, as the former closely resembles the erstwhile badla system.
On relative terms, volumes in the index options segment continue to remain poor.
This may be due to the low volatility of the spot index. Typically, options are considered
more valuable when the volatility of the underlying (in this case, the index) is high. A
related issue is that brokers do not earn high commissions by recommending index
options to their clients, because low volatility leads to higher waiting time for round-trips.
Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in January
48
2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are
increasingly becoming pessimistic on the market.
Farther month futures contracts are still not actively traded. Trading in equity
options on most stocks for even the next month was non-existent.
Daily option price variations suggest that traders use the F&O segment as a less
risky alternative (read substitute) to generate profits from the stock price movements. The
fact that the option premiums tail intra-day stock prices is evidence to this. If calls and
puts are not looked as just substitutes for spot trading, the intra-day stock price variations
should not have a one-to-one impact on the option premiums.
The spot foreign exchange market remains the most important segment but the
derivative segment has also grown. In the derivative market foreign exchange
swaps account for the largest share of the total turnover of derivatives in India
followed by forwards and options. Significant milestones in the development of
derivatives market
49
This period has also witnessed several relaxations in regulations relating to forex
markets and also greater liberalisation in capital account regulations leading to
greater integration with the global economy.
Cash settled exchange traded currency futures have made foreign currency a
separate asset class that can be traded without any underlying need or exposure a n d
on a leveraged basis on the recognized stock exchanges with credit risks being
assumed by the central counterparty
Since the commencement of trading of currency futures in all the three exchanges,
the value of the trades has gone up steadily from Rs 17, 429 crores in October 2008
to Rs 45, 803 crores in December 2008. The average daily turnover in all the
exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same
period. The turnover in the currency futures market is in line with the international
scenario, where I understand the share of futures market ranges between 2 3 per
cent.
Table 4.1ForexMarketActivity
April05-
April06-
April07-
April08-
Mar06
4,404
Mar07
6,571
Mar08
12,304
Mar09
9,621
2.6:1
2.7:1
2.37: 1
2.66:1
50.5
51.9
49.7
54.9
19.0
17.9
19.3
21.5
30.5
30.1
31.1
32.7
Source: RBI
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5. National Exchanges
In enhancing the institutional capabilities for futures trading the idea of setting up
of National Commodity Exchange(s) has been pursued since 1999. Three such
Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE),
Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and
Multi Commodity Exchange (MCX), Mumbai have become operational. National
Status implies that these exchanges would be automatically permitted to conduct futures
trading in all commodities subject to clearance of byelaws and contract specifications by
the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002,
MCX and NCDEX, Mumbai commenced operations in October/ December 2003
respectively.
MCX
MCX (Multi Commodity Exchange of India Ltd.) an independent and demutulised multi commodity exchange has permanent recognition from Government of
India for facilitating online trading, clearing and settlement operations for commodity
futures markets across the country. Key shareholders of MCX are Financial Technologies
(India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of
Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India,
51
Bank of
India, Bank of
Baroda,
NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by
Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing
Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL),
Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural
Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral
aspects of commodity economy, viz., warehousing, cooperatives, private and public
sector marketing of agricultural commodities, research and training were adequately
addressed in structuring the Exchange, finance was still a vital missing link. Punjab
National Bank (PNB) took equity of the Exchange to establish that linkage. Even today,
NMCE is the only Exchange in India to have such investment and technical support from
the commodity relevant institutions.
52
NMCE facilitates electronic derivatives trading through robust and tested trading
platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust
delivery mechanism making it the most suitable for the participants in the physical
commodity markets. It has also established fair and transparent rule-based procedures and
demonstrated total commitment towards eliminating any conflicts of interest. It is the
only Commodity Exchange in the world to have received ISO 9001:2000 certification
from British Standard Institutions (BSI). NMCE was the first commodity exchange to
provide trading facility through internet, through Virtual Private Network (VPN).
NMCE follows best international risk management practices. The contracts are
marked to market on daily basis. The system of upfront margining based on Value at Risk
is followed to ensure financial security of the market. In the event of high volatility in the
prices, special intra-day clearing and settlement is held. NMCE was the first to initiate
process of dematerialization and electronic transfer of warehoused commodity stocks.
The unique strength of NMCE is its settlements via a Delivery Backed System, an
imperative in the commodity trading business. These deliveries are executed through a
sound and reliable Warehouse Receipt System, leading to guaranteed clearing and
settlement.
NCDEX
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology
driven commodity exchange. It is a public limited company registered under the
Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April
23,2003. It has an independent Board of Directors and professionals not having any
vested interest in commodity markets. It has been launched to provide a world-class
commodity exchange platform for market participants to trade in a wide spectrum of
commodity derivatives driven by best global practices, professionalism and transparency.
53
Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and
various other legislations, which impinge on its working. It is located in Mumbai and
offers facilities to its members in more than 390 centres throughout India. The reach will
gradually be expanded to more centres.
NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed,
Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil,
Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green
Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice,
Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe),
Wheat, Yellow Peas, Yellow Red Maize & Yellow soyabean meal.
54
RESARCH METHODOLOGY
Method of data collection:Secondary sources:It is the data which has already been collected by some one or an organization for
some other purpose or research study .The data for study has been collected from various
sources:
Books
Journals
Magazines
Internet sources
RESEARCH DESIGN
55
Non probability
The non probability respondents have been researched by selecting the persons who do the
trading in derivative market. Those persons who do not trade in derivative market have not been
interviewed.
Exploratory and descriptive research
The research is primarily both exploratory and descriptive in nature. The sources of
information are both primary and secondary. The secondary data has been taken by referring to
various magazines, newspapers, internal sources and internet to get the figures required for the
research purposes. The objective of the exploratory research is to gain insights and ideas. The
objective of the descriptive research study is typically concerned with determining the frequency
with which something occurs. A well structured questionnaire was prepared for the primary
research and personal interviews were conducted to collect the responses of the target
population.
SAMPLING METHODOLOGY
Sampling Technique
Initially, a rough draft was prepared a pilot study was done to check the accuracy of the
Questionnaire and certain changes were done to prepare the final questionnaire to make it more
judgmental.
Sampling Unit
56
The respondents who were asked to fill out the questionnaire in the National Capital Region are
the sampling units. These respondents comprise of the persons dealing in derivative market. The
people have been interviewed in the open market, in front of the companies, telephonic
interviews and through other sources also
Sample Size
The sample size was restricted to only 50 respondents.
Sampling Area
The area of the research was National Capital Region (NCR).
Time:
2 months
Statistical Tools Used:
Simple tools like bar graphs, tabulation, line diagrams have been used.
ANALYSIS
Q. Education qualification of investors who investing in derivative market.
Education
Under graduate
Graduate
No. of result
6
10
57
Post graduate
Professional
23
11
Income range
below 1,50,000
1,50,000-3,00,000
3,00,000-5,00,000
above 5,00,000
No. of Result
1
9
14
26
58
Q. Normally what percentage of your monthly household income could be available for
investment
Investment
Between 5% to 10%
Between 11% to 15%
Between 16% to 20%
Between 21% to 25%
More than 25%
No. of result
2
6
13
18
11
59
60
Q. What kind of risk do you perceive while investing in the stock market?
No.of result
19
22
6
3
61
Reasons
Lack of knowledge & understanding
Increase speculation
Risky & highly leveraged
Counter party risk
No.of result
27
2
17
4
Purpose of investment
Hedge their fund
Risk control
More stable
Direct investment without buying & holding assets
62
No. of Result
27
9
1
13
Participation as
investor
Speculator
Broker/Dealer
Hedger
No. of Result
23
2
8
17
63
Q. From where you prefer to take advice before investing in derivative market?
Advice From
Brokerage houses
Research analyst
Websites
News Networks
Others
No. of Result
15
7
2
23
3
Participate in
Stock index futures
Stock index Options
No. of Result
19
13
64
6
9
3
Q. What contract maturity period would interest you for trading in?
65
66
Result of
No.of
investment
Great results
Moderate but
result
acceptable
Disappointed
4
24
22
Q. What is best describes the overall approach to invest as a mean of achieving investors
goals.
OPTIONS
Relative level of stability in overall investment
portfolio
increasing investment value while minimizing
potential for loss of principal
Investment growth with moderate high levels of
risk
Maximum long term returns with high risk
67
NO. of Result
17
19
4
10
INTERPRETATION
Most of the investors who invest in derivatives market are post graduate.
Investors generally perceive slump in stock market kind of risk while investing in
derivative market.
68
People are generally not investing in derivative market due to lack of knowledge
and difficulty in understanding and it is very risky also.
People generally prefer to take advice from news network before investing in
derivative market.
From this survey we come to know that most of investors make a contract of 3
month maturity period.
69
A knowledge need to be spread concerning the risk and return of the derivative
market.
More variation in stock index future need to be made looking a demand side of
investors.
LIMITAITONS OF STUDY
1. LIMITED TIME:
The time available to conduct the study was only 2 months. It being a wide topic, had
a limited time..
2. LIMITED RESOURCES:
Limited resources are available to collect the information about the commodity
trading
3. VOLATALITY:
Share market is so much volatile and it is difficult to forecast anything about it
whether you trade through online or offline
4. ASPECTS COVERAGE:
Some of the aspects may not be covered in my study.
70
BIBLIOGRAPHY
Books referred:
Options Futures, and other Derivatives by John C Hull
Derivatives FAQ by Ajay Shah
NSEs Certification in Financial Markets: - Derivatives Core module
Financial Markets & Services by Gordon & Natarajan
Reports:
Report of the RBI-SEBI standard technical committee on exchange traded
Currency Futures
Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA
Websites visited:
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.ncdex.com
www.google.com
www.derivativesindia.com
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ANNEXURE
<INPUT TYPE=\
3,00,000
<INPUT TYPE=\ 3,00,000 5,00,000
5,00,000
3. Normally what percentage of your monthly household income could be available for
investment?
72
11% to 15%
<INPUT TYPE=\ Between 16% to 20%
21% to 25%
<INPUT TYPE=\ More than 25%
4. What is your primary investment purpose?
<INPUT TYPE=\ Retirement Planning
<INPUT TYPE=\ Building up a corpus for charity donations
<INPUT TYPE=\ Supporting future education of your children
<INPUT TYPE=\ Other (Specify) _____________________
5. What kind of risk do you perceive while investing in the stock market?
<INPUT TYPE=\ Uncertainty of returns
stock market
<INPUT TYPE=\ Fear of being windup of company
(Specify) _________________
6. Why people do not invest in derivative market? (Rank your preference 1-4)
<INPUT TYPE=\ Lack of knowledge and difficulty in understanding
<INPUT TYPE=\ Increase speculation
<INPUT TYPE=\ Very risky and highly leveraged instrument
<INPUT TYPE=\ Counter party risk
73
9. From where you prefer to take advice before investing in derivative market?
<INPUT TYPE=\ Brokerage houses
analyst
<INPUT TYPE=\ Websites
Networks
<INPUT TYPE=\ Other (Specify) _________________
10. In which of the following would you like to participate?
<INPUT TYPE=\ Stock Index Futures
Options
<INPUT TYPE=\ Future on individual stock
individual stock
<INPUT TYPE=\ Currency futures
11. What contract maturity period would interest you for trading in?
<INPUT TYPE=\ 1 month
74
13. Which of the following statements best describes your overall approach to invest as a
mean of achieving your goals?
<INPUT TYPE=\ Having a relative level of stability in my overall investment portfolio.
<INPUT TYPE=\ Moderately increasing my investment value while minimizing potential
for loss of
principal.
<INPUT TYPE=\ Pursue investment growth, accepting moderate to high levels of risk
and
principal fluctuation.
<INPUT TYPE=\ Seek maximum long-term returns, accepting maximum risk with
principal
fluctuation.
14. What was the result of your investment?
<INPUT TYPE=\ Great results
<INPUT TYPE=\ Moderate but acceptable
<INPUT TYPE=\ Disappointed
75
ABBREVATIONS
A
AMEX- America Stock Exchange
B
BSE- Bombay Stock Exchange
BSI- British Standard Institute
C
CBOE - Chicago Board options Exchange
CBOT - Chicago Board of Trade
CEBB - Chicago Egg and Butter Board
CME - Chicago Mercantile Exchange
CNX- Crisil Nse 50 Index
CPE - Chicago Produce Exchange
CWC- Central Warehousing Corporation
D
76
G
GAICL-Gujarat Agro Industries Corporation Limited
GSAMB- Gujarat State Agricultural Marketing Board
I
IMM - International Monetary Market
IPSTA- India Pepper & Spice Trade Association
M
MCX Multi Commodity Exchange
N
NAFED-National Agricultural Co-Operative Marketing Federation Of India
NCDEX National Commodities and Derivatives Exchange
NIAM- National Institute Of Agricultural Marketing
NMSE- National Multi Commodity Exchange
NOL- Neptune Overseas Limited
NSCCL- National Securities Clearing Corporation
NSDL- National Securities Depositories Limited
NSE - National Stock Exchange
O
OTC- Over The Counter
P
PHLX - Philadelphia Stock Exchange
77
78