PROJECT REPORT ON

Investments in Derivative Markets

UNIVERSITY OF MUMBAI

MASTER OF COMMERCE

(Banking & Finance)

SEMESTER III

2016-17

SUBMITTED BY

Name: Samriddhi Rakhecha

Roll No.: 16

PROJECT GUIDE

Dr. Kuldeep Sharma

K.P.B HINDUJA COLLEGE OF COMMERCE

1
 315, NEW CHARNI ROAD, MUMBAI-400 004

M.Com (Banking & Finance)

3rd SEMESTER

Investments in Derivative Markets

SUBMITTED BY

Samriddhi Rakhecha

Roll No.: 16

2
 Smt. P.D. Hinduja Trusts

K.P.B. HINDUJA COLLEGE OF COMMERCE

315, New Charni Road, Mumbai 400 004 Tel.: 022- 40989000 Fax: 2385 93 97. Email:

NAAC Re-Accredited A
O 9001:2008THE BEST COLLEGE OF UNIVERSITY OF MUMBAI FOR THE ACADEMIC YEAR 2010
Prin. Dr. Minu Madlani (M. Com., Ph. D.)

CERTIFICATE

This is to certify that Ms. Samriddhi Rakhecha of M.Com (Banking &

Finance) Semester 3rd [2016-2017] has successfully completed the

Project on Investments in Derivative Markets under the guidance of

DR. KULDEEP SHARMA.

________________ ________________
Project Guide Co-coordinator

________________ ________________

Internal Examiner External Examiner

3
________________ ________________
Principal College Seal

DECLARATION

I Mr. / Ms. Samriddhi Rakhecha, student of M.Com-Banking &

Finance, 3rd semester (2016-2017), hereby declare that I have completed
the project on Investments in Derivative Markets

The information submitted is true and original copy to the best of

our knowledge.

(Signature)

Student

4
Contents

Chapter Topic Page No.

1.1 Introduction 6
1.2 History of Derivatives 10
1.3 Objective of the Study 11
1.4 Rationale of the Study 11
2.1 Definition of Derivatives 12
2.2 Types of Derivative Markets 13
2.3 Forward Contracts 14
2.4 Future Contracts 15
2.5 Pricing of Future Contracts 18
Difference between Futures &
2.6 20
Forwards Contracts
2.7 Options 21
2.8 Swaps 22
2.9 Other kinds of Derivatives 23
3.1 Indian Derivative Market 24
Development of Derivative Market in
3.2 36
India
3.3 Benefits of Derivatives 40
4 Conclusion 42
5 Bibliography 43
Chapter 1.1: Introduction
FINANCE

Finance is the lifeblood of any business and it is very vital for its growth
and development. It is very essential for the smooth functioning of
5
the business. Business activity cannot function smoothly unless it has got
sufficient funds at its disposal for purchase of machines, materials and
land and building to house them and to meet day to day expenses, to meet
several other purposes to run the business.

According to the Guthumann and Dougall

Business finance can
broadly be defined as the activity concerned with planning, raising,control
ling, administering of the funds used in the business.

Finance is classified into two classes

Public finance
Private finance

Public finance: It deals with the requirements, receipts and disbursements

of funds in the government institutions like states, local self-government

Private finance: It is concerned with requirements, receipts and

disbursement of funds in case of an individual, a profit seeking business
organization and a non-profit organization.

The main reasons a business needs finance are to:

Start a business:-Depending on the type of business, it will need to finance

the purchase of assets, materials and employing people. There will also
need to be money to cover the running costs. It may be some time before
the business generates enough cash from sales to pay for these costs. Link
to cash flow forecasting.

Finance expansions to production capacity:-As a business grows, it needs

higher capacity and new technology to cut unit costs and keep up with

6
competitors. New technology can be relatively expensive to the business
and is seen as a
Long term investment, because the costs will outweigh the money saved
or generated for a considerable period of time. And remember new
technology is not just dealing with computer systems, but also new
machinery and tools to perform processes quicker, more efficiently and
with greater quality.

To develop and market new products:-In fast moving markets, where

competitors are constantly updating their products,
a business needs to spend money on developing and marketing new produ
cts.

To enter new markets:-When a business seeks to expand it may look to sell

their products into new markets. These can be new geographical areas to
sell to (e.g. export markets) or new types of customers. This costs money
in terms of research and marketing e.g. advertising campaigns and setting
up retail outlets.

Take-over/ Acquisition:-When a business buys another business, it will

need to find money to pay for the acquisition (acquisitions involve
significant investment). This money will be used to pay owners of the
business which is being bought.

Moving to new premises:- Finance is needed to pay for simple expenses

such as the cost of renting of removal vans, through relocation packages
for employees and the installation of machinery.

To pay for the day to day running of business:-A business has many calls on
its cash on a day to day basis, from paying a supplier for raw materials,
paying the wages through to buying a new printer cartridge.

FINANCIAL MARKETS

7
Generally speaking, there is no specific place or location to indicate a
financial market. Wherever a financial transaction takes place, it is
deemed to have taken place in the financial market. Hence financial
markets are pervasive throughout the economic system. For instance
,issue of equity share, granting of loan by term landing institutions,
deposits of money into bank, purchase of debentures, sale of shares and so
on. However, financial markets can be referred to as those centers and
arrangement, which facilitate buying and selling of financial assets, it
claims and services. Sometimes, we do find the existence of a
specific place or location for financial markets as in the case of stock
exchange
NEW FINANCIAL PRODUCTS AND SERVICE
Today, the importance of financial services is gaining momentum all
over the world. With the injection of the economic liberation policy into
our economy and the opening of the economy to multinationals, the free
market concept has assumed much significance. As a result, the
clients both corporate and individuals are exposed to the phenomena of
volatility and uncertainty and hence they expect the financial service
company to innovate new products and services so as to meet their varied
requirements. Some of them are briefly discussed below:-

Mutual Funds:
A mutual funds refers to a fund raised by a financial service company by
pooling the savings of the public. It is invested in a diversified portfolio
with a view to spreading and minimizing risk. The fund provides
Investment Avenue for small investors who
cannot participate in the equity of big companies. Its ensures low risks, ste
adyreturns, high liquidity and better capital appreciation in the long run.

Derivative Security:
A derivative security is a security whose value depends upon the values of
other basic variables backing the security. In most cases, these variables
are nothing but the prices of traded securities. A derivative security is
basically used as risk management tool and it is resorted to cover Ac risks
due to price fluctuations by the investments manager. Derivative helps to
8
break the ; risks into various components such as credit risk, interest rates
risk, exchange rates risk and so on. It enables the various risk components
to be identified precisely and priced them and even traded them if
necessary, In India some forms of derivatives are in operation. Example:
Forwards in forex market.

Chapter 1.2: History of 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
9
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 hew
o u l d r e c e i v e f o r h i s h a r v e s t i n S e p t e m b e r.
I n y e a r s o f s c a r c i t y , h e w o u l d 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. In 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 favourable prices could be obtained during periods of
oversupply. Under such circumstances, it clearly made sense for the
farmer and the merchant to c o me t o g e t h e r a n d e n t e r i n t o
c o n t r a c t w h e r e by t h e pr i c e o f t h e g r a i n t o b e delivered in
September could be decided earlier. What they would then negotiate
happened to be futures-type contract, which would enable
b o t h p a r t i e s t o 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. Today derivatives contracts exist on variety of commodities such as cor
n,pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also
exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

Chapter 1.3: Objective of the Study

1. To study investors attitude towards stock market investment.
2. To study the investors preferences towards Derivative Market.
3. To study the factors influencing for Derivative Investment.
4. To suggest the improvement of services in Derivative Trading.

10
Chapter 1.4: Rationale of the Study
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.

11
Chapter 2.1: Definition of Derivatives
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 include a security derived from a debt instrument, share,
loan whether secured or unsecured, risk instrument or contract differences
or any other form of security. A contract which derives its value from the
prices, or index of prices, of underlying securities.

12
Chapter 2.2: Types of Derivatives
DERIVATIVE MARKETS

Exchange Traded Derivatives Over the Counter

Derivatives

National Stock Bombay Stock National Commodity

Exchange Exchange & Derivative Exchange

Index Future Index Option Stock Option Stock Future

13
Chapter 2.3: Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified
date for a specified price. One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a certain specified
future date for a certain specified price. The other party assumes a short
position and agrees to sell the asset on the same date for the same price.
Other contract details like delivery date, price and quantity are negotiated
bilaterally by the parties to the contract. The forward contracts are
normally traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

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

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

contract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

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

asset.

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

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

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing
transaction costs and increasing transactions volume. This process of
standardization reaches its limit in the organized futures market. Forward
contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of
allocating risk in the presence of future price uncertainty. However futures
are a significant improvement over the forward contracts as they eliminate
counterparty risk and offer more liquidity.

14
Chapter 2.4: Future Contracts
In finance, a futures contract is a standardized contract, traded on a futures
exchange, to buy or sell a certain underlying instrument at a certain date
in the future, at a pre-set price. The future date is called the delivery date
or final settlement date. The pre-set price is called the futures price. The
price of the underlying asset on the delivery date is called the settlement
price. The settlement price, normally, converges towards the futures price
on the delivery date. A futures contract gives the holder the right and the
obligation to buy or sell, which differs from an options contract, which
gives the buyer the right, but not the obligation, and the option writer
(seller) the obligation, but not the right. To exit the commitment, the
holder of a futures position has to sell his long position or buy back his
short position, effectively closing out the futures position and its contract
obligations. Futures contracts are exchange traded derivatives. The
exchange acts as counterparty on all contracts, sets margin requirements,
etc.

BASIC FEATURES OF FUTURE CONTRACT

1.Standardization: Futures contracts ensure their liquidity by being

highly standardized, usually by specifying:

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

crude oil to a short term interest rate.
The type of settlement, either cash settlement or physical
settlement.
The 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 currency in which the futures contract is quoted.
The grade of the deliverable. In case of bonds, this specifies
which bonds can be delivered. In case of physical
commodities, this specifies not only the quality of the

15
 underlying goods but also the manner and location of
delivery. The delivery month.
The last trading date.
Other details such as the tick, the minimum permissible price
fluctuation.

2. Margin: Although the value of a contract at time of trading should be

zero, its price constantly fluctuates. This renders the owner liable to
adverse changes in value, and creates a credit risk to the exchange, who
always acts as counterparty. To minimize this risk, the exchange demands
that contract owners post a form of collateral, commonly known as
Margin requirements are waived or reduced in some cases for hedgers
who have physical ownership of the covered commodity or spread traders
who have offsetting contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on
that contract, as determined by historical price changes, which is not
likely to be exceeded on a usual day's trading. It may be 5% or 10% of
total contract price.

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

exhaust the initial margin, a further margin, usually called variation or
maintenance margin, is required by the exchange. This is calculated by the
futures contract, i.e. agreeing on a price at the end of each day, called the
"settlement" or mark-to-market price of the contract. To understand the
original practice, consider that a futures trader, when taking a position,
deposits money with the exchange, called a "margin". This is intended to
protect the exchange against loss. At the end of every trading day, the
contract is marked to its present market value. If the trader is on the
winning side of a deal, his contract has increased in value that day, and the
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.

16
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.

4. Expiry: 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.

17
Chapter 2.5: 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, F(t) , will be found by discounting
the present value S(t) at time t to maturity T by the rate of risk-free return
r.

F(t) = S(t) x (1+r)(T-t)

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.

18
3. He then receives the underlying and pays the agreed forward price
using the matured investment. [If he was short the underlying, he returns
it now.]

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

19
Chapter 2.6: Difference between Futures & Forwards
Contracts
Feature Forward Contract Future Contract
Operational Mechanism Traded directly between Traded on the Exchanges
two parties (not traded on
the exchanges)
Contract Specifications Differ from trade toContracts are standardized
trade contracts
Counter party risks Exists Exists. However, assumed
by the clearing corp.
which becomes the
counter party to all the
trades or unconditionally
guarantees their
settlement.
Liquidation Profile Low, as contracts are High, as contracts are
tailor made contracts standardized exchange
catering to the needs of traded contracts.
the parties.
Price discovery Not efficient, as markets Efficient, as markets are
are scattered. centralized and all buyers
and sellers come to a
common platform to
discover the price.
Examples Currency market in India Commodities, futures,
Index futures and
Individual stock futures in
India.

20
Chapter 2.7: 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 & PUT OPTION.

CALL OPTION: A contract that gives its owner the right but not the
obligation to buy an underlying asset-stock or any financial asset, at a
specified price on or before a specified date is known as a Call option.
The owner makes a profit provided he sells at a higher current price and
buys at a lower future price.

PUT OPTION: A contract that gives its owner the right but not the
obligation to sell an underlying asset-stock or any financial asset, at a
specified price on or before a specified date is known as a Put option.
The owner makes a profit provided he buys at a lower current price and
sells at a higher future price. Hence, no option will be exercised if the
future price does not increase.

Put and calls are almost always written on equities, although occasionally
preference shares, bonds and warrants become the subject of options.

21
Chapter 2.8: 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.

22
Chapter 2.9: Other kinds of Derivatives
The other kind of derivatives, which are not, much popular are as follows:

BASKETS - Baskets options are option on portfolio of underlying asset.

Equity Index Options are most popular form of baskets.

LEAPS - Normally option contracts are for a period of 1 to 12 months.

However, exchange may introduce option contracts with a maturity period
of 2-3 years. These long-term option contracts are popularly known as
Leaps or Long term Equity Anticipation Securities.

WARRANTS - Options generally have lives of up to one year, the

majority of options traded on options exchanges having a maximum
maturity of nine months. Longer-dated options are called warrants and are
generally traded over-the-counter.

SWAPTIONS - Swaptions are options to buy or sell a swap that will

become operative at the expiry of the options. Thus a swaption is an
option on a forward swap. 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.

23
Chapter 3.1: Indian Derivatives Market
Starting from a controlled economy, India has moved towards a world
where prices fluctuate every day. The introduction of risk management
instruments in India gained momentum in the last few years due to
liberalisation process 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

1991 Liberalisation process initiated.

14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup LC Gupta Committee to draft a policy
framework for index futures.
11 May 1998 L.C. Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements and
Interest Rate Swaps.
24 May 2000 SIMEX chose Nifty for Trading futures and options on an
Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures
trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX
2 June 2001 Individual Stock Options & Derivatives

(1) Need for derivatives in India today

In less than three decades of their coming into vogue,
derivatives markets have become the most important markets in
the world. Today, derivatives have become part and parcel of the
day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access
to the latest trading methods and was using traditional out-dated
methods of trading. There was a huge gap between the investors
aspirations of the markets and the available means of trading.

24
 The opening of Indian economy has precipitated the process of
integration of Indias financial markets with the international
financial markets. Introduction of risk management instruments
in India has gained momentum in last few years thanks to
Reserve Bank of Indias efforts in allowing forward contracts,
cross currency options etc. which have developed into a very
large market.

(2) Myths and realities about derivatives

In less than three decades of their coming into vogue,
derivatives markets have become the most important markets in
the world. Financial derivatives came into the spotlight along
with the rise in uncertainty of post-1970, when US announced
an end to the Bretton Woods System of fixed exchange rates
leading to introduction of currency derivatives followed by other
innovations including stock index futures. Today, derivatives
have become part and parcel of the day-to-day life for ordinary
people in major parts of the world. While this is true for many
countries, there are still apprehensions about the introduction of
derivatives. There are many myths about derivatives but the
realities that are different especially for Exchange traded
derivatives, which are well regulated with all the safety
mechanisms in place.
What are these myths behind derivatives?
Derivatives increase speculation and do not serve any
economic purpose
Indian Market is not ready for derivative trading
Disasters prove that derivatives are very risky and highly
leveraged instruments.
Derivatives are complex and exotic instruments that
Indian investors will find difficulty in understanding.
Is the existing capital market safer than Derivatives?
(i) Derivatives increase speculation and do not serve any
economic purpose:

25
Numerous studies of derivatives activity have led to a broad consensus,
both in the private and public sectors that derivatives provide numerous
and substantial benefits to the users. Derivatives are a low-cost, effective
method for users to hedge and manage their exposures to interest rates,
commodity prices or exchange rates. The need for derivatives as hedging
tool was felt first in the commodities market. Agricultural futures and
options helped farmers and processors hedge against commodity price
risk. After the fallout of Bretton wood agreement, the financial markets in
the world started undergoing radical changes. This period is marked by
remarkable innovations in the financial markets such as introduction of
floating rates for the currencies, increased trading in variety of derivatives
instruments, on-line trading in the capital markets, etc. As the complexity
of instruments increased many folds, the accompanying risk factors grew
in gigantic proportions. This situation led to development derivatives as
effective risk management tools for the market participants. Looking at
the equity market, derivatives allow corporations and institutional
investors to effectively manage their portfolios of assets and liabilities
through instruments like stock index futures and options. An equity fund,
for example, can reduce its exposure to the stock market quickly and at a
relatively low cost without selling off part of its equity assets by using
stock index futures or index options.

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

managing risks and raising capital, derivatives improve the allocation of
credit and the sharing of risk in the global economy, lowering the cost of
capital formation and stimulating economic growth. Now that world
markets for trade and finance have become more integrated, derivatives
have strengthened these important linkages between global markets,
increasing market liquidity and efficiency and facilitating the flow of
trade and finance.

(ii) Indian Market is not ready for derivative trading:

Often the argument put forth against derivatives trading is that the Indian
capital market is not ready for derivatives trading. Here, we look into the

26
prerequisites, which are needed for the introduction of derivatives, and
how Indian market fares:

PRE REQUISITES INDIAN SCENARIO

Large market India is one of the largest market
Capitalisation capitalized countries in Asia with a
market capitalization of more than
Rs.765000 crores
High Liquidity in the The daily average traded volume in
underlying Indian capital market today is around
7500 crores. Which means on an
average every month 14% of the
countrys market capitalization gets
traded. These are clear indicators of
high liquidity in the underlying.
Trade Guarantee The first clearing corporation
guarantee trades has become fully
functional from July 1996 in the form
of National Securities Clearing
Corporation (NSCCL). NSCCL is
responsible for guaranteeing all open
positions on the NSE for which it
does the clearing

A Strong Depository National Securities Depositories

Limited (NSDL) which started
functioning in the year 1997 has
revolutionized the security settlement
in our country.
A Good Legal In the Institution of SEBI today the
Guardian Indian capital market enjoys a strong,
independent, and innovative legal
guardian who is helping the market to
evolve to a healthier place for trade
practices.

27
 (3) Comparison of New System with Existing System
Many people and brokers in India think that the new system of
Futures & Options and banning of Badla is disadvantageous and
introduced early, but I feel that this new system is very useful
especially to retail investors. It increases the no of options
investors for investment. In fact it should have been introduced
much before and NSE had approved it but was not active
because of politicization in SEBI. The figure 3.3a 3.3d shows
how advantages of new system (implemented from June 20001)
v/s the old system i.e. before June 2001 New System Vs
Existing System for Market Players
SPECULATORS

Existing SYSTEM
New

Approach Peril & Prize Approach Peril &

1) Deliver
Prize based 1) Both profit & 1)Buy & Sell 1) Maximum
trading, margin
loss to stocks on loss
1)
trading & carry
extent of delivery basis possible to
forward
price change premium
transactions. 2) Buy call &
2) Buy index Futures paid
put by paying
Advantages
hold till expiry premium

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

ARBITRAGEURS
1)Buying 1) Risk free
stocks in one game.
Existing SYSTEM
and selling in
another New
exchange. 1)B Approach
Group
Approach Peril & Prize
Forward promising as
Peril & Prize
transactions.
1) Make money still in weekly
whichever settlement.
2) If Future 28
Contract more way the 2)Cash & carry
or less than Market arbitrage
fair price. moves. continues
 Fair price = Cash price + Cost of Carry

HEDGERS

Existing SYSTEM New

1)Fix price today to
Approach Peril & Prize buyApproach
later by payingPeril & Prize
premium.
1)No leverage 1)Additional cost
1)Difficult to available risk 2)For long, buy is only premium.
offload holding reward ATM Put option. If
during adverse dependant on market goes up, long
market market prices. position benefit else
conditions as exercise the option.
circuit filters
limit to curtail 3)Sell deep OTM
losses. call option with
underlying shares, 29
earn premium +
profit with increased
price
 Advantages:- Availability of leverage

SMALL INVESTORS

Existing SYSTEM New

Approach Peril & Prize Approach

1)IfPeril & Prize
Bullish buy 1)Plain Buy/Sell 1)Buy Call/Put 1)Downside
stocks else sell implies unlimited options based on remains
it. profit/ loss market outlook. protected &
upside
2)Hedge position if unlimited.
holding underlying
Advantages:- Losses protected stock

4. Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the
last few years, which has accompanied the modernization of commercial
and investment banking and globalisation of financial activities. The
recent developments in information technology have contributed to a
great extent to these developments. While both exchange-traded and OTC
derivative contracts offer many benefits, the former have rigid structures
compared to the latter. It has been widely discussed that the highly
leveraged institutions and their OTC derivative positions were the main
cause of turbulence in financial markets in 1998. These episodes of
turbulence revealed the risks posed to market stability originating in
features of OTC derivative instruments and markets. The OTC derivatives
markets have the following features compared to exchange traded
derivatives:

30
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. 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

31
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.

5. Factors contributing to the growth of derivatives:

Factors contributing to the explosive growth of derivatives are price
volatility, globalisation of the markets, technological developments and
advances in the financial theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects
having value maybe commodities, local currency or foreign currencies.
The concept of price is clear to almost everybody when we discuss
commodities. There is a price to be paid for the purchase of food grain,
oil, petrol, metal, etc. the price one pays for use of a unit of another
persons money is called interest rate. And the price one pays in ones own
currency for a unit of another currency is called as an exchange rate.

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

have demand and producers or suppliers have supply, and the
collective interaction of demand and supply in the market determines the
price. These factors are constantly interacting in the market causing
changes in the price over a short period of time. Such changes in the price
are known as price volatility. This has three factors: the speed of price
changes, the frequency of price changes and the magnitude of price
changes.

The changes in demand and supply influencing factors culminate in

market adjustments through price changes. These price changes expose
individuals, producing firms and governments to significant risks. The

32
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 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

33
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 breakthrough. Advances in this area include the
development of high speed processors, network systems and enhanced
method of data entry. Closely related to advances in computer technology
are advances in telecommunications. Improvement in communications
allow for instantaneous worldwide conferencing, Data transmission by
satellite. At the same time there were significant advances in software
programmes without which computer and telecommunication advances
would be meaningless. These facilitated the more rapid movement of
information and consequently its instantaneous impact on market price.

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

a whole resources are rapidly relocated to more productive use and better
rationed overtime the greater price volatility exposes producers and
consumers to greater price risk. The effect of this risk can easily destroy a
business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy. To the extent the
technological developments increase volatility, derivatives and risk
management products become that much more important.

D.} ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward

contracts in its traditional form, was the only hedging tool available.
Option pricing models developed by Black and Scholes in 1973 were used
to determine prices of call and put options. In late 1970s, work of Lewis
Edeington extended the early work of Johnson and started the hedging of
financial price risks with financial futures. The work of economic
theorists gave rise to new products for risk management which led to the

34
growth of derivatives in financial markets. The above factors in
combination of lot many factors led to growth of derivatives instruments.

35
Chapter 3.2: Development of Derivative Market in
India
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995,
which withdrew the prohibition on options in securities. The market for
derivatives, however, did not take off, as there was no regulatory
framework to govern trading of derivatives. SEBI set up a 24member
committee under the Chairmanship of Dr.L.C.Gupta on November 18,
1996 to develop appropriate regulatory framework for derivatives trading
in India. The committee submitted its report on March 17, 1998
prescribing necessary preconditions for introduction of derivatives
trading in India. The committee recommended that derivatives should be
declared as securities so that regulatory framework applicable to trading
of securities could also govern trading of securities. SEBI also set up a
group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India.
The report, which was submitted in October 1998, worked out the
operational details of margining system, methodology for charging initial
margins, broker net worth, deposit requirement and realtime monitoring
requirements. The Securities Contract Regulation Act (SCRA) was
amended in December 1999 to include derivatives within the ambit of
securities and the regulatory framework were developed for governing
derivatives trading. The act also made it clear that derivatives shall be
legal and valid only if such contracts are traded on a recognized stock
exchange, thus precluding OTC derivatives. The government also
rescinded in March 2000, the three decade old notification, which
prohibited forward trading in securities. Derivatives trading commenced
in India in June 2000 after SEBI granted the final approval to this effect in
May 2001. SEBI permitted the derivative segments of two stock
exchanges, NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivatives contracts. To
begin with, SEBI approved trading in index futures contracts based on
S&P CNX Nifty and BSE30 (Sense) index. This was followed by

36
approval for trading in options based on these two indexes and options on
individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001.
Futures contracts on individual stocks were launched in November 2001.
The derivatives trading on NSE commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on
June 4, 2001 and trading in options on individual securities commenced
on July 2, 2001. Single stock futures were launched on November 9,
2001. The index futures and options contract on NSE are based on S&P
CNX Trading and settlement in derivative contracts is done in accordance
with the rules, byelaws, and regulations of the respective exchanges and
their clearing house/corporation duly approved by SEBI and notified in
the official gazette. Foreign Institutional Investors (FIIs) are permitted to
trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics

provided in the NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of

the F&O segment. It constituted 70 per cent of the total turnover
during June 2002. A primary reason attributed to this phenomenon
is that traders are comfortable with single-stock futures than equity
options, as the former closely resembles the erstwhile badla system.
On relative terms, volumes in the index options segment continue
to remain poor. This may be due to the low volatility of the spot
index. Typically, options are considered more valuable when the
volatility of the underlying (in this case, the index) is high. A
related issue is that brokers do not earn high commissions by
recommending index options to their clients, because low volatility
leads to higher waiting time for round-trips.
Put volumes in the index options and equity options segment have
increased since January 2002. The call-put volumes in index
options have decreased from 2.86 in January 2002 to 1.32 in June.

37
 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 have been (i) permission to banks to undertake
cross currency derivative transactions subject to certain conditions
(1996) (ii) allowing corporates to undertake long term foreign
currency swaps that contributed to the development of the term
currency swap market (1997) (iii) allowing dollar rupee options
(2003) and (iv) introduction of currency futures (2008). I would
like to emphasise that currency swaps allowed companies with
ECBs to swap their foreign currency liabilities into rupees.
However, since banks could not carry open positions the risk was
allowed to be transferred to any other resident corporate. Normally
such risks should be taken by corporates who have natural hedge or
have potential foreign exchange earnings. But often corporate
assume these risks due to interest rate differentials and views on
currencies.
This period has also witnessed several relaxations in regulations
relating to forex markets and also greater liberalisation in capital
account regulations leading to greater integration with the global
economy.

38
 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.

39
Chapter 3.3: Benefits of Derivatives
Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT Futures and options contract can be used for
altering the risk of investing in spot market. For instance, consider an
investor who owns an asset. He will always be worried that the price may
fall before he can sell the asset. He can protect himself by selling a futures
contract, or by buying a Put option. If the spot price falls, the short
hedgers will gain in the futures market, as you will see later. This will
help offset their losses in the spot market. Similarly, if the spot price falls
below the exercise price, the put option can always be exercised.

2.] PRICE DISCOVERY Price discovery refers to the markets ability to

determine true equilibrium prices. Futures prices are believed to contain
information about future spot prices and help in disseminating such
information. As we have seen, futures markets provide a low cost trading
mechanism. Thus information pertaining to supply and demand easily
percolates into such markets. Accurate prices are essential for ensuring the
correct allocation of resources in a free market economy. Options markets
provide information about the volatility or risk of the underlying asset.

3.] OPERATIONAL ADVANTAGES As opposed to spot markets,

derivatives markets involve lower transaction costs. Secondly, they offer
greater liquidity. Large spot transactions can often lead to significant price
changes. However, futures markets tend to be more liquid than spot
markets, because herein you can take large positions by depositing
relatively small margins. Consequently, a large position in derivatives
markets is relatively easier to take and has less of a price impact as
opposed to a transaction of the same magnitude in the spot market.
Finally, it is easier to take a short position in derivatives markets than it is
to sell short in spot markets.

4.] MARKET EFFICIENCY The availability of derivatives makes

markets more efficient; spot, futures and options markets are inextricably
linked. Since it is easier and cheaper to trade in derivatives, it is possible

40
to exploit arbitrage opportunities quickly and to keep prices in alignment.
Hence these markets help to ensure that prices reflect true values.

5.] EASE OF SPECULATION Derivative markets provide speculators

with a cheaper alternative to engaging in spot transactions. Also, the
amount of capital required to take a comparable position is less in this
case. This is important because facilitation of speculation is critical for
ensuring free and fair markets. Speculators always take calculated risks. A
speculator will accept a level of risk only if he is convinced that the
associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying

at the expiration of derivative contract. Thus derivatives help in
discovery of future as well as current prices.
An important incidental benefit that flows from derivatives trading
is that it acts as a catalyst for new entrepreneurial activity.
Derivatives markets help increase savings and investment in the
long run. Transfer of risk enables market participants to expand
their volume of activity.

41
Chapter 4: Conclusion
From the above analysis it can be concluded that:

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

turnover of Derivative Market is increasing year by year in the Indias
largest stock exchange NSE. In the case of index future there is a
phenomenal increase in the number of contracts. But whereas the turnover
is declined considerably. In the case of stock future there was a slow
increase observed in the number of contracts whereas a decline was also
observed in its turnover. In the case of index option there was a huge
increase observed both in the number of contracts and turnover.

2. After analyzing data it is clear that the main factors that are driving the
growth of Derivative Market are Market improvement in communication
facilities as well as long term saving & investment is also possible
through entering into Derivative Contract. So these factors encourage the
Derivative Market in India.

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

take more risk & earn more return. So in this way it helps the Indian
Economy by developing entrepreneurship. Derivative Market is more
regulated & standardized so in this way it provides a more controlled
environment. In nutshell, we can say that the rule of High risk & High
return apply in Derivatives. If we are able to take more risk then we can
earn more profit under Derivatives.

Commodity derivatives have a crucial role to play in the price risk

management process for the commodities in which it deals. And it can be
extremely beneficial in agriculture-dominated economy, like India, as the
commodity market also involves agricultural produce. Derivatives like
forwards, futures, options, swaps etc are extensively used in the country.
However, the commodity derivatives have been utilized in a very limited
scale. Only forwards and futures trading are permitted in certain
commodity items. RELIANCE is the most active future contracts on
individual securities traded with 90090 contracts and RNRL is the next
most active futures contracts with 63522 contracts being traded.
42
Chapter 5: Bibliography
Sources of Data:

Wikipedia.com
Scribd.com
Investopedia.com
Bseindia.com
Nseindia.com

43