INTRODUCTION

BACKGROUND OF THE STUDY

The evolution occurred in stages. The Chicago Board of Trade (CBOT), which opened in
1848, is, to this day, the largest futures market in the world. The general rules framed by CBOT
in 1865 became a pacesetter for many other markets. In 1870, the New York cotton exchange
was founded.

The London metal exchange was established in 1877 and is now the leading market in
metal trading (both spot and forward). Thereafter many new futures market were started. The
first financial futures market was the international monetary, founded in 1972 by the Chicago
mercantile exchange. The London international financial futures exchange followed this in 1982.

As already mentioned, some form of forward trading probably existed in India also.
Unfortunately, India has a not had as good a tradition of record keeping as the west, and
therefore, hard evidence of forward trading in our history is lacking. The first organized forward
markets came into existence in India in the late 19th and early 20th century in Calcutta (for jute
and jute goods) and Mumbai (for cotton).

Chronologically, India’s experience in organized forward trading is almost as long as that of

the United Kingdom, and certainly longer than many developed nations. However, the tidal wave
of price control, nationalization and state intervention in markets, which swept through all
economic policy making after independence, led to a rapid decline in number of futures markets.
Frequently markets were closed due to the feeling that they were responsible for sudden
movements of price in the commodities, the underlying presumption was that speculation of
forward market was creating exacerbating price pressure. The ban imposed on trading in
derivatives way back in 1969 under notification by the central government has been revoked
recently.

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Problem Statement

The problem is to analyze Derivative ways of minimizing the Risk in Indian Capital
market and to analyze the current scenario of Derivative markets in India.

Need and Importance of the Study

World financial market has witnessed a spectacular change in the field of derivative
markets in the past one decade, especially in the field of option, futures and swaps. India also
could not become a loop from the world trend and mainly after the liberalization has set in
motion. India introduced the different types in phased manner. A derivative market has gained
momentum since its introduction in India and has played a major role in Indian financial
markets. Today the derivative volume in India is Rs. 4000 crores. In this context the study of
Current scenario of Indian derivative market is very contextual and important as well. That is
why this subject is the topic of this dissertation.

Similarly, on the equity market, many retail investors who are uncomfortable about the
equity market would enter if they were given the alternative of buying insurance, which controls
their downside risk. This would enhance the action of the savings of the country, which are
routed through the equity market. More importantly, derivative is one of the important tools of
hedging risk. Therefore, the study of current scenario of derivative market in India is very
importance.

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Objectives of the Research

The main objectives of the project are as follows: -

a) To study the current scenario of derivatives market in India.

b) To analyze whether the purpose for which derivatives are used has actually been
Achieved.

c) To study the concept of derivatives and the purpose for which financial institutions
adopt derivatives.

d) To know the participants of derivative trading.

e) To understand the terminology of Derivative.

Limitations of the study

a) The study comprises of only few important topics out of derivative market.

b) Time limit will also be a constraint while conducting the study, so the study does not give
picture of the whole market.

c) Data collected is only from secondary sources, the reliability of the data cannot be
justified.

d) This research purely conducted for the academic purpose only.

While highlighting the following limitations every effort will be made to present the data and its
analysis within the acceptable limits of reliability and validity.

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 COMPANY PROFILE OF KARVY STOCK BROKING LTD

The Karvy Group was formed in 1983 at Hyderabad, India. Karvy ranks among the top
player in all the fields it operates. Karvy was started by a group of five chartered accountants in
1979. The first firm in the group, Karvy Consultants Limited was incorporated on 23rd July,
1983. In a very short period, it became the largest Registrar and Transfer Agent in India. This
business was spun off to form a separate joint venture with Computer share of Australia, in 2005.
Karvy’s foray into stock broking began with marketing IPO’s in 1993. Karvy was among the
first few members of National Stock Exchange, in 1994 and became a member of the Stock
Exchange Mumbai in 2001. Dematerialization of shares gathered pace in mid-90s. Karvy has
575 offices over 375 locations across India and overseas at Dubai and New York. Karvy has a
professional management team and ranks among the best in technology, operations, and more
importantly, in research of various industrial segments.
Investment is the stepping stone to achieving one’s financial dreams. Mutual funds offer
an opportune way to long-term wealth creation. However, with more and more funds flooding
the market, the task of selecting the most suitable scheme gets even more complicated. Mutual
fund Advisory Service at Karvy guides through this maze and ensures that the investments are
backed by our quality research.

At Karvy, they help to reach the goals by offering:

a) Products of 33 AMCs

b) Research reports (existing funds and NFOs; strategy reports etc.)

c) Customized mutual fund portfolios

d) Portfolio revision (depending on changing market outlook and evolving trends).

e) Access to online consolidated portfolio statement.

4
Vision:
a) To have a single minded focus on investor servicing.

b) To establish Karvy as a household name for financial services.

c) To set industry standards.

d) To establish a leadership position in all chosen areas of business.

Mission:
To be a leading and preferred service provider to customer and to achieve this leadership
position by building an innovative, enterprising, and technology driven organization which will
set the highest standards of service and business ethics.

Quality Policy:
To achieve and retain leadership, Karvy shall aim for complete customer satisfaction, by
combining its human and technological resources, to provide superior quality financial services.
In the process, Karvy will strive to exceed Customer's expectations.

Quality Objectives:
a) Build in-house processes that will ensure transparent and harmonious relationships with
its clients and investors to provide high quality of services.

b) Establish a partner relationship with its investor service agents and vendors that will help
in keeping up its commitments to the customers.

c) Provide high quality of work life for all its employees and equip them with adequate
knowledge & skills so as to respond to customer's needs.

d) Continue to uphold the values of honesty & integrity and strive to establish unparalleled
standards in business ethics.

5
 e) Use state-of-the art information technology in developing new and innovative financial
products and services to meet the changing needs of investors and clients.

f) Strive to be a reliable source of value-added financial products and services and

constantly guide the individuals and institutions in making a judicious choice of same.

g) Strive to keep all stake-holders proud and satisfied.

Achievements:
a) Among the top 5 stock brokers in India (4% of NSE volumes)

b) India's No. 1 Registrar & Securities Transfer Agents

c) Among the top 3 Depository Participants

d) Largest Network of Branches & Business Associates

e) ISO 9002 certified operations by DNV

f) Among top 10 Investment bankers

g) Largest Distributor of Financial Products

h) Adjudged as one of the top 50 IT uses in India by MIS Asia

i) Full Fledged IT driven operations

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Research Methodology
TYPE OF RESEARCH
The type of research is selected on the basis of problems identified. Here the
research type used is descriptive research. Descriptive research includes fact-findings and
enquiries of different kinds. The major purpose of descriptive research is a description of the
state of affairs, as it exists in the present system. In this dissertation an attempt has been made to
discover various issues related to derivatives in the Indian market and how they help the hedge
the risk.

ACTUAL COLLECTION OF DATA

Data Collection from secondary Sources

Secondary data were gathered from numerous sources. While preparation

of this project report, the secondary data have been collected through:

a) Data was generated from general library research sources, textbooks, trade journals,
articles from newspaper, treasury management, brochures, interviews with different
brokers of Bangalore stock Exchange and Internet web site

www.nseindia.com
www.sherkhan.com
www.google.com

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 Overview of Derivatives

1.1.1 DEFINITION OF DERIVATIVES

Derivatives are the financial instruments, which derive their value from some other
financial instruments, called the underlying. The foundation of all derivatives market is the
underlying market, which could be spot market for gold, or it could be a pure number such as the
level of the wholesale price index of a market price.

“A derivative is a financial instrument whose value depends on

the value of other basic underlying variables”
John c hull
According to the Securities Contract (Regulation) Act, 1956, derivatives include:

a) A security derived from a debt instrument, share, and loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
b) A contract, which derives its value from the prices or index of prices of underlying securities.

Therefore, derivatives are specialized contracts to facilitate temporarily for hedging

which is protection against losses resulting from unforeseen price or volatility changes. Thus,
derivatives are a very important tool of risk management.
Derivatives perform a number of economic functions like price discovery, risk transfer
and market completion.
The simplest kind of derivative market is the forward market. Here a buyer and seller
write a contract for delivery at a specific future date and a specified future price. In India, a
forward market exists in the form of the dollar-rupee market. But forward market suffers from
two serious problems; counter party risk resulting in comparatively high rate of contract non-
compliance and poor liquidity.

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 Futures markets were invented to cope with these two difficulties of forward markets.
Futures are standardized forward contracts traded on an organized stock exchange. In essence, a
future contract is a derivative instrument whose value is derived from the expected price of the
underlying security or asset or index at a pre-determined future date.

1.1.2 PREREQUISITES FOR DERIVATIVES MARKET

There are five essential prerequisites for derivatives market to flourish in a country.

a) Large market capitalization

At a market capitalization of near $1.5 trillion, India is well ahead of many other
countries where derivatives markets have succeeded.

b) Liquidity in the underlying

A few years ago, the total trading volume in India used to be around Rs-300
crore a day. Today, daily trading volume in India is around Rs-2000 crore a day. This
implies a degree of liquidity, which is around six times superior to the earlier conditions.
There is empirical evidence to suggest that there are many financial instruments in the
country today, which have adequate to support derivative market.

c) Clearing house that guarantees trades

Counter party risk is one of the major factor recognized as essential for starting a strong
and healthy derivatives market. Trade guarantee therefore becomes imperative before a
derivatives market could start. The first clearinghouse corporation guarantees trades have
become fully functional from July 1996 in the form of National Securities Clearing Corporation
(NSCC). NSCC is responsible for guaranteeing all open positions on the National Stock
Exchange (NSE) for which it does the clearing. Other exchanges are also moving towards setting
up separate and well-funded clearing corporations for providing trade guarantees.

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 d) Physical infrastructure
India’s equity markets are all moving towards satellite connectivity, which allows
investors and traders anywhere in the country to buy liquidity services from anywhere else. This
telecommunications infrastructure, India’s capabilities in computer hardware and software, will
enable the establishment of computer system for creation of derivatives markets. Setting up of
automated trading system as an experience with various prospective exchanges will also be
beneficial while setting up the derivative market.

e) Risk-taking capability and Analytical skills

India’s investors are very strong in their risk-bearing capacity and can cope with the
risk that derivatives pose. Evidence of the volumes traded on the capital markets, which are akin
to a futures market, is indicative of this capacity. In contrast, in some other countries, investors
simply lack the risk-bearing capacity to sustain the growth of even the equity market. It is
expected that such a barrier will not appear in India.

On the subject of analytical skills, derivatives require a high degree of analytical

capability for many subtle trading strategies to pricing. India has an enormous pool of
mathematically literate finance professionals, who would excel in this field.

Lastly, an obvious advantage for the Indian market is that we have enormous
experience with futures markets through the settlement cycle oriented equity which is not truly a
spot market but a futures market (including concepts like market-to-market margin, low delivery
ratios, and last-day-of settlement abnormalities in prices). We also have active futures markets
on six commodities. With this state of development of the capital markets it is felt that there is no
major hurdle left for the creation of development of the capital markets. Hence on July 2, 1996
the SEBI board gave an in principal approval for the launch of derivatives markets in India.

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1.1.3 Regulations for Derivatives Trading

1.1.3.1 Objects of regulations

There are 3 basic objects of regulations. They are
a) To protect market integrity
b) To ensure fierce level of competition and
c) To prevent fraud

SEBI set up a 24- member committee under the chairmanship of Dr. L.C. Gupta
to develop the appropriate regulatory framework for derivatives trading in India. The
committee submitted its report on March 1998. On May, 1998, SEBI accepted the
Recommendations of the committee and approved the phased introduction of derivatives trading
in India beginning with stock index futures. SEBI also approved the “suggestive be-laws”
recommended by the committee for the regulation and control of trading and settlement of
derivatives contracts. The provisions in the SC (R) A and the regulatory framework developed
there under govern trading in securities. The amendment of the SC (R) A made trading in
derivatives possible within the framework of the Act.

1. Any exchange fulfilling the eligibility criteria as prescribed by the L.C.Gupta

committee report may apply to SEBI for grant of recognitions under the section 4 of
the SC (R) A, 1956 to start trading in the derivatives. The derivatives Exchange/
segment should have a separate governing council and the representation members of
the governing council and representation of trading clearing members shall be limited
to maximum of 40% of total members of the governing council the exchange shall
regulate the sales practices of its members and will obtain prior approval of SEBI
before start of trading in any derivatives market.

2. The exchange shall have minimum 50 members.

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 3. The members of the existing segment of the exchange will not automatically become
the members of the derivatives segment. The members of the derivative segment need
to fulfill the eligibility as lay down by the L.C.Gupta
Committee.

The clearing and settlement of derivatives trades shall be Through SEBI approved
clearing corporations or house. Clearing corporations/houses
Complying with the eligibility condition as laid down by the committee has to apply to SBI for
grant of approval.

Derivatives brokers/dealers and clearing members are required to seek registration from
SEBI. This is in addition to their registration as brokers of existing stock exchanges.
The minimum net worth for clearing members of the derivatives clearing corporations/houses
shall be Rs.300lakhs. The minimum contract value shall not be less than Rs.2 lakhs. Exchange
should also submit details of the futures and options contract they propose to introduce.

The initial margin requirement exposure limits linked capital adequacy and Margin
demands related to the risk of loss on the position shall be prescribed by SEBI/exchange from
time to time.

The L.C.Gupta committee requires strict enforcement of “know your customer” rule and
requires that every client shall be registered with the derivatives broker.

The members of the derivatives segment are also required to make their clients aware of
risk involved in derivatives trading by issuing to the client the Risk “Disclosure Document” and
obtain a copy of the same duly signed by the client.

The trading members are required to have qualified approved user and salesperson that
have passed a certification programmed approval by SEBI.

These are the regulations specified by the SEBI for derivatives trading.
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1.1.3.2 Measures Specified By SEBI:

A. Protection of Investor Rights in Derivative Market:

The following measure has been specified by SEBI to protect the rights of investors in
the derivatives market.
1. Investor’s money has to be dept. separate at all levels and is permitted to be used
only against the liability of the investor and is no available to the trading member
or clearing member or even any other investor.
2. the trading member is required to provide every investor with a risk disclosure
document which will disclose the risks associated with the derivatives trading so
that investors can take a conscious decision to trade in derivatives.
3. Investors would bet the contract note duly time stamped for receipt of the order
and execution of the order: the order will be executed with the identity of the
client and without client 10 orders will not accepted by the system. The investor
could also demand the trade confirmation slip with his ID in support of the
contract note. This will protect from the risk of price favor, if any extended by the
member.
4. in derivatives markets all money paid by the investor towards margins on all open
positions is dept. in trust with the clearing house/clearing corporations and in the
event of default of the trading or clearing member the amounts paid by the client
towards margins are segregated and not utilized towards the default of the
member. However, in the event of default of a member, losses suffered by the
investors, if any ,on settled/closed out position are compensated from the Investor
Protection Fund, as per the rules, bye – laws and regulations of the derivative
segment of the exchange.

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 TYPES OF DERIVATIVES

Derivatives

Forwards Future Options Swaps

One form of
classification of derivatives is between commodity derivatives and financial derivatives. Thus
Commodity Security Call Put
futures, option or swaps on gold , sugar, jute, pepper etc. are commodity derivatives.
Security Interest rate
While futures, options or swaps on currencies, gilt-edged securities, stock and share stock
market indices etc. are financial derivatives.
Commodity Currency

A) OPTIONS:

The concept of options is not new one. In Fact, options have been in use for centuries.
The idea of an option existed in ancient Greece and Rome. The Romans wrote options on the
cargo that were transported by their ship. In the 17th century, there was an active option markets
in Holland. In fact, options were used in a large measure in the ‘tulip bulb mania ‘ of that
century. However, in the absence of mechanism to guarantee the performance of the contract,
the refusal of many put option writers to take delivery of the tulip bulb and pay the high prices of
the bulb they had originally agreed to, led to bursting of the bulb bubble during the winter of
1637.A number of speculators were wiped out in the process.

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 In India, options on stocks of companies were illegal until 25th January 1995 according to
sec. 20 of Securities Contracts (Regulation) Act, 1956. When Securities Laws (Amendment) Act,
1956 deleted sec. 20, thus making the introduction of options as legal act.
An options contract is an agreement between a buyer and a seller. Such a contract confers
on the buyer a right but not an obligation to buy or sell a specified quantity of the underlying
asset at a fixed price on or up to a fixed day in the future on a payment of a premium to the
seller. The premium paid by the buyer to the seller is the price of an option contract

Options on a futures contract have added a new dimension to future trading like futures
options provide price protection against adverse price move. Present day options trading on the
floor of an exchange began in April 1973. When the Chicago Board of trade created the Chicago
Board Options Exchange (CBOE) for the sole purpose of trading Options on a limited number of
NEW YORK STOCK EXCHAGE listed equities

B) FORWARDS:

A forward is an agreement between two parties to exchange an agreed quantity of asset at

a specified future date at a predetermined price specified in the agreements. The parties
concerned agree the settlement date and price in advance. The promised asset may be currency,
commodity, instrument etc. It is the oldest type of all the derivatives. The party who promises to
buy but he specified asset at an agreed price at a fixed future date is said to be in the ‘Long
position ‘ and the party who promises to sell at an agreed price at a future date is said to be in ‘
short position’.

C) FUTURES:

15
 It is similar to the forward contract in all the respect. In fact, a future is a standardized
form of forward contract. A future is a contract or an agreement between two parties to exchange
assets / currency or commodity at a certain future date at an agreed price. The trader who
promises to buy is said to be in ‘ long position ‘ and the party who promises to sell said be in
‘short position’.

Futures contracts are contracts specifying a standard volume of a particular currency to

be exchanged on a specific settlement date. A future contract is an agreement between a buyer
and a seller. Such a contract confers on the buyer an obligation to buy from the seller, and the
seller an obligation to sell to the buyer a specified quantity of an underlying asset at a fixed price
on or before a fixed day in future. Such a contract can be for delivery of an underlying asset.

To eliminate counter party risk and guarantee traders, futures markets use a clearing
house which employs initial margin, daily market to market margin; exposures limits etc. to
ensure contract compliance and guarantee settlement standardized futures contracts generate
liquidity. In addition, due to these instruments being traded on recognized exchange’s results in
greater transparency, fairness and efficiency.

Due to these inherent advantages, futures markets have been enormously successful in
comparison with forward markets all over the world.

The difference between forward contract and future is that future is a standardized
contract in terms of quantity, date and delivery. It is traded on organized exchanges. So it has
secondary markets. Future contract is always settled daily, irrespective of the maturity date,
which is called marking to the market.

D) SWAP:

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 Swap is an agreement between two parties to exchange one set of financial obligations
with other. It is widely used throughout the world but is recent in India. Swap may be interest
swap or currency swaps.

Swaps give companies extra flexibility to exploit their comparative advantage in their
respective borrowing markets.

Swaps allow companies to focus on their comparative advantage in borrowing in a single

currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum.

Swaps allow companies to exploit advantages across a matrix of currencies and

maturities.

1.1.5 DERIVATIVE MARKETS IN INDIA

Prior to liberalization, in India financial markets, there were only a few financial
products and the stringent regulatory products and the stringent regulation environment also
eluded any possibility of development of a derivatives market in country. All Indian corporate
were mainly relying on term lending institution for meeting their project financing or any other
financing requirements and on commercial banks for meeting working capital finance
requirement. Commercial banks are on their assets and liabilities. The only derivative product
they were aware of is the foreign exchange forward contract. But this scenario changed in the
post liberalization period. Conservative Indian business practitioners began to take a different
view of various aspects of their operations to remain competitive. Financial risks were given

17
adequate attention and “treasury function” has assumed a significance role in all major corporate
since then.

Initially, banks were allowed to pass on gains arising out of cancellation of forward’s
contracts to the customers and customers were permitted to cancel and re-book the forward
contracts. This remarkable change was followed by the introduction of cross currency forward
contacts. But the major milestone in developing forex derivatives market in India was the
introduction of cross currency options. The RBI’s objective of introducing cross currency
options was to provide a complicated hedging strategy for the corporate in their risk management
activities.

The concept of “derivatives” is of course not new to the Indian market. Though
derivatives in the financial markets have nothing to talk about home, in the commodity markets
they have a long history of over hundred years. In 1875, the first commodity futures exchange
was set up in Mumbai under the guidance of Bombay Cotton Traders Association. A
clearinghouse for clearing and settlement of these traders was set up in 1918. Over a period of
twenty years during 1900-1920, other futures markets were set up in various places. Futures
market in raw jute in Kolkata (1912), wheat futures market in Hapur (1913), and bullion futures
market in Mumbai (1920).
When it comes to financial markets, derivatives in equities claim a long existence. The
official history of Bombay Stock Exchange (then known as Native Share and Stock Brokers
Association) reveals that the concept of options existed since 1898 as is reflected from a quote
given by one of the MPs-“India being the original home of options, a native broker would give a
few points to the brokers of the other nations in the manipulation of puts and calls”.
However, such an early expertise gained by Indian traders in derivatives trading has come
to an end with the Government of India’s ban on forward contract during the 1960’s on the
ground of their intrinsic undesirability. But ironically, the same were re-introduced by the
government in the 1980’s as essential instruments for eliminating wide fluctuations in prices and
more so because of the World Bank – UNCTAD report, which strongly urged the Indian
government to start futures trading in major cash crops, especially in view of India’s entry to
WTO.
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 With the world embracing the derivative trading on large scale, the Indian market
obviously cannot remain aloof, especially after liberalization has been set in motion. Now we are
in the threshold of introducing trading in derivatives, beginning with the stock index futures to be
well set for the introduction of derivative trading. With L.C. Gupta committee having recently
submitted its report on the subject, SEBI is engaged in the process of assessing the feasibility and
desirability of introducing such trading.

The NSE and BSE are two exchanges on which financial derivatives are traded. The
combined notional value of the daily volumes on both the bourses stands at around RS. 400 cr. In
developed markets trading in the derivatives segment are thrice as large as in the cash markets.
In India, the figure is hardly 20% of cash markets. Quite clearly our derivative markets have a
long way to go.

According to the Executive Director of Association of NSE Member of India (Amni),

Vinod Jain, “Volumes in derivatives segment are stagnating due to lack of growth in the number
of markets participants. Besides these products are still to catch up with the masses who are
keeping away from this segment due to lack of understanding of the products and high contract
price”

Like our stock markets, the Indian derivatives markets are also becoming heavily
dependent on few instruments. For instance, futures in three blue chip companies such as Satyam
Computers, Reliance Industries and Infosys Technologies, have accounted for as 42% of the total
turnover in the derivatives segment of the National Stock Exchange in June 2002. Stock futures
of Satyam Computers, Infosys Technologies and HPCL accounted for 37% of the total turnover
in May 2002, 35% in April 2002 and 34% in March 2002.

These highly speculative stock futures instruments accounted for about 69% of the total
turnover. This may lead to price manipulations. Meanwhile, options contracts are witnessing a
decline in trading interest. The turnover in individual stock options plunged to Rs. 4,642cr. In
June compared with Rs. 5,133cr. In May similarly, the turnover index options also declined from
Rs. 463cr. In May to Rs. 389cr. In June.
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COMMODITY DERIVATIVES

Trading in derivatives first started to protect farmers from the risk of the value of their
crop going below the cost price of their produce. Derivative contracts were offered on various
agricultural products like cotton, rice, coffee, wheat, pepper, et cetera.

The first organized exchange, the Chicago Board of Trade (CBOT) -- with standardized
contracts on various commodities -- was established in 1848. In 1874, the Chicago Produce
Exchange -- which is now known as Chicago Mercantile Exchange -- was, formed (CME).

CBOT and CME are two of the largest commodity derivatives exchanges in the world.

THE INDIAN SCENARIO

Commodity derivatives have had a long and a chequered presence in India. The
commodity derivative market has been functioning in India since the nineteenth century with
organized trading in cotton through the establishment of Cotton Trade Association in 1875. Over
the years, there have been various bans, suspensions and regulatory dogmas on various contracts.

There are 25 commodity derivative exchanges in India as of now and derivative contracts
on nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs 5
lakh crore (Rs 5 trillion) by the end of 2004-2005.

National Commodity and Derivatives Exchange (NCDEX) is the largest commodity

derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight.

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 It is only in the last decade that commodity derivatives exchanges have been actively
encouraged. But, the markets have suffered from poor liquidity and have not grown to any
significant level, till recently.

However, in the year 2003, four national commodity exchanges became operational;
National Multi-Commodity Exchange of India (NMCE), National Board of Trade (NBOT),
National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange
(MCX).

The onset of these exchanges and the introduction of futures contracts on new
commodities by the Forwards Market Commission have triggered significant levels of trade.
Now the commodities futures trading in India is all set to match the volumes on the capital
markets.

INVESTING IN COMMODITY DERIVATIVES

Commodity derivatives, which were traditionally developed for risk management

purposes, are now growing in popularity as an investment tool. Most of the trading in the
commodity derivatives market is being done by people who have no need for the commodity
itself.

They just speculate on the direction of the price of these commodities, hoping to make
money if the price moves in their favour.

The commodity derivatives market is a direct way to invest in commodities rather than
investing in the companies that trade in those commodities.

21
 For example, an investor can invest directly in a steel derivative rather than investing in
the shares of Tata Steel. It is easier to forecast the price of commodities based on their demand
and supply forecasts as compared to forecasting the price of the shares of a company which
depends on many other factors than just the demand and supply of the products they manufacture
and sell or trade in.

Also, derivatives are much cheaper to trade in as only a small sum of money is required to buy a
derivative contract.

Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that
the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on
his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy
soybean futures instead.

Before we look into how investment in a derivative contract works, we must familiarize
ourselves with the buyer and the seller of a derivative contract. A buyer of a derivative contract
is a person who pays an initial margin to buy the right to buy or sell a commodity at a certain
price and a certain date in the future.

On the other hand, the seller accepts the margin and agrees to fulfill the agreed terms of
the contract by buying or selling the commodity at the agreed price on the maturity date of the
contract.

Now let us say the investor buys soybean futures contract to buy one tonne of soybean for
Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin
of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here.

On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price --
Spot Price is the current market price of the commodity at any point in time).

The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately
sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of

22
Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end
up making a loss of 34.5%.

If the investor wants, instead of taking the delivery of the commodity upon maturity of the
contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange
of the difference in the spot price of the commodity and the exercise price as per the futures
contract.

At present, the option of cash settlement lies only with the seller of the contract. If the
seller decides to make or take delivery upon maturity, the buyer of the contract has to fulfill his
obligation by either taking or making delivery of the commodity, depending on the specifications
of the contract.

In the above example, if the seller decides to go for cash settlement, the contract can be
settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of the
commodity and the exercise price. Once again, the return on the investment of Rs 870 is 34.5%.

The above example shows that with very little investment, the commodity futures market
offers scope to make big bucks. However, trading in derivatives is highly risky because just as
there are high returns to be earned if prices move in favour of the investors, an unfavorable move
results in huge losses.

The most critical function in a commodity derivatives exchange is the settlement and
clearing of trades. Commodity derivatives can involve the exchange of funds and goods. The
exchanges have a separate body to handle all the settlements, known as the clearing house.

For example, the seller of a futures contract to buy soybean might choose to take delivery
of soyabean rather than closing his position before maturity. The function of the clearing house
or clearing organization, in such a case, is to take care of possible problems of default by the
other party involved by standardizing and simplifying transaction processing between
participants and the organization.

23
 In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of
work in terms of policy liberalization, setting up the right legal system, creating the necessary
infrastructure, large-scale training programs, et cetera still needs to be done in order to catch up
with the developed commodity derivative markets.

Also, trading in commodity options is prohibited in India. The regulators should look
towards introducing new contracts in the Indian market in order to provide the investors with
choice, plus provide the farmers and commodity traders with more tools to hedge their risks.

a) COMMODITIES DERIVATIVES MARKETS

In order to give more thrust on agricultural sector, the National Agricultural

Policy, 2000 has envisaged and domestic market reforms and dismantling of all controls and
regulations in agricultural commodity markets. It has also proposed to extend the coverage of
futures markets to minimize the wide fluctuations in commodity market prices and for hedging
the risk from price fluctuations.
As a result of these recommendations, there are presently, 15 exchanges
carrying out futures trading in as many as 30 commodity items. Out to these, two exchanges viz.
IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have been upgraded to
international exchanged to deal international contracts in peeper and castor oil respectively.
Moreover, permission has been given to two more exchange viz. the First Commodities
Exchange of India Ltd., Kochi (for copra/coconut, its oil and oilcake), and Keshave Commodity
Exchange Ltd., Delhi (for potato), where futures trading started very recently.

24
 The government has also permitted four exchange viz., EICA, Mumbai. The
Central Gujarat Cotton Dealers Association, Vadodara; The South India cotton Association
Coimbattore; and the Ahmedabad Cotton Merchants Association, Ahmedabad, for conducting
forward (non-transferable specific delivery) contracts in cotton. Lately as part of further
liberalization of trade in agriculture and dismantling of ECA, 1955 futures trade in sugar has
been permitted and three new exchanges viz., E-Commodities Limited, Mumbai; NCS InfoTech
Ltd., Hyderabad; and E-Sugar India.com, Mumbai have been given approval for conducting
sugar futures (Ministry of Food and Consumer Affairs, 1999).
In the recent past, the GOI has set up a committee to explore and appraise matters
important to the establishment and financing of the proposed national commodity exchange for
the nationwide trading of commodity futures contracts. The usage of warehouse receipts as a
means for delivery of commodities under the contracts is also being explored.

The warehouse receipts system has been operationalized in COFEI (coffee futures
exchange of India) with effect from 1998. The Government of India is on the move to establish a
system of warehouse receipts in other commodity stock exchanges at various places of the
country.

Besides these domestic developments, during 1998, Reserve Bank of India permitted the
Indian Corporate Sector to access the exchanges subject to certain conditions with a view to
enable domestic metal manufacturers to compete with global players. The de-regulation of oil-
imports being on the cards, government should create the right atmosphere for oil sector to
participate in the international oil-derivatives Markets.

Despite these developments, there are still many impediments that hold back the farming
community from entering the futures market and reap full benefits.

b) CURRENCY DERIVATIVES

25
 Foreign exchange derivatives market is one of the oldest derivatives markets in
India. Presently, India has got a well-established dollar-rupee forward market with contrast
traded for one month, two months and three months expiration. Currency derivatives markets
have begun to evolve with the allowing of banks to pass on the gains upon cancellation of a
forward to the customer and permitting customer to cancel and rebook forward contracts.

Introduction of cross currency options can be considered as another major step

towards developing forex derivatives markets in India.

Today, Indian corporate is permitted to purchase cross currency options to hedge

exposures arising out of trade. Authorized dealers who offer these products have to necessarily
cover their exposure in international markets i.e., they shall not carry the risk in their own books.
Cross currency options are essentially meant for buying or selling any foreign currency in terms
of US dollar. They are therefore, useful only to those traders who invoice their exports and
imports in currencies other than US dollar or for corporate who borrow in currencies other than
US dollar. As against this, majority of Indian trade is invoiced in the US dollars. Thus, they have
almost no relevance in the Indian context.

Indian banks are allowed to use the foreign currency interest rate swaps, forward
rate agreements/interest rate options/swaps, and forward rate agreements/interest rate
option/swap/caps/floors to hedge interest rate and currency mismatch in their balance sheets.
Resident and the non-resident clients are also permitted to use the above products as hedges for
liabilities on their balance sheets.

Here it is worth remembering that globally, foreign exchange traders are becoming as
common as stock traders. But in India, forex dealers still play second fiddle to stock traders and
merely meet the needs of the exporter’s deposits. This may be due to their risk averting behavior
and perhaps lack of proper research. Such being the position of the forex market, it is too
premature to expect that once, foreign currency-Indian rupee options are introduced, the market
will pick up momentum.

26
 This is all the more essential in a market where exchange rates though stated to be
market determined, are often found influenced by RBI’s intervention in the exchange market. As
a result, exchange rate movements hardly obey the principle of interest rate differentials. The
incongruence in the domestic money rates as derived from the USD/INR forwards yield curve
supports this assertion.
For example, the one-year domestic term money is around 6-6.25% whereas that of the
one-year implied forward rate is around 5.40%. In such a scenario, it is difficult for a currency
trader to take a firm view on the exchange rate movement.

c) STOCK MARKET DERIVATIVES

Today trading on the “spot market” for equity in India has always been a futures market
with weekly/fortnightly settlements. These markets features the risks and difficulties of futures
market, But without the gains in price discovery and hedging services that come with separation
the spot market from the futures market. India’s primary market is acquainted with two types of
derivatives…
• Convertible bonds
• Warrants

As these warrants are listed and traded, it could be said that options market of a limited
sort already exist in our market.

Besides, a wide range of interesting derivatives markets exists in the informal sector.
Contracts such as “bhav-bhav” “teji-mandi” etc. are traded in these markets. These informal
markets enjoy a very limited participation and have their presence outside the conventional
institutions of India’s financial system.

The first step towards introduction of derivatives trading in India in its current format
was the promulgation of the securities laws (Amendment) Ordinance, 1995 that withdrew the
prohibition on options in securities. The real push to derivatives market in India was however
27
given by the SEBI. The security market watchdog, in November 1996 by setting up of a
committee under the chairmanship of Dr L C Gupta, to develop “appropriate regulatory
framework for derivatives trading in India.”
In 2000, SEBI permitted NSE and BSE to commence trading in index futures contracts
based on S&P CNX Nifty and BSE 30(Sensex) index. This was followed by approval for trading
in options based on these two indexes and options on individual securities. Futures contracts on
Individual stocks were launched on November 9, 2001.
Trading and settlement is done in accordance with the rules of the respective
exchanges. But the trading volumes were initially quite modest.
This could be due to -----

 Initially, few members have been permitted by SEBI to trade on derivatives;

 FII’S, MFS have been allowed to have a very limited participation;

 Mandatory requirements for brokerage firms to have “SEBI approved-certification-test-

passed” brokers for undertaking derivatives trading’ and

 Lack of clarity on taxation and accounting aspects under derivatives trading.

The current trading behavior in the derivatives segments reveals that single stock
futures continues to account for sizeable proportion. A recent press report indicates that futures
in Indian exchanges have reached global volumes. One possible reason for such skewed behavior
of the traders could be that futures closely resemble the erstwhile badla system. Such distortions
are not however in the interest of the market.

SEBI has permitted trading in options and futures on individual stocks, but not on
all the listed stocks. It was very selective, stocks that are said to be highly volatile with a low
market capitalization are not allowed for option trading. This act of SEBI is strongly resented by
a section of the market. Their argument is that equity options are indispensable to investors who
need to protect their investment from volatility. The higher the volatility of a stock the more
28
necessary it is to list options on that stock. They are highly vocal in arguing that SEBI should
design an effective monitoring, surveillance and risk management system at the level of the
exchanges and clearing house to avert and manage the default risks that are likely to arise owing
to high volatility in low market capital stocks instead of simply banning trading in options on
them. SEBI needs to examine these arguments.
It may have to take a stand to nip in the bud all kinds of manipulations by handling out
severe punishments to all such erring companies.
Today, mutual funds are permitted to use equity derivative products for “hedging and
portfolio rebalancing”. However, such usage is not favored by fund managers as they strongly
apprehend that the dividing line between hedging and speculation being thin, they may always
get exposed to the questioning by the regulatory authorities.

d) CREDIT DERIVATIVES AND OTHERS

A credit derivative is a financial transaction whose pay-off depends on whether or not a

credit event occurs.
A credit event can be:
• Bankruptcy
• Default
• Upgrade
• Downgrade
• Interest rate movement
• Mortgage defaults
• Unforeseen pay-offs.

29
 A credit derivative, like any other derivative, derives it’s value from an case is the
credit. In the event of the underlying asset failing to perform as expected, credit derivatives,
ensures that someone other than the principal lender absorbs the resulting financial loss.

Credit derivatives market in India though could be said as non-existent holds huge
potential. Some of the important factors/situation such as opening up of the insurance sector to
foreign private players, relief to investors, tax benefits to corporates, proxy hedgers etc., could
provide the momentum to the credit derivatives market in India, boosting yields and bringing
down risk for both the corporates and banks.
Secondly, Indian banking system is saddled with huge NPA’s, which it is of course,
eagerly trying to get rid of. The mounting pressure on profitability is making banks more credit-
averse. In such a situation, if markets can offer “credit-insurance” in the form of derivatives,
everyone would jump for it.

FUTURES

A futures contract is a type of derivative instrument, or financial contract, in which two parties
agree to transact a set of financial instruments of physical commodities for future delivery at a
particular price. If you buy a futures contract, you are basically agreeing to buy something that a
seller has not year produced for a set price. But participating in the futures market does not
necessarily mean that you will be responsible for receiving or delivering large inventories of
physical commodities-remember, b buyers and sellers in the futures market primarily enter into
futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the
primary activity of the cash/spot market). That is why futures are used as financial instruments
by not only producers and consumers but also speculators.

30
The consensus in the investment world is that the futures market is a major financial hub,
providing an outlet for intense competition among buyers and sellers and, more importantly,
providing a center to manage price risks. The futures market is extremely liquid, risky and
complex by nature, but it can be understood if we break down how it functions.

While futures are not for the risk averse, they are useful for a wide range of people. In this
tutorial, you’ll learn how the futures market works, who uses futures and which strategies will
make you a successful trader on the futures market.

1.2.1 A Brief History

Before the North American futures market originated some 150 years ago, farmers would grow
their crops and then bring them to market in the hope of selling their inventory. But without any
indication of demand, supply often exceed what was needed and un purchased crops were left to
rot in the streets! Conversely, when a given commodity-wheat, for instance – was out of season,
the goods made from it became very expensive because the crop was no longer available.
In the mid-nineteenth century, central grain markets were established and a central market place
was created for farmers to bring their commodities and sell them either for immediate delivery.
The latter contracts-saved many a farmer the loss of crops and profits and helped stabilize supply
and prices in the off-season.

Today’s futures market is a global market place for not only agricultural goods, but also for
currencies and financial instruments such as Treasury bonds and securities (securities futures).
It’s a diverse meeting place4 of farmers, exporters, importers, manufacturers and speculators.
Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas
farmer can match a bid from a buyer in Europe.

1.2.2 Evolution of futures market in India

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 a) Organized futures market evolved in India by the setting up of “Bombay Cotton Trade
Association Ltd.” In 1875. In 1983, a separate association called “The Bombay Cotton
Exchange Ltd.” Was constituted.

b) Futures trading in oilseeds were started with the setting up of Guajarati Vyapari Mandali
in 1900. A second exchange, the Seeds Traders Association Ltd., trading oelseeds such
as castor and groundnuts, was set up in 1926 in Mumbai. Then, many other exchanges
trading in jute, pepper, turmeric, potatoes, sugar, and silver, followed.

c) Futures market in bullion began at Mumbai, in 1920.

d) But, in the 1940s, trading in forwards and futures was made difficult through price
controls till 1952 when the government passed the Forward Contract Regulation Act,
which controls all transferable forward contracts and futures.

e) During the 1960s and 70s the Central Government suspended trading in several
commodities like cotton, jute, edible oilseeds, etc. as it felt that these markets helped
increase prices for commodities.

f) Two committees that were appointed-Datwala committee in 1966 and Khusro Committee
in 1980 recommended the reintroduction of futures trading in major commodities, but
without much result.

g) One more committee on Forwards market, the Kabra Committee was appointed in 1993,
which recommended futures trading in wide range of commodities and also up gradation
of futures market. Accepting partially the recommendations, Government permitted
futures trading in many of the commodities.

1.2.3 Schedule of Commencement of Trading in Futures

The Two major Stock Exchanges of India NSE and BSE commenced Trading as Under:
1.2.3.1 National Stock Exchange
1. SNX Nifty futures: September 2000
2. Trading in Individual Stock Futures: December 2001
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1.2.3.2 BSE Mumbai Stock Exchange
1. Sensex BSE Futures: June 2000
2. Individual Stock Futures: December 2001
NSC conducts derivative trading at its F&O (Futures & Options) Segment, while BSE
conducts derivative trading at the DTSS (Derivatives Trading and Settlement System).

After introducing BSE 30 Sensex Futures initially in June 2000, BSE also followed
derivative trading with its other indices viz. BSETECK, BSE100, BSE200, BSE500, and
BSEPSU.

The Sensex futures contracts are to be on a monthly cycle. The contract month identifies the
month and year in which the futures contract ceases to exist. At a given point of time, there
would be multiple series (3 in this case) open in the Index futures.

The lifetime of each series will currently be a maximum of three month. These monthly
series would mature on the last Thursday of the respective month and the new monthly series
would come into existence on the immediately following trading day. In case the last
Thursday of the month is a holiday the expiry will be on the previous working day.

National Stock Exchange (NSE) accounts for over 97 percent activity in equity derivatives in
India. Therefore, the status of equity derivatives markets in India can be measured in terms
of the NSE’s performance.

Out of the total derivatives volume at NSE, individual stock futures account for almost 70
percent. Single stock call and put options constitute about 20 percent of the volumes. Index
futures constitute about 10 percent and index options constitute about 2 percent of the
volumes.

India entered the derivatives league in June 2000 with the introduction of index futures and
then India witnessed the introduction of index options in June 2001, stock options in July
33
2001 and futures on individual securities in November 2001. There has been a steady
increase in the volumes. For instance, average daily volumes in NSE derivative segment rose
from Rs. 438 crore in October 2001 to Rs. 1073 crore in May 2002.

Volumes in derivatives segment have grown phenomenally in the past few months,
particularly after the introduction of stock futures and options. This spurt in activity can be
attributed to stock futures that have aroused trading interest like no other derivative product.

1.2.4 How Future Market Works?

The futures market is a centralized marketplace for buyers and sellers from around the world
who meet and enter into futures contracts. Price can be based on an open cry system, or bids
and offers can be matched electronically. The futures contract will state the price that will be
paid and the date of delivery. But almost all futures contracts end without the actual physical
delivery of the commodity.

1.2.5 What Exactly Is a Futures Contract?

Let’s say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into
an agreement with the cable company to receive a product at a future date, with the price and
terms for delivery already set. You have secured your price for now and the next year-even
if the price of cable rises during that time. By entering into this agreement with the cable
company, you have reduced your risk of higher prices.

That’s how the futures market works. Except instead of a cable TV provider, a producer of
wheat may be trying to secure a selling price for next season’s crop, while a bread maker
may be trying to secure a buying price of determine how much bread can be made and at
what profit. So the farmer and the bread maker may ente4r into a futures contract requiring
the delivery of 5,000 bushels of grain to the buyer in June at a price of $40 per bushel. By
entering into this futures contract, the farmer and the bread maker secure a price that both
parties believe will be a fair price in June. It is this contract-and not the grain per se-that can
then be bought and sold in the futures market.

34
So, a futures contract is an agreement between two parties: a short position-the party who
agrees to deliver a commodity-and a long position-the party who agrees to receive a
commodity. In the above scenario, the farmer would be the holder of the short position
(agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy).
We will talk more about the outlooks of the long and short positions in the section on
strategies, but for now it’s important to know that every contract involves both positions.

In every futures contract, everything is specified: the quantity and quality of the commodity,
the specific price per unit, and the date and method of delivery. The “price” of a futures
contract is represented by the agreed-upon price of the underlying commodity or financial
instrument that will be delivered in the future. For example, in the above scenario, the price
of the contract is 5,000 bushels of grain at a price of $40 per bushel.

1.2.6 Forward contracts v/s Future contracts

Forward Contracts
• A forward contract is one to one bi-parties contract, to be performed in the future, at
the terms decided today. ( E.g. forward currency market in India).

• Forward contract6s offer tremendous flexibility to the parties to design the contract in
terms of the price, quantity, (in case of commodities), delivery time and place.

• Forward contracts suffer from poor liquidity and default risk.

• Not traded on exchanges but are traded over the counter

35
 • Contract specifications differ from trade to trade as they are individually agreed
between two counter parties

• Counter party Risk exists

• Liquidation Profile: Poor Liquidity as contracts are tailor maid contracts.

• Price discovery: Poor; as markets are fragmented

Future contracts
• Future contracts are organized/standardized contracts, which are traded on the
exchanges.

• These contracts, are standardized by the exchanges are very liquid in nature.

• In futures market, clearing corporation/house provides the settlement guarantee.

• Counter party risk exists, but is assumed by the clearing corporation/house reducing
the risk to almost nil.

• Liquidation Profile: Very high Liquidity as contracts is standardized contracts.

• Price Discovery: Better; as fragmented markets are brought to the common platform
whereby the price is much more transparent due to the standardization and market
reporting of volumes and prices.

• Where a forward contract can only be reversed with the same counter party with whom
it was entered into, a futures contract can be reversed with any member of the
exchange.

1.2.7 Economic Importance of the Futures Market

Because the futures market is both highly active and central to the global
marketplace, it’s a good source for vital market information and sentiment indicators.

A. Price Discovery
36
 Due to its highly competitive nature, the futures market has become and
tomorrows estimated amount of supply and demand. Futures market prices depend
on a continuous flow of information from around the world and thus require a high
amount of transparency. Factors such as weather, war, debt default, refugee
displacement, land reclamation and deforestation can all have a major effect on
supply and demand and, as a result, the present and future price of a commodity.
This kind of information and the way people absorb it constantly changes the price of
a commodity. This process is known as price discovery.

B. Risk Reduction

Futures markets are also a place for people to reduce risk when making
purchases. Risks are reduced because the price is pre-set, therefore letting
participants know how much they will need to buy or sell. This helps reduce the
ultimate cost to the retail buyer because with less risk there is less of a chance that
manufacturers will jack up prices to make up for profit losses in the cash market.

1.2.8 Characteristics of Futures trading

A “Futures Contract” is a highly standardized contract with certain distinct
features. Some of the important features are as under:

37
 a. A future trading is necessarily organized under the auspices of a market
association so that such trading is confined to or conducted through members
of the association in accordance with the procedure laid down in the Rules &
Bye-laws of the association.

b. It is invariably entered into for a standard variety known as the “basis variety”
with permission to deliver other identified varieties known as “tenderable
varieties”.

c. The units of price quotation and trading are fixed in these contracts, parties to
the contracts not being capable of altering these units.

d. The delivery periods are specified.

e. The seller in a futures market has the choice to decide whether to deliver
goods against outstanding sale contracts. In case he decides to deliver goods,
he can do so not only at the location of the Association through which trading
is organized but also at a number of other pre-specified delivery centers.

f. In futures market actual delivery of goods takes place only in a very few
cases. Transactions are mostly squared up before the due date of the contract
and contracts are settled by payment of differences without any physical
delivery of goods taking place.

1.2.9 How to trade in Future Market?

38
At the risk of repeating ourselves, it’s important to note that futures trading are not for
everyone. You can invest in the futures market in a number of different ways, but before
taking the plunge, you must be sure of the amount of risk you’re willing to take. As a
futures trader, you should have a soled understanding of how the market and contracts
function. You’ll also need to determine how much time, attention, and research you can
dedicate to the investment. Talk to your broker and ask questions before opening a
futures account.

Unlike traditional equity traders, futures traders are advised to only use funds that have
been earmarked as pure “ –the risks rally are that high. Once you’ve made the initial
decision to enter the market, the next question should be: How?’” Here are three different
approaches to consider:

a) Do It Yourself

As an investor, you can trade your own account without the aid or advice of a
broker. This involves the most risk because you become responsible for managing funds,
ordering trades, maintaining margins, acquiring research and coming up with your own
analysis of how the market will move in relation to the commodity in which you’ve
invested. It requires time and complete attention to the market.

b) Open a Managed Account

Another way to participate in the market is by opening a managed account,

similar to an Equity account. Your broker would have the power to trade on your behalf,
following conditions agreed upon when the account was opened. This method could
lessen your financial risk because a professional would be making informed decisions on
your behalf. However, you would still be responsible for any losses incurred as well as
for margin calls. And you’d probably have to pay an extra management fee.

c) Join a Commodity Pool

39
 A third way to enter the market and one that offers the smallest risk is to join a
commodity pool. Like a mutual fund, the commodity pool is a group of commodities
which can be invested in. No one person has an individual account; funds are combined
with others and traded as one. The profits and losses are directly proportionate to the
amount of money invested. By entering a commodity pool, you also gain the opportunity
to invest in differs types of commodities. You are also not subject to margin calls.
However, it is essential that to pool be managed by a skilled broker, because the risks of
the futures market are still present in the commodity pool.

1.2.10 Standardization in Future Market

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
a) The underlying asset or instrument. This could be anything from a barrel of
crude oil to a short term interest rate.

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

c) 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.

d) The currency in which the futures contract is quoted.

e) The grad3e of the deliverable. In the case of bonds, this specifies which
bonds can be delivered. In the case of physical commodities, this specifies
not only the quality of the underlying goods but also the manner and location
of delivery, for example, the NYMEX Light Sweet Crude Oil contract
specifies the acceptable sulfur content and API specific gravity, as well as the
location where delivery must be made.

f) The delivery month.

g) The last trading date.

40
 h) Other details such as the commodity tick, the minimum permissible price
fluctuation.

1.2.11 The Players of Future Market

The players in the futures market fall into two categories: hedgers and speculators.
a) Hedgers

Farmers, manufacturers, importers and exporters can all be hedgers. A hedger

buys or sells in the futures market to secure the future price of a commodity intended to
be sold at a later date in the cash market. This helps protect against price risks.

The holder of the long position in futures contracts I (the buyers of the
commodity), are trying to secure as low a price as possible. The short holders of the
contract (the sellers of the commodity) will want to secure as high a price as possible.
The futures contract, however, provides a definite price certainty for both parties, which
reduces the risks associated with price volatility. Hedging by means of futures contracts
can also be used as means to lock in an acceptable price margin between the const of the
raw material and the retail cost of the final product sold.

b) Speculators

Other market participants, however, do not aim to minimize risk but rather to
benefit from the inherently risky nature of the figures market. These are the speculators,
and they aim to profit from the very price change that hedgers are protecting themselves
against. Hedgers want to minimize their risk no matter what they’re investing in, while
speculators want to increase their risk and therefore maximize their profits.

In the futures market, a speculator buying a contract low in order to sell high in
the future would most likely be buying that contract from a hedge selling a contract low
in anticipation of declining prices in the future.

41
 Unlike the hedger, the speculator does not actually seek to own the commodity in
question. Rather, he or she will enter the market seeking profits by offsetting rising and
declining prices through the buying and selling of contracts.
Trader Short Long

The hedger Secure a price now Secure a price now

to Protect against to protect against
future declining future rising prices
prices
The Secure a price now Secure a price now
speculator in anticipation of in anticipation of
declining prices rising prices

In a fast- paced market into which information is continuously being fed,

speculators and hedgers bounce off of-and benefit from-each other. The closer it gets to
the time of the contract’s expiration, the more soled the information entering the market
will be regarding the commodity in question. Thus, all can expect a more accurate
reflection of supply and demand and the corresponding price.

Regulatory Bodies
At present, there are three tiers of regulations of forward/futures trading system
exists in India, namely, Government of India, Forward Markets Commission and
Commodity Exchanges.

The FC(R) Act, 1952 prohibits options in commodities. For the purpose of
forward contracts in certain commodities can be regulated by notifying those
commodities u/s 15 of the Act; forward trading in certain other commodities can be
prohibited by notifying these commodities u/s 17 of the Act.

42
1.2.12 Futures Strategies
Essentially, futures contracts try to predict what the value of an index of
commodity will be at some date in the future. Speculators in the futures market can use
different strategies to take advantage of rising and declining prices. The most co0mmon
are known as going long, going short and spreads.

a) Going Long

When an investor goes long-that is, enters a contract by agreeing to buy and receive
delivery of the underlying at a set price it means that he or she is trying to profit from an
anticipated future price increase.

For example, let’s say that, with an initial margin of $2,000 in June, Joe the speculator
buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000.
By buying in June, Joe is going long, with the expectation that the price of gold will rise by the
time the contract expires in September.
By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the
contract in order to realize a profit. The 1,000 ounc3e contract would now be worth $352,000
and the profit would be $2,000. Given the very high leverage (remember the initial margin was
$2,000), by going long, Joe made a 100% profit!

Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The
speculator would have realized a 100% loss. It’s also important to remember that throughout the
time that Joe held the contract; the margin may have dropped below the maintenance margin
level. He would, therefore, have had to respond to several margin calls, resulting in an even
bigger loss or smaller profit.

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b) Going short

A speculator who goes short-that is, enters into a futures contract by agreeing to sell and
deliver the underlying at a set price-is looking to make a profit from declining price levels. By
selling high now, the contract can be repurchased in the future at a lower price, thus generating a
profit for the speculator.

Let’s say that Mr. X did some research and came to the conclusion that the price of oil
was going to decline over the next six months. He could sell a contract today, in November, at
the current higher price, and buy it back within the next six months after the price has declined.
This strategy is called going short and is used when speculators take advantage of a declining
market.

Suppose that, with an initial margin deposit of $3,000, Mr. X sold one May crude oil
contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of
$25,000. By March, the price of oil had reached $20 per barrel and Mr. X felt it was time to cash
in on her profits. As such, he bought back the contract which was valued at $20,000. By going
short, Mr. X made a profit of $5,000! But again, if Mr. X research had not been thorough, and he
had made a different decision, her strategy could have ended in a big loss.

c) Spreads

As you can see, going long and going short are positions that basically involve the buying or
selling of a contract now in order to take advantage of rising or declining prices in the future.
Another common strategy used by futures traders is called “spreads”.

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Spreads involve taking advantage of the price difference between two different contracts of the
same commodity. Spreading is considered to be one of the most conservative forms of training in
the futures market because it is much safer that the trading of long/short (naked) futures
contracts.

There are many different types of spreads, including:

Calendar spread: This involves the simultaneous purchase and sale of two futures of the same
type, having the same price, but different delivery dates.

Inter market Spread: Here the investor, with contracts of the same month, goes long to one
market and short in another market. For example, the investor may take short June Wheat and
Long June Pork Bellies.

Inter-Exchange Spread: This is any type of spread in which each position is created in different
futures exchanges. For example, the investor may create a position in the Chicago Board of
Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).

1.2.13 Futures Market Characteristics

In the futures market, margin has a definition distinct from its definition in the stock
market, where margin is the use of borrowed money to purchase securities. In the futures market,
margin refers to the initial deposit of “good faith” made into an account in order to enter into a
futures contract. This margin is referred to as good faith because it is this money that is used to
debit any day-to-day losses.

When you open a futures contract, the futures exchange will state a minimum amount
of money that you must deposit into your account. This original deposit of money is called the
initial margin. When your contract is liquidated, you will be refunded the initial margin plus or
45
minus any gains or losses that occur over the span of the futures contract. In other words, the
amount in your margin account changes daily as the market fluctuates in relation to your futures
contract. The minimum-level margin is determined by the futures exchange and is usually 5% to
10% of the futures contract. These predetermined initial margin amounts are continuously under
review: at times of high market volatility, initial margin requirements can be raised.

The initial margin is the minimum amount required to enter into a new futures contract,
but the maintenance margin is the lowest amount an account can reach before needing to be
replenished. For example, if your margin account ropes to a certain level because of a series of
daily loss3es, brokers are required to make a rain call and request that you make an additionally
deposit into your account to bring the margin back up to the initial amount.

Let’s say that you had to deposit an initial margin of Rs 1,000 on a contract and the
maintenance margin level is Rs500. A series of losses dropped the value of your account to Rs
400. This would them prompt the broker to make a margin call to you, requesting a deposit of at
least an additional Rs 600 to bring the account back up to the initial margin level of Rs 1,000.
When a margin call is made, the funds usually have to be delivered immediately. If
they are not, the brokerage can have the right to liquidate your position completely in order to
make up for any losses it may have incurred on your behalf.

A. Leverage: The Double-Edged Sword

In the futures market, leverage refers to having control over large cash amounts of
commodities with comparatively small levels of capital. In other words, with a relatively small
amount of cash, you can enter into a futures contract that is worth much more than you initially
have to pay (deposit into your margin account). It is said that in the futures market, more than
any other form of investment, price changes are highly leveraged, meaning a small change in a
futures price can translate into a huge gain or loss.

46
 Futures positions are highly leveraged because the initial margins that are set by the
exchanges are relatively small compared to the cash value of the contracts in question (which is
part of the reason why the futures market is useful but also very risky). The smaller the margin in
relation to the cash value of the futures contract, the higher the leverage. So for an initial margin
of $5,000, you may be able to enter into a long position in a futures contract for 30,000 pounds
of coffee valued at $50,000, which would be considered highly leveraged investments.
You already know that the futures market can be extremely risky and, therefore, not for
the faint of heart. This should become more obvious once you understand the arithmetic of
leverage. Highly leveraged investments can produce two results: great profits or greater losses.

As a result of leverage, if the price of the futures contract moves up even slightly, the
profit gain will be large in comparison to the initial margin. However, if the price just inches
downwards, that same high leverage will yield huge losses in comparison to the initial margin
deposit. For example, say that in anticipation of a rise in stock prices across the board, you buy a
futures contract with a margin deposit of $10,000, for an index currently standing at 1,300. The
value of the contract is worth $250 times the index (e.g. $250 *1300=$325,000), meaning that
for every point gain or loss, Rs250 will be gained or lost.

If after a couple of months, the index realized a gain of 5%, this would mean the index
gained 65 points to stand at 1365. In terms of money, this would mean that you as an investor
earned a profit of $16250 (65 point*$250): a profit of 162%!

On the other hand, if the index declined 5%, it would result in a monetary loss of
$16250-a huge amount compared to the initial margin deposit made to obtain the contract. This
means you still have to pay $6250 out of your pocket to cover your losses. The fact that a small
change of 5% to the index could result in such a large profit or loss to the investor (sometimes
even more than the initial investment made) is the risky arithmetic of leverage. Consequently,
while the value of a commodity or a financial instrument may not exhibit very much price
volatility, the same percentage gains and losses are much more dramatic in futures contracts due
to low margins and high leverage.
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B. Pricing and Limits

As mentioned before, contracts in the futures market are a result of competitive price
discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit
(gold ounces, bushels, barrels, index points, percentages and so on).

Prices on futures contracts, however, have a minimum amount that they can move.
These minimums are established by the futures example, the minimum sum that a bushel of grain
can move upwards or downwards in a day is a quarter of one U.S.cent. for futures investors, it’s
important to understand how the minimum price movement for each commodity will affect the
size of the contract in question. If you had a wheat contract for 5,000 bushels, a minimum of
$1,500 per contract (0.30cents *5,000) could be gained or lost on that particular contract in one
day. In this case, the daily price limit is 30cents per bushel.

Futures prices also have a price change limit that determines the prices between which
the contracts can trade on a daily basis. The price change limit is added to and subtracted from
the previous day’s close and the results remain the upper and lower price boundary for the day.

Say that the price change limit on silver per ounce is $0.25. yesterday, the price per
ounce closed at $5.today’s upper price boundary for silver would be $5.25 and the lower
boundary would be $4.75. If at any moment during the day the price of futures contracts for
silver reaches either boundary, the exchange shuts down all trading of silver futures for the day.
The next day, the new boundaries are again calculated by adding and subtracting $0.25 to the
previous day’s close. Each day the silver ounce could increase or decrease by $0.25 until an

48
equilibrium price is found. Because trading shuts down if prices reach their daily limits, there
may be occasions when it is not possible to liquidate an existing futures position at will.

The exchange can revise this price limit if it feels it’s necessary. It’s not uncommon for
the exchange to abolish daily price limits in the month that the contract expires (delivery or
“spot” month). This is because trading is often volatile during this month, as sellers and buyers
try to obtain the best price possible before the expiration of the contract.

C. Price Conditions

Limit Price/Order: An order that allows the price to be specified while entering the
order into the system.

Market Price/Order: An order to buy or sell securities at the best price obtainable at the
time of entering the order.

Stop Loss (SL) Price/Order: The one that allows the Trading Member to place an order
which gets activated only when the market price of the relevant security reaches or crosses a
threshold price. Until then the order does not enter the market.

A sell order in the Stop Loss Book gets triggered when the last traded price in the price
in the normal market reaches or falls below the trigger price of the order. A buy order in the Stop
Loss book gets triggered when the last traded price in the normal market reaches or exceeds the
trigger price of the order.

E.g. If for stop loss buy order, the trigger is 93.00, the limit price is 95.00 and the
market (has traded) price is 90.00, then this order is released into the system once the market
price reaches or exceeds 93.00. This order is added to the regular lot book with time of triggering
as the time stamp, as a limit order of 95.00

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Cost and carry model of Futures pricing

a) Fair price= Spot price+ Cost of carry-Inflows

b) FPtT=CPt+CPt *(RtT-DtT)*(T-t)/365 oFPtT-Fair price of the asset at

time t for time T.

c) CPt-Cash price of the asset.

d) RtT-Interest rate at time t for the period up to T.

e) DtT – Inflows in terms of divided or interest between t and T.

f) Cost of carry= Financing cost, Storage cost and insurance cost.

g) If Futures price > Fair price; Buy in the cash market and
simultaneously sell in the futures market.

h) If Futures price<Fair price; sell in the cash market and simultaneously

buy in the futures market.

This arbitrage between Cash and Future markets will remain till prices in the Cash and
Future markets get aligned.

D. Margin

To minimize credit risk to the exchange, traders must post margin or a

performance bond, typically 5%-15% of the contract’s value.

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.

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 a) Clearing margin are financial safeguards to ensure that companies or corporations
perform on their customers open futures and options contracts. Clearing margins are distinct
from customer margins that individual buyers and sellers of futures and options contracts are
required to deposit with brokers.

b) Customer margin: within the futures industry, financial guarantees required of both
buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of
contract obligations. Futures Commission Merchants are responsible for overseeing customer
margin accounts. Margins are determined on the basis of market risk and contract value. Also
referred to as performance bond margin.
c) Initial margin: is paid by both buyer and seller. It represents the loss on that contract,
as determined by historical price changes that is not likely to be exceeded on a usual day’s
trading. The initial Margin requirement is established by the Futures exchange, in contrast to
other securities Initial Margin which is set by the Federal Reserve in the U.S. Markets.
a. A futures account is marked to market daily. If the margin drops below the margin
maintenance requirement established by the exchange listing the futures, a margin call will be
issued to bring the account back up to the required level.
d) Maintenance margin: A set minimum margin per outstanding futures contract that
a customer must maintain in his margin account.
e) Margin-equity ratio is a term used by speculators, representing the amount of their
trading capital that is being held as margin at any particular time. The low margin requirements
of futures results in substantial leverage of the investment. However, the exchanges require a
minimum amount that varies depending on the contract and the trader. The broker may set the
requirement higher, but may not set it lower. A trader, of course, can set it above that, if he
doesn’t want to be subject to margin calls.
f) Performance bond margin: The amount of money deposited by both a buyer and
seller of a futures contract or an options seller to ensure performance of the term of the contract.
Margin in commodities is not a payment of equity or down payment on the commodity itself, but
rather it is a security deposit.

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 g) Return on margin (ROM): Is often used to judge performance because it
represents the gain or loss compared to the exchange’s perceived risk as reflected in required
margin. ROM is equal to (ROM+1) (year/trade duration)-1. For example if a trader earns 10% on
margin in two months, that would be about 77% annualized

1.2.14 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:
a) 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. Physical delivery is common with commodities and bonds. 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). The Nynex crude futures contract uses this method of
settlement upon expiration.
b) 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. Ice Brent futures use this method.

Expiry is the time when the final price of the future is determined. For many equity
index and interest rate futures contracts (as well as for most equity options), this happens on the
third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures
contract. For example, for most CME and CBOT contracts, at the expiry on December, the
March futures become the nearest contract. This is an exciting time for arbitrage desks, as they
will try to make rapid gains during the short period 9normally 30 minutes) where the final prices
are averaged from. At this moment the futures and the underlying assets are extremely liquid and
any mispricing between an index and an underlying asset is quickly traded by arbitrageurs. At
this moment also, the increase in volume is caused by traders rolling over positions to the next
contract or, in the case of equity index futures, purchasing underlying components of those
52
indexes to hedge against current index positions. On the expiry date, a European equity arbitrage
trading desk in London or Frankfurt will see positions expire in as many as eight major markets
almost every half an hour.

OPTIONS

The concept of options is not new one. In fact, options have been in use for centuries.
The idea of an option existed in ancient Greece and Rome. The Romans wrote options on the
cargo that were transported by their ship. In the 17th century, there was an active option markets
in Holland. In fact, options were used in a large measure in the tulip bulb mania of that century.
However, in the absence of mechanism to guarantee the performance of the contract, the refusal
of many put option writers to take delivery of the tulip bulb and pay the high prices of the bulb
they had originally agreed to, led to bursting of the bulb bubble during the winter of 1637. A
number of speculators were wiped out in the process.

In India, options on stocks of companies were illegal until 25th January 1995 according to
sec. 20 of Securities Contracts (Regulation) Act, 1956. When Securities Laws (amendment) act,
1956 deleted sec, 20, thus making the introduction of options as legal act.

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 An options contract is an agreement between a buyer and a seller. Such a contract confers
on the buyer a right but not an obligation to buy or sell a specified quantity of the underlying
asset at a fixed price on or up to a fixed day in the future on a payment of a premium to the
seller. The premium paid by the buyer to the seller is the price of an option contract.

Options on a futures contract have added a new dimension to future trading like futures
options provide price protection against adverse price move. Present day options trading on the
floor of an exchange began in April 1973. When the Chicago Board of trade created the Chicago
Board Options Exchange (CBOE) for the sole purpose of trading options on a limited number of
NEW YORK STOCK EXCHANGE listed equities.

1.3.1 Definition of option

An option is a contract, which gives the buyer the right, but not the obligation to buy or
sell shares of underlying security at a specific price of or before a specific date.

Options are fundamentally different from futures contracts. An option gives the holder of
the option the right to do something. The holder does not have to exercise this right. In contrast,
in a forward or futures contract, the two parties have committed themselves to doing something.
Whereas it costs nothing (except margin requirements) to enter into a futures contract, the
purchase of an option requires an up-front payment.

‘Option’, as the word suggest, is a choice given to the investor to either honor the
contract: or if he chooses not to walk away from the contract.

1.3.2 Types of options

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 a) Call option
b) Put option
c) Index option
d) Stock option

a) Call options
A call option is an option to buy a stock at a specific price on or before a certain
date. In this way, call options are like security deposits. If, for example, you wanted to rent a
certain property, and left a security deposit for it, the money would be used to insure that you
could, in fact, rent that property at the price agreed upon when you returned. If you never
returned, you would give up your security deposit, but you would have no other liability. Call
options usually increase the value as the value of the underlying instrument rises.

When you buy a call option, the price you pay for it, called the option premium, secures
your fight to buy that certain stock at a specified price called the strike price. If you decide not to
use the option to buy the stock, and you are not obligated to, your only cost is the option
premium.

b) Put option

Put options are options to sell a stock at a specific price on or before a certain date. In this
way, put options are like insurance policies.

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are,
hence, protected if the asset is damaged in an accident.

If this happens, you can use your policy to regain the insured value of the car. In this
way, the put options gains in value as the value of the underlying instrument decreases. If all
goes well and the insurance is not needed, the insurance company deeps your premium in return
for taking on the risk.
55
 With a put option, you can “insure” a sock by fixing a selling price. If something happens
which causes the stock price to fall, and thus, “damages” your asset, you can exercise your
option and sell it at its “insured” price level.

If the price of your stock goes up, and there is no “damage”, then you do not need to use
the insurance, and once again, your only cost is the premium. This is the primary function of
listed options, to allow investors way to manage risk.

Technically, an option is a contract between two parties. The buyer receives a privilege
for which he pays a premium. The seller accepts an obligation for which he receives a fee.

c) Index options:
These options have the index as the underlying. Some options are European while others
are American. Like index futures contracts, index options contracts are also cash settled.

d) Stock options
Stock options are options on individual stocks. Options currently trade on over 500 stocks
in the United States. A contract gives the holder the right to buy or sell shares at the specified
price.

1.3.3 Options Styles

Settlement of options is based on the expiry date. However, there are three basic styles
of options you will encounter which affect settlement. The styles have geographical names,
which have nothing to do with the location where a contract is agreed. The styles are:
a) European options:
These options give the holder the right, but not the obligation, to buy or sell the
underlying instrument only on the expiry date. This means that the option cannot be exercised

56
early. Settlement is based on a particular strike price at expiration. Currently, in India only index
options are European in nature.

b) American options:
a. These options give the holder the right, but not the obligation, to buy or sell the
underlying instrument on or before the expiry date. This means that the
option can be exercised early. Settlement is based on a particular strike price at
expiration.
b. Options in stocks that have been recently launched in the Indian market are “American
options”.

c) Capped option:
When an option is allowed to exercise only during a specified period of time prior to its
expiration unless the option reaches the cap value prior to expiration in which the option is
automatically exercised.

1.3.4 Advantages of option Trading

a) Risk management: put option allow investors holding shares to hedge against a possible
fall in their value. This can be considered similar to taking out insurance against a fall in
the share price.
b) Time to decide: By taking a call option the purchase price for the shares is locked in.
This gives the call option holder until the Expiry Day to decide whether or not to exercise
the option and buy the shares. Likewise the taker of a put option has time to decide
whether or not to sell the shares.
c) Speculation: the ease of trading in and out of an option position makes it possible to
trade options with no intention of ever exercising them. If and investor expects the
market to rise, they may decide to buy call options. If expecting a fall, they may decide to
buy put options. Either way the holder can sell the option prior to expiry to take a profit
of limit a loss. Trading options has a lower cost than shares, as there is no stamp duty
payable unless and until options are exercised.

57
 d) Leverage: Leverage provides the potential to make a higher return from a smaller initial
outlay than investing directly. However, leverage usually involves more risks than a
direct investment in the underlying shares. Trading in options can allow investors to
benefit from a change in the price of the share without having to pay the full price of the
share.
e) Income generation: Shareholders can earn extra income over and above dividends by
writing call potions against their shares. By writing an option they receive the option
premium upfront. While they get to keep the option premium, there is a possibility that
they could be exercised against and have to deliver their shares to the taker at the exercise
price.
f) Strategies: By combining different options, investors can create a wide range of potential
profit scenarios. To find out more about options strategies read the module on trading
strategies.

1.3.5 Hedging Strategies for Stock Options

1.3.5.1 Bull Market Strategy

A. Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If he expects
the market price of the underlying asset to rise, then you would rather have the right to
purchase at a specified price and sell later at a higher price than have the obligation to
deliver later at a higher price.
The investor’s profit potential buying a call option is unlimited. The investor’s profit is
the market price less the exercise price less the premium. The greater the increase in price
of the underlying, the greater the investor’s profit.

58
 The investor’s potential loss is limited. Even if the market takes a drastic decline
in price levels, the holder of a call is under no obligation to exercise the option. He may
let the option expire worthless. The investor breaks even when the market price equals
the exercise price plus the premium.

An increase in volatility will increase the value of your call and increase your
return. Because of the increased likelihood that the option will become in-the-money, and
increase in the underlying volatility (before expiration), will increases the value of a long
options position. As an option holder, your return will also increase.

B) Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option.
Basically, an investor anticipating a bull market could write Put options. If the market
price increase and puts become out-of-the-money, investors with long put positions will
let their options expire worthless.
By writing Puts, profit potential is limited. A put writer profits when the price of
the underlying asset increase and the option expires worthless. The maximum profit is
limited to the premium received.

However, the potential loss is limited. Because a short put position holder has an
obligation to purchase if exercised. He will be exposed to potentially large losses if the
market moves against his position and declaims.

An increase in volatility will increases the value of your put and decreased your
return. As an option writer, the higher price you will be forced to pay in order to buy back
the option at a later date, lower is the return.

C) Bullish Call Spread Strategies

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 A vertical call spread is the simultaneous purchase and sale of identical call
options but with different exercise prices.

To “buy a Call Spread” is to purchase a call with a lower exercise price and to
write a call with a higher exercise price. The trader pays a net premium for the position.

To “sell a Call Spread” is the opposite, here the trader buys a call with a higher
exercise price and writes a call with a lower exercise price, receiving a net premium for
the position.

An investor with a bullish market outlook should buy a call spread. The “Bull
Call Spread” allows the investor to participate to a limited extent in a bull market, while
at the same time limiting risk exposure.

The investor’s profit potential is limited. When both calls are in-the-Money, both
will be exercised and the maximum profit will be realized. The investor delivers
on his short call and receives a higher price than he is paid for receiving delivery on his long
call.

The investor’s potential loss is limited. At the most, the investor can lose is the
net premium. He pays a higher premium for the lower exercise price call than he receives
for writing the higher exercise price call.

The investor breaks even when the market price equals the lower exercise price
plus the net premium. At the most, an investor can lose is the net premium paid. To
recover the premium, the market price must be as great as the lower exercise price plus
the net premium.

D) Bullish Put Spread Strategies

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 A vertical put spread is the simultaneous purchase and sale of identical put
options but with different exercise prices.

To “buy a put spread” purchase a put with a higher exercise price and to write a
put with a lower exercise price. The trader pays a net premium for the position.

To “sell a put spread” is the opposite: the trader buys a put with a lower a
exercise price and writes a put with a higher exercise price, receiving a net premium for
the position.

An investor with a bullish market outlook should sell a put spread. The “vertical
bull put spread” allows the investor to participate to a limited extent in a bull market,
while at the same time limiting risk exposure.
The investor’s profit potential is limited. When the market price reaches or
exceeds the higher exercise price, both options will be out-of-the-money and will expire
worthless. The trader will realize his maximum profit, the net premium.
The investor’s potential loss is also limited. If the market falls, the options will be in-the-
money. The puts will offset one another, but at different exercise prices.

1.3.5.2 Bear Market Strategies

A. Puts in a Bearish Strategy

When investor purchases a put investor’s are long and want the market to fall. A
put option is a bearish position. It will increase in value if the market falls. An investor
with a bearish market outlook shall buy put options. By purchasing put options, the trader
has the right to choose whether to sell the underlying asset at the exercise price.

In a falling market, this choice is preferable to being obligate to buy the

underlying at a price higher. An investor’s profit potential is practically unlimited. The
higher the fall in price of the underlying asset, higher the profits.
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 The investor’s potential loss is limited. If the price of the underlying asset rises
instead of falling as the investor has anticipated, he may let the option expire worthless.
At the most, he may lose the premium for the option.

The trader’s breakeven point is the exercise price minus the premium. To profit,
the market price must be below the exercise price. Since the trader has paid a premium he
must recover the premium he paid for the option.

An increase in volatility will increase the value of your put and increase your
return. An increase in volatility will make it more likely that the price of the underlying
instrument will move. This increases the value of the option.

B) Calls in a Bearish Strategy

Another option for a bearish investor is to go short on a call with the intent to
purchase it back in the future. By selling a call, you have a net short position and needs
to be bought back before expiration and cancel out your position.

For this an investor needs to write a call option. If the market price falls, long call
holders will let their out-of-the-money option expire worthless, because they could
purchase the underlying asset at the lower market price.

The investor’s profit potential is unlimited because a shore call position holder
has an obligation to sell if exercised: he will be exposed to potentially large losses if the
market rises against his position.

The investor breaks even when the market price equals the exercise price: plus the
premium. At any price greater than the exercise price plus the premium, the trader is

62
losing money. When the market price equals the exercise price plus the premium, the
trader breaks even.

An increase in volatility will increase the value of your call and decrease your call
and decrease your return. When the option writer has to buy back the option in order to
cancel out his position. He will be forced to pay a higher price due to the increased value
of the calls.
C) Bearish put spread strategies

A vertical put spread is the simultaneous purchase and sale of identical put
options but with different exercise prices.

To “buy a put spread” is to purchase a put with a higher exercise price and to
write a put with a lower exercise price. The trader pays a net premium for the position.
To “Sell a put spread” is the opposite. The trader buys a put with a lower
exercise price and writes a put with a higher exercise price, receiving a net premium for
the position.

To put on a bear put spread you buy the higher strike put and sell the lower strike
put. You sell the lower strike and buy the higher strike of either calls or puts to set up a
bear spread.

An investor with a bearish market outlook should buy a put spread. The “Bear Put
Spread” allows the investor to participate to a limited extent in a bear market, while at the
same time limiting risk exposure.

The investor’s profit potential is limited, when the market price falls to or below
the lower exercise prices. If the market rose than falls, the options will be out-of-the-
money and expire worthless. Since the trader has paid a net premium.

63
 The investor breaks even the market price equals the higher exercise price less the
net premium. For the strategy to be profitable, the market price must fall. When the
market price falls high exercise price less the net premium, the trader break even, when
the market falls beyond this point, the trader profits.

D) Bearish Call Spread Strategies

A vertical all spread is the simultaneous purchase and sale of identical call options
but with different exercise prices.

To “buy a call spread” is to purchase a call with a lower exercise price and to
write a call with a higher exercise price. The trader pays a net premium for the position.

To “sell a call spread” is the opposite: the trader buys a call with a higher
exercise price and writes a call with a lower exercise price, receiving a net premium of
the position.
To put on a bear call spread you sell the lower strike call and buy the higher strike
call. An investor sells the lower strike and buys the higher strike of either calls or puts to
put on a bear spread.

Investors with a bearish market outlook should sell a call spread. The “bear call
Spread” allows the investor to participate to a limited extent in a bear market, while at the
same time limiting risk exposure.

The investor’s profit potential is limited. When the market price falls to the lower
exercise price, both out-of-the-money options will expire worthless. The maximum profit
that the trader can realize is the net premium: the premium he receives for the call at the
higher exercise price.

64
 Here the investor’s potential loss is limited. If the market rises the options will
offset one another. At any price greater than the high exercise price, the maximum loss
will equal high exercise price minus low exercise price minus net premium.

1.3.5.3 Volatile Market Strategies

A. Straddles in a volatile market outlook

Volatile market trading strategies are appropriate when the trader believes the market will
move but does not have an opinion on the direction of movement of the market. As long as there
is significant movement upward of downwards, these strategies offer profit opportunities. A
trader not is bullish or bearish. He must simply be of the opinion that the market is volatile.

a) A straddle is the simultaneous purchase (or sale) of two identical options, one a call and
the other a put.

b) To “buy a straddle” is to purchase a call and a put with the same exercise price and
expiration date.

c) To “sell a straddle” is the opposite; the trader sells a call and a put with the same
exercise price and expiration date.

65
 A trader, viewing a market as volatile, should buy option straddles. A “straddle purchase”
allows the trader to profit from either a bull market or form the bear market.
Here the investor’s profit potential is unlimited. If the market is volatile, the trader can profit
from an up or downward movement by exercising the appropriate option while letting the other
option expire worthless. (Bull market, exercise the call; bear market, the put.)
While the investor’s potential loss is limited. If the price of the underlying asset remains stable
instead of either rising or falling as the trader anticipated, the most he will lose is the premium he
paid for the option.

B). Strangles in a volatile market outlook

A strangle is similar to a straddle, except that the call and the put have different exercise
prices. Usually, both the call and the put are out-of-the-money.

a) To “buy a strangle” is to purchase a call and a put with the same expiration date, but
different exercise prices.

b) To “sell a strangle” is to write a call and a put with the same expiration date, but different
exercise prices.

A trader, viewing a market as volatile, should buy strangles. A “strangle purchase” allows
the trader to profit from either a bull market or bear market. Because the options are typically
out-of-the-money, the market must move to a greater degree than a straddle purchase to be
profitable.

The trader’s profit potential is unlimited. If the market is volatile, the trader can profit
from an up of downward movement by exercising the appropriate option, and letting the other
expire worthless. (in a bull market, exercise the call; in a bear market, the put).

66
 The investor’s potential loss is limited. Should the price of the underlying remain stable,
the most the trader would lose is the premium he paid for the options. Here the loss potential is
also very minimal because, the more the options are our-of-the-money, the lesser the premiums.

c).The Short Butterfly Call Spread

Like the volatility positions we have looked at so far, the short Butterfly position will
realize a profit if the market makes a substantial move. It also uses a combination of puts and
calls to achieve its profit\loss profile but combine them in such a manner that the maximum
profit is limited.

You are short the September 40-45-50 butterfly with the underlying at 45. You: you are
neutral but want the market to move in either direction. The position is a neutral one consisting
of two short options balanced out with two long ones.

The spread shown above was constructed by using 1 short call at a low exercise price,
two long calls at a medium exercise price and 1 short call at a high exercise price.

Your potential gains or losses are: limited on both the upside and the downside. Say
investor had built a short 40-45-5- butterfly. The position would yield a profit only if the market
movers below 40 or above 50. The maximum loss is also limited.

1.5.3.4 Stable Market Strategies

A. Straddles in a stable market outlook

Volatile market trading strategies are appropriate when the trader believes the market will
move but does not have an opinion on the direction of movement of the market. As long as there
is significant movement upwards or downwards, these strategies offer profit opportunities. A

67
trader need not be bullish or bearish. He must simply be of the opinion that the market is
volatile. This market outlook is also referred to as “neutral volatility”.

a) A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the
other a put.

b) To “buy a straddle” is to purchase a call and a put with the same exercise price and
expiration date.

c) To “sell a straddle” is the opposite: the trader sells a call and a put with the same exercise
price and expiration date.

A trader, viewing a market as stable, should: write option straddles. A “straddle sale”
allows the trader to profit from writing calls and puts in a stable market environment.

The investor’s profit potential is limited. If the market remains stable, trader’s long out-
of-the-money calls or puts will let their options expire worthless. Writer of these options will not
have been called to deliver on the call and practically unlimited loss if on the put.

The investor’s potential loss is unlimited. Should the price of underlined rise of fall,
writer of call or put would have to deliver, exposing him to unlimited loss if he has to deliver on
the call and practically unlimited loss if on the put.

The breakeven points occur when the market price at expiration equals the exercise price
plus the premium and minus the premium.

B) Strangles in a stable market outlook

68
 A strangle is similar to a straddle, except that the call and the put have different exercise
prices. Usually, both the call and the put are out-of-the-money.

a) To “buy a strangle” is to purchase a call and a put with the same expiration date, but
different exercise prices. Usually the call strike price is higher than the put strike price.

b) To “sell a strangle” is to write a call and a put with the same expiration date, but different
exercise prices.

A trader, viewing a market as stable, should: write strangle. A “strangle sale” allows the
trader to profit from a stable market.

The investor’s profit potential is: unlimited. If the market remains stable, investors having
out-of-the-money long put or long call position will let their options expire worthless.
The investor’s potential loss is: unlimited. If the price of the underlying interest rises or
falls instead of remaining stable as the trader anticipated he would have to deliver on the call
of the put.

C) Long Butterfly Call Spread Strategy

The long butterfly call spread is a combination of a bull spread and a bear spread,
utilizing calls and three different exercise prices.
A long butterfly call spread involves:
a) Buying a call with a low exercise price,

b) Writing two calls with a mid-range exercise price,

c) Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell
two 45 strikes. This spread is put on by purchasing one each of the outside strike and selling
two or the inside strikes. To put on a short butterfly, you do just the opposite.
69
 The investor’s profit potential is limited. Maximum profit is attained when the market
price of the underlying interest equals the mid-range exercise price (if the exercise prices are
symmetrical).

The investor’s potential loss is: limited. The maximum loss is limited to the new
premium paid and is realized when the market price of the underlying asset is higher than the
high exercise price or lower than the low exercise price.

The breakeven points occur when the market price at expiration equals the high exercise
price minus the premium and the low exercise price plus the premium. The strategy is
profitable when the market price is between the low exercise price plus the net premium and
the high and high exercise price minus the net premium.

1.3.6 Clearing & Settlement

1.3.6.1 Settlement of Options Contracts

70
 Options contracts have three types of settlements, daily premium settlement, exercise
settlement, interim exercise settlement in the case of option contracts on securities and final
settlement.

A. Daily premium settlement for options

Buyers of an option are obligated to pay the premium towards the options
purchased by him. Similarly the seller of an option is entitled to receive the premium for
the option sold by him. The premium payable amount and the premium receivable
amount are netted to compute the net premium payable or receivable amount for each
client for each option contract.

B. Exercise settlement for options

Although most option buyers and sellers close out their options positions by an
offsetting closing transaction, an understanding of exercise can help an option buyer
determine whether exercise might be more advantageous than an offsetting sale of the
option. There is always a possibility of the option seller being assigned an exercise. Once
an exercise of an option has been assigned to an option seller, the option seller is bound
to fulfill his obligation.

C. Interim Exercise Settlement

Interim exercise settlement takes place only for option contracts on securities. An
investor can exercise this in-the-money option at any time during trading hours, through
his trading member. Interim exercise settlement is effected for such options at the close
of the trading hours, on the day of exercise. Valid exercised option contracts are assigned
to short positions in the option contract with the same series (i.e. having the same
underlying, same expiry date and same strike price), on a random basis, at the client
level.

71
 The CM who has exercised the option receives the exercise settlement value per unit of
the option from the CM who has been assigned the option contract.

D. Final Exercise Settlement

Final Exercise settlement is effected for all open long in-money strike price
options existing at the close of trading hours, on the expiration day of an option contract.
All such long positions are exercised and automatically assigned to short positions in
option contracts with the same series, on a random basis. The investor who has long in
the money options on the expiry date will receive the exercise settlement value per unit of
the option from the investor who has been assigned the option contract.

1.3.6.2 The Functions of the clearing house

The clearinghouse is a financial institution associated with the futures and options
exchanges that guarantees the financial integrity of the market and the performance on futures
and options contracts. It can be considered a third party between the buyer and seller of futures
and options contracts, taking no active position in the market but assuring that for every short
position there Is a long position.

A. Settlement Basis at NSE

1. S&P CBX Nifty Futures/Market to market and final

2. Futures on individual securities settlement be settled in cash on T+1 basis

3. S&P CNX Nifty Options Cash settlement on T+1 basis

72
 4. Options on individual securities premium settlement on T+1 basis and

5. Option exercise settlement on T+3 Basis.

B. Settlement price

1. S&P CNX Nifty Futures/Futures Daily settlement price will be on individual securities
the closing price of the futures contracts for the trading day and the final settlement price
shall be the closing value of the underlying index/security on the last trading day.

2. S&P CNX Nifty Options/options: The settlement price shall be on individual security,
closing price of the underlying security.

The trading volume on NSE’S derivatives market has seen a steady increase since the launch
of the first derivative contract. The total turnover at the FO segment of NSE during January
2004 was Rs. 324063 crores.

1.3.7 OPTION TERMINOLOGY

There are several important terms used in option they are: -

1) Call option: -
Gives the buyer the right, but not the obligation to buy a specific futures contract
at a predetermined price within a limited period of time.

A call option is a contract, which gives the owner the right to buy an asset for a certain
price on or before a specified date. For example, if you buy a call option on a certain share of
XYZ Company, you have the right to purchase 100 shares (assuming of course, that the option
involves 100 shares).

73
 Suppose current share price (S) of Reliance Industries is Rs. 291. You expect that price
in a three months period will go up Rs. 300. But you also fear that the price may also fall below
Rs. 291. To reduce the chance of risk and at the same time to have the opportunity of making
profit, instead of buying the share, you can buy a 3-month call option on Reliance Industries at
an agreed exercise price (E) of, say, RS.280. Ignoring the option premium, taxes, transaction
costs and the time value of money, the decision to exercise your option depends upon the share
price after three months. You will exercise option when the share price after three months is
above Rs. 280 and you will not exercise when the share price after three month is below Rs. 240.

Thus option should be exercised when:

Share price at expiration > Exercise price = St>E

Do not exercise option when:

Share price at expiration <= Exercise price =St<E

The value of call option at expiration is:

Value of call option at expiration= Maximum [(share price –exercise price), 0]

Ct = Max [(St – E), 0]
The expression above indicates that the value of call option at expiration is the maximum
of the share price minus the exercise price and zero. The call option holder’s opportunity to make
profit is unlimited. It depends on the actual market price of the underlying share when the option
is exercised. Greater the market value of the underlying asset, the larger is the value of the
option. The following figure shows the value of call option.
For the call option writer, he will gain when share price is below the strike price and
will lose when stock price is above the strike price. The call buyer’s gain is call seller’s loss. The
pay-off of a call option writer.

2) Put option: -

74
 Gives the buyer the right, but not the obligation, to sell a specific futures contract
at a predetermined price within a limited period of time.

Put option is a contract that gives the holder a right to sell specified shares at
an agreed price on or before a given maturity. Thus, if you buy a put option on shares of XYZ
Company, you have the right to sell 100 shares of this company at the specified price at any time
between today and the specified date.

Suppose the current price (S) of Reliance Industries is Rs. 291 and you expect that the
price will fall within a three months. Therefore, you can buy a 3-month put option on Reliance
Industries at an agreed exercise price (E), say, Rs. 295. If the price actually falls to (St) Rs. 280
after three months, you will exercise your option. You will buy the share for Rs. 280 from the
market and deliver it to the put-option writer to receive Rs. 295.

Your gain is Rs.15 ignoring the put option premium, transaction cost and taxes. You will
not exercise if the share price rises above exercise price; the put option is worthless and its value
is zero.

Thus, exercise the put option when

Exercise price >Share price at expiration = E > St

Do not exercise put option when

Exercise price <=Share price at expiration = E<St

The value of put option at expiration will be

Value of put option at expiration= Maximum [(Exercise price –Share price), 0]
Pt = Max [(E-St), 0]

The put option buyer’s gain is the seller’s loss. The potential loss of the put option is
limited to the exercise price. Since the buyer has to pay a premium to the seller for purchasing a
put option, the potential profit of the buyer and the potential loss of the seller will reduce by the
amount of premium.
75
Combination

Puts and calls represent basic options. They serve as a building for developing more complex
options. The algebra corresponding to combination of buying option and equity stock is as
follows:

Pay -offs just before expiration date

If St< E If St > E

1) Put option E – S1 0

2) Equity stock S1 S1

= Combination E S1

Thus if you buy a stock with a put option on that stock (exercisable at price E), your
payoff will be E if the price of the stock is less that E, otherwise your payoff will be S1.
Consider a more complex combination that consists of
1. Buying stock
2. Buying a put option on that stock and
3. Borrowing an amount equal to the exercise price.

76
 The payoff from this combination is identical to the payoff from buying a call option. The
algebra of this equivalence is shown as follows:

Pay –off just before expiration date

If S1< E If S1 >E
1) Buy
the equity stock S1 S1

2) Buy a put option E-S1 0

3) Borrow an amount equal

To exercise price -E -E

(1) + (2) + (3) = Buy a call option 0 S1-E

If C1 is the terminal value of the call option (remember that C 1 = Max (S1-E, 0), P1 the
terminal value of the put option (remember that P1= Max (E-S1, 0), S1 the price of the stock, and
E the amount borrowed, then we have
C1= S1+P1-E
This is referred to as the put –call parity.

77
3) Holder: - The buyer of the option.

4) Premium: -The amount paid by the buyer of the option to the seller.

5) Writer: - The option seller.

6) Strike price: -The predetermined price at which a given futures contract bought or sold.
Also called the “exercise price” these levels are set at regular intervals.

7) At-the money: - An option is at-the money when the underlying futures price equals or
Nearly equals, the strike price.

For e.g.: - A T-bond Put or Call option is at-the-money if the option

strike price is at 78 and the price of the T-Bond futures contract is at or near 78.00

8) In-the money: - A call option is in-the money when the underlying futures price is greater
Than the strike price.
For e.g.: - If T-Bond futures are at 80.00 and the T-Bond call option strike
Price is 78.00; the call is in-the money

Whereas the put option is in-the money when the strike price of the option is greater than the
price of the underlying futures contract.
For e.g.: - If the strike price of the put option is 80.00 and T-Bond futures
are trading at 77.00 the put option is in- the money

9) Out-of-the money: - A call option is out-of-the money if the Strike price is greater than the
Underlying futures price.
78
 For e.g.: - if T-Bond futures are at 80.00 and the T-Bond call option strike
price is 82.00 the option is out-of-the money.
The put option is out-of-the money if the underlying futures price is greater than the
strike price

For e.g.: - if T-Bond futures are at 77.00 and the T- Bond put option strike price is
76.00 the put option is out-of-the money.

Call option Put option

In-the money Futures > strike Futures < strike

At-the money Futures = strike Futures = strike

Futures < strike Futures > strike

Out-of-the money

1.3.8 FACTORS DETERMINING THE OPTION VALUE:

The precise location of the option value depends on five key factors:

79
 a) Exercise price
b) Expiration date
c) Stock price
d) Stock price variability
e) Interest rate
a) Exercise Price:
Other things being constant, higher the exercise price, the lower the value of call option.
It should be remembered that the value of call option could never be negative; regardless of how
high the exercise price is set.

b) Expiration Date:
Other things being constant, the longer the time to expiration date the more valuable the
call option. Consider two American calls with maturities of one year and two years. The two-
year call obviously is more valuable than one-year call because it gives its holder one more year
within which it can be exercised.

c) Stock Price:
The value of a call option, other things being constant, increases with the stock price.

d) Stock Price Variability:

A call option has value when there is possibility that the stock price exceeds the exercise
price before the expiration date. Other things being equal, the higher the variability of the stock
price, the greater the likelihood that stock price will exceed the exercise.

80
1.3.9 REASONS FOR USING OPTIONS

The reasons for using options on futures are reflected in the structure of an option contract.

1) An option, when purchased gives the buyer the right, but not the obligation, to buy or sell
a specific amount of a specific commodity at a specific price within a specific period of
time.

2) The decision to exercise the option is entirely that of the buyer.

3) The purchaser of the options can lose no more than the initial amount of money invested
(premium).

4) An option buyer is never subject to margin calls. This enables the purchaser to maintain a
market position, despite any adverse moves without putting up additional funds.

1.3.10 MOTIVES for BUYING and SELLING OPTIONS

One may be buyer or seller of call or put option for a variety of reasons.
A call option buyer for e.g. is bullish that he is or she believes the price of the underlying futures
contract will rise. If price do rise, the call option buyer has three course of action available.

First is to exercise the option and acquires the underlying futures contract at the strike price
Second is to offset the long call position with a sale and realize a profit.

81
Third is to let the option expires worthless and forfeit the unrealized profit.

The seller of the call option expects futures prices to remain relatively stable or to decline
modestly. If prices remain stable, the receipt of the option premium enhances the rate of return
on a covered position. If prices decline, selling the call against a long futures position enables the
writer to use the premium as a cushion to provide protection to the extent of the premium
received. For instance, if T-bond futures were purchased at 80.00 and call option with an 80.00
strike price were sold for 2.00, T-bond futures could decline to the 78.00 levels before there
would be a net loss in the position.

However, T-bond futures rise to 82.00 the call option seller forfeits the opportunity for profit
because the buyer would likely exercise the call against him and acquire a future position at
80.00(strike price
The perspective of the put buyer and put seller are completely different. The buyer of the
put option believes for the underlying futures will decline for e.g.: - if a T-Bond put option with a
strike price of 82.00 is purchased for 2.00 while T-Bond futures also are at 82.00, the put option
will be profitable for the purchaser to exercise if T-Bond futures decline below 80.00

82
Table 1- Month wise Product wise Basic Statistics:

83
 %chan %chan
ge ge
from from
oct-09 Feb-
to Mar- 10to
Category Product 9-Oct 9-Nov 9-Dec 10-Jan 10-Feb 10-Mar 10 Mar-10
Traded
Value (Rs
in crores)
Stock
Total Futures 465829 438220 395954 444134 354485 405316 -12.99 14.34
Index
Futures 329610 363523 329496 298849 326871 268266 -18.61 -17.93
Stock
Options 45387 43666 42855 51454 41285 51398 13.24 24.5
Index
Options 669591 816408 756677 695860 847236 843167 25.92 -0.48
Premiu
m Value :-
Stock
Options 1142 1196 1075 1186 947 1068 -6.48 12.78
Index
Options 9477 11732 10340 8168 11145 9927 4.75 -10.93

Daily Stock
Average Futures 23291 21911 18855 23375 17724 19301 -17.13 8.9
Index
Futures 16481 18176 15690 15729 16344 12775 -22.49 -21.84
Stock
Options 2269 2183 2041 2708 2064 2448 7.89 18.6
Index
Options 33480 40820 36032 36624 42362 40151 19.93 -5.22
Premiu
m Value :-
Stock
Options 57 60 51 62 47 51 -10.53 8.51
Index
Options 474 587 492 430 557 473 -0.21 -15.08
Number
of
Contrac
ts
140445 1326054 113073 125466 107257 114206
Total Stock Futures 26 6 32 79 89 25 -18.68 6.48
136154 1517855 133378 120563 138918 105427
Index Futures 47 2 33 59 43 34 -22.57 -24.11
137856 125289 141417 122362 141711
Stock Options 9 1360703 8 8 7 9 2.8 15.81
266712 3296527 295259 270846 345887 325799
Index Options 52 4 40 05 04 54 22.15 -5.81

Daily
Average Stock Futures 702226 663027 538444 660352 536289 543839 -22.55 1.41
Index Futures 680772 758928 635135 634545 694592 502035 -26.26 -27.72
Stock Options 68928 68035 59662 74430 61181 67482 -2.1 10.3
133356 140599 142550 172943 155142
Index Options 3 1648264 7 6 5 6 16.34 -10.29
Open
Interest
(end of
respective
expiry day)
ValueinRs.
Crore Stock Futures 33712 33194 34226 34121 33271 36841 9.28 10.73
Index Futures 19036 19706 19104 20489 17685 20616 8.3 16.58
Stock Options 6703 6746 7184 7763 7059 7172 7 1.6
Index Options 59575 67110 72322 68881 70458 77216 29.61 9.59

Number of 115081 102215 110846 110391 113861

contracts Stock Futures 3 1066936 5 7 9 8 -1.06 3.14
Index 84
Futures 816893 806772 753898 870481 751524 802888 -1.71 6.83
Stock
Options 247967 229704 223088 255816 243375 215671 -13.02 -11.38
Index 250417 277974 282778 289260 293038
Options 9 2679857 3 8 3 5 17.02 1.31
Number of
 Table 2- Showing Month wise Product wise Turnover in the
F&O
Segment

Stock Index Index

Months Futures Futures Stock Options Options

Oct-09 465829 329610 45387 669591

Nov-09 438220 363523 43666 816408

Dec-09 395954 329496 42855 756677

Jan-10 444134 298849 51454 695860

Feb-10 354485 326871 41285 847236

Mar-10 405316 268266 51398 843167

85
 Graph 1- Showing Monthly wise Product wise Turnover in
the F&O
Segment

86
 Graph 2- Showing Monthly wise Product wise Turnover in
the F&O
Segment

87
 Graph 3- Showing Monthly wise Product wise Turnover in
the F&O
Segment

88
 Graph 4- Showing Monthly wise Product wise Turnover in
the F&O
Segment

89
 Graph 5- Showing Monthly wise Product wise Turnover in
the F&O
Segment

90
 Graph 6- Showing Monthly wise Product wise Turnover in
the F&O

91
Segment

92
 Table 3 - Institutional, Retail & Proprietary Investors – Turnover
Analysis
Institutio
Proprieta
Month nal Retail
ry
investors
Gross
Gross Traded Gross
Traded Percentag Value Traded
Value(Rs e (Rs Value
incrores) Contributi incrore Percentage (Rs percentage
on s) Contribution incrores) Contribution
4,15,73 16,65,1
9-Oct 13.76 9,39,932 31.11
8 65 55.12
18,33,9 1,045,44
9-Nov 4,44,197 13.36 55.18 31.45
92 2
16,60,5 10,18,64
9-Dec 3,70,730 12.16 54.45 33.4
86 9
16,19,6
10-Jan 4,34,120 14.56 54.34 9,26,855 31.1
19
1,791,6
10-Feb 4,11,091 13.1 57.06 9,36,989 29.84
72
10-Mar 1,843,1
388,516
12.39 86 58.77 904,593 28.84

Table 4 - Summary of Members’ Trading Activity:

Total Turnover (F&O Segment)

Month Oct-09 Nov-09 Dec-09 Jan-10 Feb- 10 Mar-10

Upto Rs. 10 crores 53 56 64 66 68 68
Rs. 10 crores upto 98 96 100 103 101 108
Rs. 50 crores
Rs. 50 crores upto 241 221 229 227 224 201
Rs.250 crores
Rs. 250 crores upto 96 116 110 103 118 105
93
Rs.500 crores
Rs. 500 crores upto 123 123 121 133 117 131
Rs.1000 crores
Rs. 1000 crores and 344 350 341 344 349 366
more
 Table 5 - Month wise Basic Statistics of the F&O Segment:

Particular
Nov-09 Dec-09 Jan-10 Feb-10 Mar-10
s Oct-09
Traded
Value (Rs
in crores)
1,568,14
16,61,816 15,24,982 14,90,297 15,69,877
Total 15,10,417 7
Daily
75,521 83,091 72,618 78,437 78,494 74,674
Average

Number of
Contracts
5,57,09,79 6,27,65,07 5,54,24,00 5,31,01,82 6,04,29,96 5596043
Total 4 5 3 1 3 2
Daily 2,664,78
27,85,490 31,38,254 26,39,238 27,94,833 30,21,498
Average 2

Open
Interest
(Rs in
crores)
End of day
1,06,945 1,15,610 1,09,988 1,13,430 116271
averages 1,05,442
% of Open
interest to
Daily
140 129 159 140 145 156
Average
Traded
value

94
Graph 7 - Following is the graphical representation of the

above data w.r.t. the Daily Average of Traded Value &

Number of contracts, and Open Interest.

Daily Average number of Daily Average Traded Value Open interest - end of day
contracts averages

3400000
3300000
3200000
86000 3100000
3000000
2900000
2800000 Daily
2700000 Avg
numbe
2600000 r of
66000 2500000 contrac
2400000 ts
2300000
2200000
2100000
2000000
46000 1900000
Daily Avg. Traded Value & Open Interest (Rs. in crores) 1800000
16000 1700000
Oct-09 1600000
Nov-09 1500000
Dec-09 1400000
Months 1300000
Jan-10 1200000
Feb-10 1100000
Mar-10 1000000
900000
800000
700000
600000
500000
400000
300000

95
 20000

Table 6 – Showing latest traded securities in future segment out

of 190 Securities listed at NSE

S No Symbol Traded Value (Rs.) No of Contracts

1 ABAN 2581708720 5560
2 ABB 352577025 846
3 ABIRLANUVO 107633600 298
4 ACC 480933704 1333
5 ADANIENT 18912800 99
6 ALBK 112610453 318
7 AMBUJACEM 352053920 714
8 ANDHRABANK 334574905 1345
9 APIL 57614220 154
10 APOLLOTYRE 275276750 1132
11 AREVAT&D 184375688 801
12 ASHOKLEY26000 1355170785 2541
13 ASIANPAINT 22712550 55
14 AUROPHARMA 301688100 452
15 AXISBANK 1878676133 3562
16 BAJAJ-AUTO 567183340 1402
17 BAJAJHIND 869426415 4442
18 BALRAMCHIN 446056080 1972
19 BANKBARODA 297221225 667
20 BANKINDIA 403008193 1237
21 BEL 156590366 258
22 BEML 39277406 99
23 BGRENERGY 229904060 1071

96
24 BHARATFORG 135395100 265
25 BHARTIARTL 1828144000 11615
26 BHEL 1853102655 5134
27 BHUSANSTL 565389750 670
28 BIOCON 136449000 264
29 BOSCHLTD 4870855 10
30 BPCL 364856250 1282
31 BRFL 93575788 377
32 CAIRN 1708516563 4494
33 CANBK 100108120 302
34 CENTURYTEX 936465438 2161
35 CESC 142406550 335
36 CHAMBLFERT 84205358 395
37 CHENNPETRO 128075940 243
38 CIPLA 417734063 982
39 COLPAL 27494665 74
40 CONCOR 16240125 49
41 CROMPGREAV 301761075 660
42 CUMMINSIND 31264975 64
43 DABUR 54536490 126
44 DCHL 176298670 331
45 DENABANK 92954663 224
46 DISHTV 86721366 454
47 DIVISLAB 244915965 583
48 DLF 4466450640 17833
49 DRREDDY 349416920 688
50 EDUCOMP 923462307 3317
51 EKC 38603100 157
52 ESSAROIL 297534451 1509
53 FEDERALBNK 58934643 255
54 FINANTECH 391959128 1656
55 FORTIS 587322385 2442
56 FSL 63684675 231
57 GAIL 1027844888 2240
58 GESHIP 58003200 164
59 GLAXO 14920050 28
60 GMRINFRA 418136500 2649
61 GODREJIND 14585025 79
62 GRASIM 379792494 766
63 GSPL 120310910 224
64 GTL 5250863 17
65 GTLINFRA 137529268 677
97
 66 GTOFFSHORE 5354100 13
67 GVKPIL 178142338 832
68 HCC 247731120 872
69 HCLTECH 426898355 919
70 HDFC 1611014964 3980
71 HDFCBANK 1886909900 4902
72 HDIL 1841804323 8211
73 HEROHONDA 1197769750 3156
74 HINDALCO 4253145026 6636
75 HINDPETRO 152781786 739
76 HINDUNILVR 338476400 1422
77 HINDZINC 157568525 259
78 HOTELEELA 103727250 278
79 IBREALEST 520465010 2597
80 ICICIBANK 6879703723 20458
81 ICSA 42245760 273
82 IDBI 430226400 1550
83 IDEA 188546940 1059
84 IDFC 642232406 1345
85 IFCI 896214070 2259
86 INDHOTEL 246667757 625
87 INDIACEM 264603903 1377
88 INDIAINFO 213898625 741
89 INDIANB 50754220 131
90 INFOSYSTCH 4710547400 8909
91 IOB 53901368 199
92 IOC 129287580 360
93 ISPATIND 405314730 1677
94 ITC 1021233881 3411
95 IVRCLINFRA 213039900 638
96 JINDALSAW 3444908000 3230
97 JINDALSTEL 2888460288 4264
98 JISLJALEQS 2854388 12
99 JPASSOCIAT 967545564 3811
100 JPPOWER 36162188 170
101 JSWSTEEL 4075381698 7969
102 KFA 125566251 620
103 KOTAKBANK 531627443 1286
104 KSOILS 55022810 138
105 LICHSGFIN 3492035748 9266
106 LITL 329228097 970
107 LT 1781221570 5433
98
108 LUPIN 276340103 490
109 M&M 1111701739 3264
110 MARUTI 769208830 2711
111 MCDOWELL-N 634325013 1907
112 MCLEODRUSS 626863725 2518
113 MLL 50382045 183
114 MOSERBAER 41422219 227
115 MPHASIS 676155720 1355
116 MRPL 60654390 177
117 MTNL 103099360 436
118 MUNDRAPORT 304785315 1280
119 NAGARCONST 142428700 433
120 NAGARFERT 50085788 307
121 NATIONALUM 239616358 1021
122 NEYVELILIG 124789720 573
123 NOIDATOLL 164649030 598
124 NTPC 1481231781 4406
125 OFSS 89574195 130
126 ONGC 625807474 2524
127 ONMOBILE 73107760 339
128 OPTOCIRCUI 82712514 186
129 ORCHIDCHEM 121254630 371
130 ORIENTBANK 181529640 469
131 PANTALOONR 39689688 120
132 PATELENG 42957500 94
133 PATNI 193697855 275
134 PETRONET 66018920 195
135 PFC 79214400 252
136 PIRHEALTH 42182850 66
137 PNB 548170350 1807
138 POLARIS 346460380 745
139 POWERGRID 164418485 796
140 PRAJIND 127363610 663
141 PTC 86020575 321
142 PUNJLLOYD 955021500 3570
143 RANBAXY 490250960 1281
144 RCOM 1035531350 8723
145 RECLTD 555323146 1126
146 RELCAPITAL 1541358584 7337
147 RELIANCE 4857559470 14927
148 RELINFRA 1540674959 5536
149 RELMEDIA 63646050 484
99
150 RENUKA 1216750250 3369
151 RNRL 317527166 1415
152 ROLTA 175430340 538
153 RPOWER 558698100 1850
154 SAIL 3259491436 9677
155 SBIN 3188848067 11533
156 SCI 27552120 73
157 SESAGOA 7610364525 11050
158 SIEMENS 301569446 540
159 SINTEX 178442390 435
160 STER 1482607706 3989
161 STERLINBIO 46788125 172
162 SUNPHARMA 264820028 660
163 SUNTV 77463700 182
164 SUZLON 991711800 4555
165 SYNDIBANK 24948900 76
166 TATACHEM 447591690 1018
167 TATACOMM 107529975 721
168 TATAMOTORS 9512513201 15012
169 TATAPOWER 457666610 1653
170 TATASTEEL 6338060533 13146
171 TATATEA 105353683 195
172 TCS 3667293150 4613
173 TECHM 988275360 1893
174 TITAN 98448770 259
175 TRIVENI 342568188 645
176 TTML 65847541 264
177 TULIP 71054300 167
178 TV-18 178236344 1282
179 UCOBANK 49594750 174
180 ULTRACEMCO 161738360 352
181 UNIONBANK 192121861 622
182 UNIPHOS 111479060 529
183 UNITECH 2270602800 6857
184 VIDEOIND 86349349 440
185 VIJAYABANK 61846770 187
186 VOLTAS 179231670 375
187 WELGUJ 427040880 969
188 WIPRO 837708720 1976
189 YESBANK 534839910 951
190 ZEEL 295629250 775

100
Table 7 – Showing the top 10 futures contracts on individual securities
traded at NSE

Symbol No of Contracts Traded Value (Rs.)

ICICIBANK 20293 6824171550

DLF 17645 4419397440

RELIANCE 14649 4766992260

TATAMOTORS 14573 9236353598

TATASTEEL 12941 6239865943

SBIN 11404 3153165873

BHARTIARTL 11347 1785979050

SESAGOA 10660 7347532875

SAIL 9546 3215522408

LICHSGFIN 9202 3467929344

101
Graph- 8 Showing the top 10 futures contracts on individual securities
traded at NSE

102
Table- 8 Top 5 Traded Symbols Futures Segment

TradedValue
(Rs.incrores)
Traded symbols Percentage
OTHERS 359376 53.35%

NIFTY 234416 34.80%

TATAMOTORS 25659 3.81%

BANKNIFTY 23256 3.45%

TATASTEEL 15917 2.36%

RELIANCE 14958 2.22%

103
Table - 9 Showing latest traded securities in future segment out of
190 Securities listed at NSE

S No Symbol No of Cont Notional Value (Rs.)

1 ABAN 78 37545680
2 ACC 18 6714270
3 ALBK 2 771260
4 AMBUJACEM 75 38255049
5 ANDHRABANK 102 26044740
6 APOLLOTYRE 41 10873370
7 ASHOKLEY 720 404492640
8 AUROPHARMA 20 14385000
9 AXISBANK 127 68901166
10 BAJAJHIND 202 42793392
11 BALRAMCHIN 394 96387480
104
12 BANKINDIA 1 288135
13 BEML 2 825000
14 BHARATFORG 2 1034500
15 BHARTIARTL 2241 364989125
16 BHEL 205 75950859
17 BHUSANSTL 20 18455500
18 BIOCON 8 4266000
19 CAIRN 747 296335189
20 CANBK 4 1441680
21 CENTURYTEX 21 9517019
22 CHAMBLFERT 91 20767794
23 CIPLA 26 11635751
24 CROMPGREAV 1 463750
25 DCHL 10 5327800
26 DENABANK 3 1305938
27 DLF 2457 639098360
28 EDUCOMP 21 6306301
29 EKC 1 250000
30 ESSAROIL 242 51252139
31 FORTIS 299 76799125
32 FSL 53 15553875
33 GAIL 169 80528850
34 GMRINFRA 184 30674000
35 GRASIM 4 2078586
36 GSPL 39 21256975
37 GTLINFRA 19 4123713
38 GVKPIL 21 4764725
39 HCC 1 300720
40 HCLTECH 3 1494935
41 HDFC 139 57647821
42 HDFCBANK 155 61180730
43 HDIL 503 120094885
44 HEROHONDA 372 151019760
45 HINDALCO 2650 1750291720
46 HINDPETRO 36 7955318
47 HINDUNILVR 188 45955050
48 HOTELEELA 113 44851125
49 IBREALEST 110 23511540
50 ICICIBANK 2128 727511842
51 ICSA 2 342480
52 IDBI 203 60322920
53 IDEA 197 36648585
105
54 IDFC 113 55976694
55 IFCI 1008 434177756
56 INDHOTEL 89 37081583
57 INDIACEM 58 11695048
58 INFOSYSTCH 3276 1814983790
59 IOC 1 337200
60 ISPATIND 515 134516649
61 ITC 449 137529619
62 IVRCLINFRA 1 347600
63 JINDALSAW 130 143480500
64 JINDALSTEL 148 105012048
65 JPASSOCIAT 306 83099311
66 JPPOWER 4 921406
67 JSWSTEEL 42 22525358
68 KFA 50 11003250
69 LICHSGFIN 47 18417885
70 LITL 46 16268043
71 LT 250 84276060
72 M&M 47 16716836
73 MARUTI 192 56506080
74 MCLEODRUSS 2 500400
75 MLL 12 3383695
76 MOSERBAER 8 1490940
77 MRPL 120 44066125
78 MTNL 191 48041120
79 MUNDRAPORT 1 232200
80 NAGARFERT 50 8589001
81 NATIONALUM 84 20090126
82 NEYVELILIG 3 612937
83 NOIDATOLL 41 12020380
84 NTPC 1662 574589276
85 ONGC 154 39360533
86 ORCHIDCHEM 12 4331775
87 PETRONET 5 1789920
88 PNB 66 20443020
89 POLARIS 2 998760
90 POWERGRID 92 19899688
91 PRAJIND 27 5208720
92 PTC 3 795475
93 PUNJLLOYD 240 70491300
94 RANBAXY 145 58078240
95 RCOM 1669 209036310
106
 96 RECLTD 80 40754513
97 RELCAPITAL 386 85243801
98 RELIANCE 8051 2716686525
99 RELINFRA 223 64750124
100 RELMEDIA 2 256110
101 RENUKA 495 194011750
102 RNRL 506 128143635
103 ROLTA 4 1391310
104 RPOWER 445 140533800
105 SAIL 1711 595649027
106 SBIN 1547 439087480
107 SCI 1 392400
108 SESAGOA 1256 911924775
109 SINTEX 5 1965600
110 STER 57 21808481
111 STERLINBIO 24 6882000
112 SUNPHARMA 13 5373585
113 SUZLON 1356 316745700
114 SYNDIBANK 8 2669880
115 TATACOMM 8 1272600
116 TATAMOTORS 2706 1789973184
117 TATAPOWER 12 3489680
118 TATASTEEL 3767 1890850456
119 TCS 1017 843704950
120 TRIVENI 10 5534760
121 TTML 50 13412576
122 TV-18 44 6494628
123 UCOBANK 4 1237750
124 UNITECH 2880 1007530650
125 VIDEOIND 1 204960
126 VIJAYABANK 32 11142810
127 WELGUJ 10 4807440
128 WIPRO 22 9670140
129 YESBANK 4 2368410

107
Table 10 –Showing the top 20 futures contracts on individual securities
traded at NSE

Symbol No of Contracts Notional Value (Rs.)

RELIANCE 2258 761971590

UNITECH 1606 559655775
RELIANCE 1238 422369670
TATASTEEL 1209 607963314
BHARTIARTL 1179 193945875
DLF 1126 297567000
TATASTEEL 970 497085713
NTPC 946 327168481
TATAMOTORS 918 609243280
HINDALCO 876 596562915
SBIN 790 224520714
RELIANCE 733 244891365
INFOSYSTCH 692 390371350
SAIL 656 234401378
RCOM 613 75686870
RELIANCE 613 211792800
108
SUZLON 569 131672400
SAIL 545 190287563
ICICIBANK 540 187076330
RELIANCE 540 194958735

Graph 10 – Showing the top 20 futures contracts on individual securities

traded at NSE

109
Table 11 – Top 5 Traded Symbols Option Segment

Traded symbols Traded value Percentage

110
NUFTY 842519.38 94.18%
OTHERS 32193.41 3.60%
RELIANCE 7053.8 0.79%
TATAMOTORS 4884.07 0.55%
TATASTEELS 4155.29 0.46%
HINDALCO 3758.98 0.42%

Index Futures and Index Options

111
Index futures saw a trading volume of Rs.13686.34 crores arising out of 531089 contracts and
Index options saw 1368248 contracts getting traded at a notional value of Rs.36441.52 crores.
The total turnover of the Futures & Options segment of the Exchange was around Rs.66792.46
crores.

Instrument wise summary:

Table 12 -Index Futures

Symbol No of Traded Total Traded Open interest

Contracts Quantity Value (Rs. In Crs.) (Qty.) as at end
Traded of trading hrs.

NIFTY 451949 22597450 11909.48 25562000

MINIFTY 53698 1073960 565.95 970180

BANKNIFTY 25183 1259150 1195.57 1042450

CNXIT 258 25800 15.27 36600

NFTYMCAP50 1 300 0.08 163200

Graph 12 -Index Futures

112
Table 13 - Index Options

113
Symbol No of Traded Total Traded Open interest
Contracts Quantity Value (Rs. In (Qty.) as at end
Traded Crs.) of trading hrs.

NIFTY 1367229 68361450 36404.56 82137050

MINIFTY 324 6480 3.46 15480
BANKNIFTY 695 34750 33.51 105650

Graph 13 - Index Options

114
Table 14 - Comparative analysis of the traded value in the F&O Segment with the Cash Segment

Months cash segment F&O segment

Oct-09 1510417 362969
Nov-09 661816 324477
Dec-09 1524982 292900
Jan-10 149029 338443
Feb-10 1569877 245143
Mar-10 1568147 286246

Turnover
(Rs. in
crores)

Cash segment F&o segment

286246
245143
F&O Segment 338443
324477 292900
362969

Cash Segment

1800000
1600000
1400000
1568147
1200000
1000000
800000
600000
400000
200000
0
Jan-10
Feb-10
Mar-10
1569877
1661816

115
1510417
1524982
1490297
Oct-09
Nov-09
Dec-09

SUMMARY OF FINDINGS
A derivative financial product is a contrived instrument, the value of which depends
indirectly on the price of a cash instrument. The price of the cash instrument is referred to as
“underlying” price, quite often. Examples of cash instruments include actual shares in a
company, physical stocks of commodities, cash foreign exchange, etc.

Nearly 90 percent of the trading volume in the Indian stock market does not result in
delivery of stock. Some of speculative transactions, which are taking place in the cash market,
will be transferred to the derivative market. Once derivatives trading is in place trading by
arbitrageurs is likely to result in better price discovery, enhancing the efficiency of the market in
the progress.

The development and growth of the Indian stock market over the last decade has been
successful in establishing a fairly active market for Indian securities, the market for risk has not
been developed. For the investment and financial institutions derivatives are strategic needs.

3.2The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices

116
 3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse people
in greater numbers
5. They increase savings and investment in the long run

The following are some observations based on the trading of future and options (F&O):

a) Single stock futures continue to account for a sizable proportion of the F&O segment. It
constituted 70 percent of the total turnover and the primary reason attributed to his
phenomenon is that traders are comfortable with single-stock futures than equity options.

b) 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
issues is that brokers do not earn high commission by recommending index options to
their clients, because low volatility leads to higher waiting time for round-trips.

c) Farther month future contracts are still not actively traded. Trading in equity options on
most stocks for even the next month was non-existent.

d) Daily option price variations suggest the traders use the F&O segment as a less risky
alternative to generate profits from the stock price movements.

Hedging the portfolio risks is at the core of portfolio management worldwide. The needs
for derivatives are manifold in portfolio management. Trading in the underlying securities is
costlier compared to trading in derivatives on account of brokerages etc. moreover frequent
117
trading in the underlying securities causes radical churning of the portfolio, which is not a sound
portfolio management strategy. Derivatives allow the portfolio managers to achieve their goals
with relative ease and in a cost-effective manner without being subject to the hassles associated
with trading in underlying securities.

From the perspective of mutual funds derivatives bring many advantages. In the case of a
new scheme where the money raised is to be parked temporarily before deploying in the targeted
securities, index futures offer a better alternative.

The trading activity of the open-ended funds depends on the magnitude of sales and
repurchases. At times repurchases may compel the fund manager to offload a portion of the
portfolio. This would lead to a number of problems.

Firstly, it is very difficult to liquidate the stocks in accordance with the portfolio
proportion. All the stocks comprising the portfolio may not be highly liquid. The threat of prices
coming down also looms large over such activity. While the sale and repurchases are pegged to
the NAV, the actual prices at the time of trading tend to be different. Index futures effectively
take care of these problems. Index futures can also be employed to neutralize the impact of any
possible adverse movement in the markets.

A majority of the respondents to a survey conducted favored stock index futures. In terms
of users’ preference stock index futures ranked number one, followed by stock index
options on stocks. Even in the US market, the regulatory framework doesn’t allow use of
futures on individual stocks. Only one or two countries in the world are known to have futures on
individual stocks. Stock Index Futures are internationally the most popular forms of equity
derivative. Derivatives of three months duration (contract duration) are widely used in the
Indian context.

While all equity investors are exposed to risks equally, the problem is more pronounced
in the case of institutional investors on account of the sheer size and portfolio management

118
needs. Index futures are cost-effective derivatives instruments than derivatives on individual
stocks. Stock index futures are the hot favorites among the mighty pension funds in the US.

Unlike individual stocks, indices are not prone to price manipulation. Therefore, futures
on stock indices are regarded as better suited for the Indian securities markets. Prices of
individual stocks are prone to manipulation on account of the limited floating stock in the
market. While an index being representative of the stocks, is also prone to this phenomenon, this
problem can be taken care of by carefully designing the index to include a variety of stocks.
Indices being averages of individual stock, they tend to be less volatile than the individual
stocks. There is underlying assumption that the prices in the cash market and futures market
converge on the expiration date. While the underlying individual securities are settled by
delivery, index futures are cash settled. The underlying reason being that it will not be cost
effective to deliver an index since it involves delivery of all securities in the same proportion.
At times it may not be feasible at all. Experience of the global derivatives markets indicates the
index futures are the most liquid of the derivatives. This is attributed to their immense popularity
in the markets. Among the equity derivatives intersect stock index futures are better placed in
terms of regulatory complexities that exist in the case of other equity derivatives such as index
options and options on individual stocks.

119
CONCLUSION AND SUGGESTIONS

4.1 CONCLUSION

The basic function of a financial system is to "facilitate the allocation and development of
economic resources, both intertemporarily and across time, in an uncertain environment". Risk is
therefore an inherent feature of every financial decision. In that context, derivative products offer
a means to transfer the risk inherent to financial decisions. Derivatives trading also add to the
market completeness. Trading in derivatives also facilitates price discovery of the underlying
cash securities via information dissemination. Besides these economic benefits, derivatives, like
any other financial instruments, contain certain risks such as market risk, credit risk etc.
Therefore, the consensus is that if used properly, derivatives can be a valuable risk management
tool but strict monitoring is needed to prevent (as far as possible) their perceived `misuse' for
speculative purposes.

While the very core of derivative products is to manage risk, it is important to appreciate
that all derivatives are highly geared, or leveraged, transactions. Traders/investors are able to
assume large positions - with similar sized risks - with very little up-front outlay and the risk to
the investor is high. A thorough grasp of product technicalities is only one aspect of the
knowledge and skills that traders require. Every trader has a view of the market and their end
objective is, of course, profit from that view. And the most effective route to achieving this is to
form a view that proves to be correct; having positioned one's self to obtain the maximum profit
from it. If a trader has a bullish he could go long in the futures market or choose to purchase a
call option.

120
 Since derivatives also suffer from risk, as do the underlying securities, derivatives
need to be handled cautiously on account of sheer size. These characteristics make derivatives
double-edged swords. This drives home the importance of adequate regulation that care of the
concerns associated with derivatives trading.
Increase in companies listed on stock exchanged emergence of securities and exchange
board of India (SEBI) as truly national level securities regulator, free pricing of public issues,
screen based trading system, more than six times increases in turnover the stock exchanges,
emergence of self-regulatory organization in the fields of merchant banking, mutual funds,
emergence of investor associations, implementation of trade guarantees besides others.

SEBI’S consistent efforts at improving the market infrastructure, providing level playing
field and ensuring transparent, fair and efficient trading at stock exchanges have started to yield
beneficial results. Depository legislation has also been approved by the parliament and
depository operations have commenced. In the four years. SEBI has consistently tried to bring in
international practices approval granted for setting up derivatives market is a big step to bring
Indian capital markets. Increased sophistication of capital market participants and the need of
market participants for risk hedging instruments are strong factors in favor of derivatives market
in India.

To summarize the role of regulation is the cushion and help other market monitoring
mechanism such as competition or reputation to maintain a fair and orderly financial markets in
which innovation is encouraged. Its objective is thus to support and encourage all the necessary
structural changes in the products or institutions architecture that allows market participants to
increase the benefits extract from the economic functions of derivatives at controlled risk levels.
Thus, one could view the role of regulation as that of a player of last resort that guarantees that
the economic benefits associated to the derivative trading activity remains on the efficient
“risk/return” frontier.

121
4.2 SUGGESTIONS

Some of the few suggestions are as follows: -

a) Regulations should be transparent and subject the same disclosure standards as those
applying to other participants in the financial markets.
b) Increase the limits on trading of derivatives by foreign institutional investors.
c) Increase the number of stocks on which options and futures are traded.
d) Reduce in the minimum contract size from 2,00,000 to say 1,00,000.
e) SEBI should promote the use of the derivatives and educate the investors on how
derivatives can reduce risk if used widely.
f) Availability of futures on all agricultural commodities would boost private sector
participation in sourcing agricultural produce from villages and transport them across the
country as also store them to transport across the time or period. This in turn helps
mitigate the crisis emanating from the vagaries of monsoon.
g) Indian currency derivatives market is basically an Over the Counter (OTC) market. It
suffers from poor participation from corporate, and fewer market makers. It therefore,
calls for increased product familiarization, market participation and development of
supporting regulation, legal and tax framework.
h) There is a need to establish research wings in all major banks for predicting intraday and
short-term movements in the exchange rate so that traders can initiate deals with
confidence.
i) Lot size should be decided by the exchange that is dealing in the derivatives market.

122
Bibliography

Name of the Book : Financial Management

Author : I.M.Pandey
Publisher : Tata McGraw hill
The researcher has extracted the facts regarding financial analysis.

Name of the Book : Financial Management

Author : Prasana Chandra
Publisher : Tata McGraw hill
The researcher has extracted the facts regarding financial analysis.

Name of the Book: futures options and other derivatives

Author : john c hull
Edition : 3rd Edition
Publisher : Tata McGraw hill
The researcher has extracted the facts regarding financial analysis.

Websites:
www.nseindia.com
www.google.com

123