Chapter – 1

Introduction
The emergence of the market for derivatives products, most notably futures and options, can be
tracked back to the willingness of risk-averse economic agents to guard themselves against
uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are
marked by a very high degree of volatility. Through the use of derivative products, it is possible to
partially or fully transfer price risks by locking-in asset prices. As instruments of risk management,
these generally do not influence the fluctuations in the underlying asset prices. However, by locking-
in asset prices, derivative product minimizes the impact of fluctuations in asset prices on the
profitability and cash flow situation of risk-averse investors.
Stock futures are derivative contracts that give you the power to buy or sell a set of stocks at a fixed
price by a certain date. Once you buy the contract, you are obligated to uphold the terms of the
agreement.
• It allows hedgers to shift risks to speculators.
• It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to
be.
• Based on the current future price, it helps in determining the future demand and supply of the
shares.
• Since it is based on margin trading, it allows small speculators to participate and trade in the futures
market by paying a small margin instead of the entire value of physical holdings.
1.2 Importance of Study
In recent times, the Derivative markets have gained importance in terms of their vital role in the
economy. The increasing investments in derivatives (domestic as well as overseas) have attracted my
interest in this area. Through the use of derivative products, it is possible to partially or fully transfer
price risks by locking-in asset prices. As the volume of trading is tremendously increasing in
derivatives market, this analysis will be of immense help to the investors.

1.3 Scope of study & Time Period

The study is limited to “Derivatives” with special reference to futures in the Indian context and the
Inter-Connected Stock Exchange has been taken as a representative sample for the study. The study
can’t be said as totally perfect. Any alteration may come. The study has only made a humble attempt
at evaluation derivatives market only in India context. The study is not based on the international
perspective of derivatives markets, which exists in NASDAQ, CBOT etc.
This study is limited to the Period of 8 weeks.

1.4 Objectives
• To analyses the options & futures.
• To find the most safest and profitable derivatives.
• To study about risk management with the help of derivatives.

1.5 Methodology & Sources of Data

Research Methodology is a systematic procedure of collecting information in order to analyses and
verify a phenomenon. The collection of information is done in two principle sources. They are as
follows

Secondary Data:
Various portals & Survey of Karvy Employees
• www.nseindia.com
• Financial newspapers, Economics times.
• Karvyvalue.com

1.6 Limitations
The following are the limitation of this study. 
The study is only limited to 2 derivatives i.e. Futures & Options.
The data collected is completely restricted to the employees of Karvys.
Chapter – 2

2.1 A Profile of Indian Derivatives Market

Maximizing earnings with minimum efforts/ costs/ risks is the fundamental of financial

Management. Abnormal sums of money in modern times could be made through Stock

Exchanges, Currency trading, Commodity Exchanges and the like. The basic qualities on

Which these exchanges operate are high risk and high volatility (which may / may not

Result in high returns). People get exposed to risky situations/ positions in order to earn

Profits derived out of the transactions entered into.

‘Need’ as they say is the mother of all inventions. Derivatives are the modern man’s

Business invention, which help people to maximize returns on their investments by taking

Minimum risk. It involves postponement of receipts of benefits till you have reached an

Optimum/ satisfied level.

Majority of middle class Indians / Indian Markets were unexposed to the benefits of

Investing their money in stock exchanges till early 90’s. Till then they were quite happy

Parking their money in Banks, Chit funds and other Government backed instruments.
They were happy too with the fixed returns, which these instruments would offer to them.

The definition of ‘earning money’ changed in the 80’s with Mr. Dhirubhai Ambani

Ushering in the era of putting one’s money in the stock exchanges as an alternate

Investment option. In early 90’s Mr. Harshad Mehta took the momentum forward to

Dizzying heights and motivated many more in making equity investment part of a

Person’s financial portfolio. Dr. Manmohan Singh by bringing in tax reforms also

Facilitated India’s common middle class man access and opportunity to invest and reap

Benefits from the country’s most powerful and money spinning institution.

IPOs became the norm. India witnessed long queues, euphoria of entering into a new era

Of financial liberalization. Indian investors were ‘sensitized’ and ‘pricked’ to the business

Of ‘making money’. It was no more a dirty word. Indian investors could now dream big.

Opportunities to become financially independent and sound were thrown in. Stock

Markets breathed, came to ‘life’, and emerged from shadows. They emerged from self-oblivion.

The equity market in India has under gone a transformation after the liberalization
Reforms in 1990s. The reforms included establishment of Securities and Exchange Board

Of India (SEBI) in 1998 and granting it a statutory status on January 30, 1992. The

Primary objectives for establishing SEBI was to protect the interest in securities, promote

The development of securities markets and regulate them. Establishing National Stock

Exchange (NSE) was also a major initiative as a part of the reforms. Introducing

Derivative trading and banning the badla system for a more transparent trading of

Securities was also a major development.

2.2 The major reforms in Indian Equities Market could be listed as

follows:

Year Activity -

1992: Free pricing of issues, FII norms relaxed.

1993: Private MFs allowed.

1994: Automated screen-based trading.

1998: Dematerialization
2000: Rolling settlement & Index derivatives.

2001: Stock Derivatives

2003: T+2 Settlements

2005: Corporatization and De-mutualisation of Exchanges, Comprehensive Risk management

framework, IPO grading, Reforms in Corporate governance & Gold exchange traded fund.

2007: Initiatives to develop Corporate Bond market & short selling and Stock lending and

Borrowing.

2.3 The history of derivative Market

Introducing derivatives by the still evolving SEBI to Indian stock markets was part of the

Exercise. It was first introduced in the National Stock Exchange and is now in existence in

The Indian system since year 2000. Indian academia’s research could focus on the success

Stories of the growth and development of Derivative Markets in India.

We can trace the introduction of Derivatives way back to 1700 BC. Around 580 B C Thales the

Milesian purchased options on Olive presses and made a fortune off of a bumper crop in olives.

So derivatives could be traced back before the time of the Christ. The uses of which have been

Passed through generations. We can trace derivatives existence in India way back in 2000 BC.

Forward trading in Japan could be traced back to the 17th century. The first futures markets in

the western hemisphere were developed in the United States, in Chicago. It later transpired

Into a formal modern exchange called as The Chicago Board of Trade (CBOT), which is

In operation since 1848. Till today it’s the largest futures market in the world. The rules

Framed by CBOT in 1865 are followed and have become pace setter for many other

Markets. The London Metal Exchange was established in 1877 and is now a leading

Market in metal trading. The point is Derivatives have a long history worldwide and have

evolved in many forms to take their present structure.

The Indian stock exchanges were dominated by the badla system of trading until recently.

The system had many loopholes, which lead to its abuse and later failure resulting into

Major revamping in its structure. It compelled SEBI to look into alternate methods of
Trading and to keep the stock markets active; it resulted into introduction of derivatives

Trading. SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop appropriate

Regulatory framework for the derivatives trading and to recommend suggestive bye-laws

For Regulation and Control of Trading and Settlement of Derivatives Contracts. The

Committee was to focus on the financial derivatives. The Committee submitted its report

In March 1998 the Board of SEBI in its meeting held on May 11, 1998 accepted the

recommendations and approved the introduction of derivatives trading in India beginning with

Stock Index Futures. The Board also approved the "Suggestive Bye-laws" recommended by the

L C Gupta Committee for Regulation and Control of Trading and Settlement of

Derivatives Contracts. SEBI circulated the contents of the report in June 98.

The L C Gupta Committee had conducted a wide market survey (with 112 respondents)

With contact of several entities relevant to derivatives trading like brokers, mutual funds,

Banks/FIs, FIIs and merchant bankers. The Committee’s observation was that there is a

Widespread recognition of the need for derivatives products including Equity, Interest
Rate and Currency derivatives products. However Stock Index Futures was the most

Preferred product followed by Stock Index Options. Options on individual stocks were

Third in the order of preference. The participants interviewed, mostly stated that their

Objective to invest in derivative trading was to ‘hedge’. The survey helped SEBI in

Focusing and directing its efforts to introduce the desired products in the derivative

Market. LCGC believed that regulation should be designed to achieve specific and well-defined

Goals. It was inclined towards positive regulation designed to encourage healthy activity

And behavior. The recommendations of the Committee are discussed in Chapter -2 under

The Literature Review.

2.4 Growth of Derivative Market in India

An assessment of IOSCO principles for Securities Regulations by the advisory panel on

Financial Regulation and Supervision pointed the gaps with regard to assistance provided

To foreign regulators, internal organizational and operational conduct, information on

Market intermediaries, prescription of risk related capital requirement and guidelines

Regarding internal control as part of good practices for market intermediaries.

NSE established the National Securities Clearing Corporations Ltd. (NSCCL) in August

1995 to build and sustain confidence in the clearing and settlement of securities. Two

depositories called National Securities Depository Ltd. (NSDL) and Central Depository

Services (India) Ltd. (CDSL) were established in 1996 and 1999 respectively to enable

Electronic record of ownership of securities and paperless trading.

As part of the risk management system in the liquid assets deposited by members with the

Exchange/clearing corporation, they cover or satisfy the following four requirements:

a) MTM (mark-to-market) losses on outstanding settlement obligations of the

Member,

b) VaR Margins (VaR margins to cover potential losses for 99 per cent of the days,

c) Extreme Loss Margins (margins to cover the expected loss in situations that lie

Outside the coverage of the VaR margins)

d) Base Minimum Capital (capital required for all risks other than market risk).
2.5 Derivatives in India: A Chronology

Date Progress

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L. C. Gupta Committee to draft a policy

Framework for index futures.

11 May 1998 L. C. Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps

24 May 2000 SIMEX chose Nifty for trading futures and options on an

Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures

Trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

31 August 2000 trading of futures and options on Nifty to commence at

SIMEX.

June 2001 Trading of Equity Index Options at NSE.

July 2001 Trading of Stock Options at NSE.

9 November, 2002 trading of Single Stock futures at BSE.

June 2003 Trading of Interest Rate Futures at NSE.

13 September, 2004 Weekly Options at BSE.

1 January, 2008 Trading of Chhota (Mini) Sensex at BSE.

1 January, 2008 Trading of Mini Index Futures & Options at NSE.

29 August, 2008 Trading of Currency Futures at NSE.

2 October, 2008 Trading of Currency Futures at BSE.

20th September 2010 United Stock Exchange.

3. What is a Derivative?

A derivative could be defined as a financial instrument whose value depends on the

Values of an underlying asset. The variables underlying derivatives are the prices of traded

Assets. For e.g. price of a stock (share), price of commodities like wheat, rice, pulses,

Interest rates, currency prices etc. Leo Melamed (1998) states that the primary purpose of

These instruments is not to borrow or lend but to transfer price risks associated with

Fluctuations to asset values. They provide three important economic functions:

• Risk Management

• Price Discovery

• Transactional Efficiency

Derivatives are used to systematically hedge business risk and an opportunity to earn

‘Wealth’ for speculators and arbitrageurs by using derivative products like ‘futures’ and

‘Options’. Futures contracts were originally developed as new financial instruments for

Price discovery and transfer (Pradhan and Bhat 2005).

Robert M Heath (1998) in the IMF working paper defined a financial derivative as-

‘Financial derivatives are financial instruments that are linked to a specific financial

Instrument or indicator or commodity, and through which specific financial risks can be
Traded in financial markets in their own right. The value of a financial derivative derives

From the price of an underlying item, such as an asset or index. Unlike debt instruments,

No principal amount is advanced to be repaid and no investment income accrues.

Financial derivatives are used for a number of purposes including risk management,

Hedging, arbitrage between markets, and speculation.’

The use of financial derivatives can reduce transaction costs, and/ or aid price discovery.

To understand how it works, lets’ take an example:

A speculator on a stock futures market anticipated a price increase from the current

Futures price of 100 rs. The market lot being 100 oz, he buys one lot of futures of that company.

100 oz of futures at have a value of 10,000. But the speculator is only required to pay out

15% a margin or deposit of 10,000. Now assume that a 10% increase occurs in the price of

That future, to 110. The value of 100 oz at 110 is 11,000. Subtracting original contract value, the

profit on the transaction is 1,000. As far as the speculator is concerned, he/ she has achieved a

Profit of 1,000 on a capital of 1,000. In short, he/ she has achieved a 100% profit

Through a 10% price rise.

3.1 Players in the Derivative Markets

Derivative instruments are traded in Commodities, Equities, Foreign Exchange and

Money Markets in India. Equity, being the underlying asset, the study focuses on the

Derivative trading in stock exchanges. Derivative Markets could be broadly classified

Into:

• Exchange traded Derivatives

• OTC Derivatives (Over the Counter)

• Open outcry system

3.1.1 Exchanges:

Exchange traded Derivatives:

In India we have, NSE (shares and index), BSE (shares and index), NCDEX (commodities),

MCX (commodities) (SEBI has granted permission to MCX-SX to operate as a full-fledged

stock exchange. Equity, equity F&O, interest rate futures and wholesale debt segments as per the
Indian Express report on 10th July 2012) and recently opened United Stock Exchange for Banks

(currency) dealing in derivatives instruments. Operation of United Stock Exchange on 21st

September 2010, an exchange to trade in currency and interest rate derivatives has marked the

beginning of a new chapter in the development of Indian financial markets. The exchange is

backed by 21 Indian public sector banks and five private sector banks. Also partnering are

Jaypee Capital, MMTC, Indian Potash and the Bombay Stock Exchange.

3.1.2 The Over the Counter Exchange:

The OTCE market is an important alternative to exchanges and report high volume trading. Not

all trading is done on the exchanges. In OTCE, trading is done on telephone and computer

networks which are linked to dealers. Trade between two financial institutions could be done

with bid and offer prices being offered simultaneously by the institutions. The OTCE trading in

India is carried out in foreign exchange and currency. Foreign Exchange and currency trading in

stock exchanges (NSE and United Stock Exchange) are allowed to be traded only in futures and

not in the spot market.

3.1.3 Open outcry system:

Although not in practice in major exchanges anymore, an open outcry system involves traders

and brokers operating on an exchange floor where they communicate their deals by shouting at

each other and using hand signals. On such exchanges, the floor is a very noisy and a colorful

place, and the activities seem to be chaotic.

4. Market Participants and Makers:

The following enter into derivative contracts either as hedgers, speculators or

Arbitrageurs:

4.1 Hedgers:

Hedgers enter into a derivative contract to cover risk associated with the Business deal. For

example farmer growing wheat is uncertain about the price he would get during harvest season.

Similarly a flour mill is unsure about the price at which it may have to procure the wheat in

future. Both the farmer and the flour meal would enter into a forward contract where the farmer
Agrees to sell his wheat to the flour mill at a predetermined price. The farmer is expecting a

price fall during harvest season and the flour meal is expecting a price rise. Hence both the

parties face price risk. The forward contract in which they have entered into would eliminate the

price risk for both the parties. This is called as hedging and the participants are called as hedgers.

The hedgers would like to conclude the contract with the delivery of the underlined asset. In the

example mentioned the contract would be settled by the farmer delivering the wheat to flour

meal on the agreed date and the agreed price.

4.2 Speculators:

Speculators enter into a derivative contract to profit by assuming risk. The speculators have an

independent view of future price behavior of the underlined asset and take appropriate position in

derivatives with the intention of making profit later. For Example, Let us say I bought SBI at Rs.

320. Since I am a long term investor I don't really bother about stop loss. But now the stock price

of SBI come down to Rs. 305. Now I am worried because my chartist warned me that the stock

can fall 270 level. What I can do is sell the SBI futures at Rs. 305. By doing so I am locking my

maximum loss of Rs. 15. This way I am immune if the price goes down below Rs. 305. Now
There if the stock goes further down to Rs. 270 like the chartist suggested then I can close my

position and make Rs. 35 overall profit and my overall cost per share comes to Rs. 285 from Rs.

320 that is more comfortable position for me because of hedging.

4.3 Arbitrageurs:

Arbitrageurs perform the function of making the prices in different markets converge and the in

tandem with each other. The markets could be physical market and the commodity exchange.

Since there cannot be any disparity in prices in the physical markets and the commodity

exchange, arbitrageurs constantly monitor the prices of different assets in different markets and

identify opportunities to make profit that emanate from mis-pricing of products in the different

markets. Unlike hedgers and speculators, arbitrageurs take riskless position and yet earn profit.

For example if the share price of Infosys is Rs. 1750/- in National Stock Exchange and Rs.

1770/- in Bombay Stock Exchange the arbitrageurs will buy at NSE and sell at BSE

simultaneously and pocket the difference of Rs. 20/- per share. An arbitrageur takes risk neutral

position and makes profits in markets which are imperfect. He cashes upon these short live
Opportunities as these imperfections are extremely short live.

Fundamentally the speculators and arbitrageurs fall in the same category since they do not

Own or disown the underlying asset by taking or giving physical delivery like hedgers.

Both render competitiveness to the market there by helping the price discovery process.

The difference between the two categories lies in the amount of risk they assume. While

Speculators have their opinions about the future price of the underlined asset the

Arbitrageurs concentrates on the price differential in different markets by taking riskless

Position with no investment of their own.

5. Survey on Options & Futures

In between the most preferred 2 derivatives i.e. Options & Futures a small survey was done on

research Analysis and Brokers to analysis which is safer to trade and most profitable.