ABSTRACT

Derivatives are new class of investment invention which offers sophisticated management of
risk. These are new segment of secondary market operation in India so investors need to
understand the complex nature of this trade and to make profit in derivatives trading this is yet to
reach to the small investors. These complex financial instruments have been called both one of
the most important financial innovations in a generation and, conversely, potentially very risky
propositions. This study aims to measure the investors’ perception towards investment decisions
equity market with reference to Allahabad district.

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RESEARCH METHODOLOGY

Research Design
A Research design is purely and simply the framework of plan for a study that guides the
collection and analysis of data. The study is intended to find the investors preference towards
cash market and derivatives. The study design is descriptive in nature.
Descriptive study is a fact-finding investigation with adequate interpretation. It is the simplest
type of research and is more specific. Mainly designed to gather descriptive information and
provides information for formulating more sophisticated studies.

Sampling Design
1. Selection of study area: The study area is in Allahabad

2. Selection of the sample size: 100

Sampling Methods
Convenience method of sampling is used to collect the data from the respondents. About 100
samples were collected from Allahabad city and most of the respondents were customers coming
in to stock broker’s office and certain addresses were collected from reputed brokers.

Formulation of the questionnaire

Data collection
(a) Primary data – collected through Structured Questionnaire.

(b) Secondary data – Earlier records from journals, magazines and other sources.

Tools used for analysis

1. Percentage analysis
2. Chi-square test

3. Correlation Analysis

4. Regression analysis

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OBJECTIVE OF THE STUDY

 The researcher will identify and evaluate the dynamics influencing investors’ perception
towards investment decision on derivatives market.
 To study Investors objective and preferred type of instrument
 To identify Investors opinion on derivatives market
 To study the Factors influence trade in derivative instrument
 To identify the investment pattern through certain key factors those influence the decision
making of investors/traders in equities.
 To understand the risk appetite of the investors

NEED FOR THE STUDY

 To educate investors who are risk averse for trade in derivatives

 Awareness about the various uses of derivatives can help investors to reduce the risk and
minimize the losses

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LIMITATIONS OF THE STUDY

 The nature of the market is dynamic so as a result the perception of the investors may
keep on varying.

 Sample size of the research has been limited and in Allahabad district only.

 This research is focused on the investors’ perception towards Equity and Index
Derivative Market only.

 Lack of awareness- the awareness about Investment in Derivative Market is not up to the
mark among investor and thus it is very difficult to communicate.

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INTRODUCTION

Many associate the financial market mostly with the equity market. The financial market is, of
course, far broader, encompassing bonds, foreign exchange, real estate, commodities, and
numerous other asset classes and financial instruments. A segment of the market has fast become
its most important one: derivatives. The derivatives market has seen the highest growth of all
financial market segments in recent years. It has become a central contributor to the stability of
the financial system and an important factor in the functioning of the real economy.
Equity market otherwise called stock market is a public entity for trading shares or stocks of a
particular company at an agreed price. Supply and demand in the stock market is affected by
various factors that in turn affect the price of the stocks (stock volatility). Investment decisions in
equities are sometimes rational where the investors take decisions analyzing the information in
the market. Some investors take irrational decisions where they ignore certain information that is
available. Irrational decisions may also be due to the investor’s limited capacity to process the
information available. Investors also take decisions matching the risk absorption level. Stock
market is said to be peculiar though there are different methods and tools to analyze before
taking decisions. Investment decisions are still found to be complicated as there are various
factors to be considered to choose equity or a stock to invest in or trade into. These
socioeconomic, demographic, and attitudinal factors act as key drivers for investment decisions.
There is always something that is underpinning an investment decision making process as the
probabilities of returns are a concern. Most of the investors feel insecure in managing their
investment on the stock market because it is difficult for an individual to identify companies
which have growth prospects for investment. Even after identifying the growth oriented
companies and their securities, the trading practices are also complicated, making it a difficult
task for investors to trade in all the exchange and follow up on post trading formalities. Hence
this is very much important to the stock dealers especially who are new to the market. The equity
investment decisions are influenced by few factors like good corporate earnings, stock
marketability, stock affordability, dividend announcements, Price earnings ratio, Momentum
effect, Contrarian effect, Investment behavior of FIIs, firm’s reputation, socially responsible
investing, Current economic indicators, Opinion from family/friends/colleagues, broker’s
recommendation, and other professional advice

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Despite the importance of the derivatives market, people have a comprehensive perspective on
its size, structure, role and segments and on how it works. The derivatives market has recently
attracted more attention against the backdrop of the financial crisis, fraud cases and the near
failure of some market participants. Although the financial crisis has primarily been caused by
structured credit-linked securities that are not derivatives, policy makers and regulators have
started to think about strengthening regulation to increase transparency and safety both for
derivatives and other financial instruments.
The securities market has witnessed a superfluity of reforms which have refined the micro
market structure, modernized operation and broadened investment choice for investors.
Derivatives are new class of investment invention which offers sophisticated management of
risk. Financial markets are characterized by a high degree of volatility. Derivative product are
used to contain the risk arising out of the fluctuations in asset price, which partially or fully
transfer price risk by locking in asset prices, derivative invention initially emerged as hedging
devices against fluctuations in commodity prices. Financial derivatives came into the spotlight
only in the 1970s. In India, trading in derivatives commenced in June 2000 with index futures on
NSE. The market regulator Securities and Exchange Board of India (SEBI), has been taking
active steps to increase liquidity in the available contracts to make the market more robust and
viable for all kinds of investors. Now derivatives market performs number of monetary function.
Derivative contract have several variants the most common are forwards, futures, options and
swaps. The derivative products that are available in India are index futures, index options, stock
futures and stock options. The SEBI has permitted derivative segments in only two stock
exchange that is National Stock Exchanges (NSE) and Bombay Stock Exchanges (BSE), and
their clearing corporation/house to commence trading and settlement in approved derivative
contract. Trading in S&P,CNX, NIFTY and BSE – 30 (SENSEX) future commenced in June
2000, index option in June 2001, options on individual securities in July 2001 and future in
September 2001. Thirty one individual scrips have been approved by the SEBI for trading in
derivative segments. There are three broad categories of participants, hedger, speculator and
arbitrageur.
When it comes to money and investing , we are not always as sensible as we think we are – that
is why there is a whole field of study that explains our sometimes- strange behavior. Derivative
Markets serves as risk reducing tool. It promotes economic efficiency by directing funds from

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those who do not have an immediate use for these funds to those who are in need of funds. It also
channels money provided by savers and depository institutions to borrowers and investees
through a variety of derivative instruments like future options, forward and swap.

Integration in the world’s commodity and financial market because of globalization and
liberalization of the countries across the world. Various types of risks for market players have
increased viz. Market Risks, Interest Rate Risk, Foreign Exchange Risk, Inflation Risk etc. Due
to successful management of such type of risks have become major issue for market players and
business houses. This has increased the scope of Financial Engineering-the application of
financial derivatives to manage risk. Today, in India the most of the index and equity derivative
business is concentrated in the NSE, which accounts for almost 100% of the equity derivative
business. The growth of the equity derivative business in India has been an unprecedented one.
With a start of average daily volume of Rs.10 crores has developed into a business opportunity
of around Rs.30,000 crores per day. This volume of trade is more than 100 times gross domestic
product of India. If we look onto the figures of market turnover in the Stock market, almost 80%
of turnover in Nifty is dedicated to derivative trading and remaining 20% is for cash market. This
alarming increase in the derivative trading have alarmed the researchers to find out the reasons
for such increase and to the way the market players are using derivatives in their trade.

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REVIEW OF THE LITERATURE

Hull (2008) Derivatives are financial instruments that derive their value from the value(s) of
other, more basic, underlying variables. Stulz, (2005) the underlying variable is usually, but not
always, a financial asset or a rate. As examples, one can have derivatives with payments linked
to the S&P 500 index, the temperature in a specific area, or the profitability of a group of
selected companies.

Avadhani (2000) opines that the “History of financial markets is replete with crises, such as the
collapse of the fixed exchange rate system in 1971, the Black Monday of October 1987, the steep
fall in the Nikkei in 1989, the US bond debacle of 1994, all these events occur because of very
high degree of volatility of financial markets and their unpredictability. Such disasters have
become more frequent with increased global integration of markets. Innovative financial
instruments have emerged to protect against hazards, these include Future and Options, which
are the most dominant forms of financial derivatives, since such volatility and associated
disasters cannot be washed away. They are called derivatives because their values are derived
from an underlying primary financial instrument, commodity or index, such as interest rates,
exchange rates, commodities and equities .For example, a commodity future price depends on
the value of the underlying commodity; the price of a stock option depends on the value of the
underlying stock and so on. A derivative provides a mechanism, which market participants use to
hedge their position against the adverse movement of variables over which they have no control.
Avadhani (2000) continues Financial derivatives came into the spotlight along with the growing
instability in current markets during the post- 1970 period, when the US announced its decision
to give up gold- dollar parity, the basic king pin of the Bretton Wood System of fixed exchange
rates. The derivative markets became an integral part of modern financial system in less than
three decades of their emergence.

According to Greenspan (1997) “By far the most significant event in finance during the past
decades has been the extraordinary development and expansion of financial derivatives…”

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Shanmnga Sundaram V (2011) examined the impact of behavioural dimensions of investors in
Capital market and found that investor decisions are influenced by psychological factors as well
as behavioural dimensions and this psychological effect is created by the fear of losing money,
sudden decline in stock indices, greed and lack of confidence about their decision making
capability.

Lovric M. et al., (2008), presented a description model of individual investor behaviour in which
investment decisions are seen as an iterative process of interactions between the investor and the
investment environment. The investment process was influenced by a number of interdependent
variables. They suggested that this conceptual model can be used to build stylized
representations of individual investors and further studied using the paradigm of agent-based
artificial financial markets.

Szyska Adam (2008) analyzed how investors’ psychology changes the vision of financial
markets and discussed the consequences of the new view of finance by capital market
practitioners-investors, corporate policy makers and concluded with some thoughts on the future
development of the capital market theory.

Hvidkjaer S (2008) analyzed the relationship between retail investor trading behaviour and the
cross section of future stock returns. The result suggests that stocks favoured by retail investors
subsequently experience prolonged underperformance relative to stock out of favour with them.
This results link the systematic component of retail investor behaviour to future returns, i.e.,
informed investors might begin selling stocks that they believe to be overvalued. The
overvaluation that these investors perceived could be driven by changes in firms fundamental
values.

Gerela.S.T.and Balsara. K.A (2001) reviewed the risk management system at the Bombay
Stock Exchange (BSE). They reported that the BSE has strengthened the risk management
measures to maintain the market integrity. The introduction of the modified carry forward
system, coupled with the Bombay Online Trade (BOLT) expansion to cities all over India, has

9
led to a significant increase in the liquidity and volumes at the exchange. As a consequence, the
risk management function at the BSE has assumed greater importance.

Kumar Dr. R. & Chandra Abhijeet,(2000) “Individual Investor’s Sentiments and Asset
Pricing” (2000).Individuals often invest in securities based on approximate rule of thumb, not
strictly in tune with market conditions. Their emotions drive their trading behavior, which in turn
drives asset (stock) prices. Investors fall prey to their own mistakes and sometimes other’s
mistakes, referred to as herd behavior. Markets are efficient, increasingly proving a theoretical
concept as in practice they hardly move efficiently. The purely rational approach is being
subsumed by a broader approach based upon the trading sentiments of investors. The present
paper documents the role of emotional biases towards investment (or disinvestment) decisions of
individuals, which in turn force stock prices to move.

Bose, Suchismita (2006) conducted research on “The Indian Derivatives Market Revisited”.
They found that Derivatives products provide certain important economic benefits such as risk
management or redistribution of risk away from risk-averse investors towards those more willing
and able to bear risk. Derivatives also help price discovery, i.e. the process of determining the
price level for any asset based on supply and demand. These functions of derivatives help in
efficient capital allocation in the economy; at the same time their misuse also poses a threat to
the stability of the financial sector and the overall economy.

Gerlinde Fellner, Boris Maciejovisky, (2002), This study finds the relationship between
individual risk attitudes measured by binary lotteries and certainity equivalents to market
behaviour. Assessment of risk attitude is very important in the domain of financial and economic
activities. Also, risk attitude is very useful in legal matters and in measures of performance and
success. Also, consultants inform investors about the various investment avenues in terms of risk

Amos Tversky, Daniel Kahnehan,(1986) According to this study there is a lack of

reconciliation between the normative and the descriptive theory of choices. Normative analysis
which is used to predict and explain actual behaviour is supported by three statements. First,
people are effective in pursuing their goals and they are more effective when there are incentives.

10
Secondly, competition favours rational individuals and organisations. Third, an intuitive appeal
of the axioms of rational choice makes it plausible that the theory derived from these axioms
support the acceptable account of choice behaviour. This paper analyses the foundations of the
normative model and proves that the deviation of actual behaviour from the normative model is
too widespread to be ignored, too systematic to be dismissed as a random error. Thus, the
normative and descriptive model of choice cannot be reconciled. The descriptive model of choice
accounts for preferences that are anomalous in the normative theory.

Gerlinde Fellner, Boris Maciejovisky, (2002), this study finds the relationship between
individual risk attitudes measured by binary lotteries and certainity equivalents to market
behaviour. Assessment of risk attitude is very important in the domain of financial and economic
activities. Also, risk attitude is very useful in legal matters and in measures of performance and
success. Also, consultants inform investors about the various investment avenues in terms of risk
criteria for which basic risk classifications are done by them. Individual Risk attitude can be
measured either by cardinal utilities or psychometric methods. Cardinal utilities depend mainly
on binary lottery methods with known probability distribution thus measuring risk attitude from
the curvature of the utility function. Psychometric methods use questionnaires asking whether
they accept a set of statements or not. Both these methods accept risk attitude as a stable
personality trait. The test was done on 26 independent markets and 280 participants. Results
indicate that two measures of risk preference, i.e., Binary lotteries method and Certainty
equivalents methods are poorly correlated. According to binary lotteries choices method, higher
the degree of risk aversion, lower is the observed market activity. Certainty equivalents on the
other hand are not related to market behaviour. This study reveals one more thing. According to
Binary lottery choices method, females are more risk averse than males. Again, we do not
observe a similar pattern with respect to certainty equivalents. However, females generally show
less market activity than males.

Melainie Powell, David Ansie, July (1997) This paper studies whether gender differences in
risk propensity and strategy in financial decision making can be viewed as general traits or
whether they arise because of contextual factors. The results of this study tells that females are
less risky seeking than males irrespective of familiarity and framing of , costs or ambiguity. It

11
also says that males and females adopt different strategies in financial decision environments but
these strategies have no significant impact on their ability to perform. Harrison Hong, Jeffery
D.Kubik, Jeremy C.Stein. This study proposes that stock-market participation is influenced by
social interaction. Any given "social" investor finds the market more attractive when more of his
peers participate this theory is supported using data from the Health and Retirement Study, and
found that social households—those who interact with their neighbours, or attend church—are
substantially more likely to invest in the market than non-social households. Moreover,
consistent with a peer-effects story, the impact of sociability is stronger in states where stock-
market participation rates are higher.

Sushant Nagpal and B S Bodla,(2009). The author in his study observes that the individuals
may be equal in all aspects, but their financial planning needs are very different. Demographics
alone no longer suffice as the basis of segmentation of individual investors. It is by using
lifestyles or psychographics along with demographics that synergism between investors can be
generated. It was studied that the modern investor is a mature and adequately groomed person.
The individual investors prefer less risky investments. Blind investments are scarce, as a
majority of investors are found to be using some source and reference groups for taking
decisions. Brokers who are in direct touch with investors play a vital role in keeping the capital
market lively by providing various services to investors. Investors have made media as a part of
their investment life. Psychographics play an important role in determining investment behavior
and preferences of individual investors. The study concludes that investors’ lifestyle
predominantly decides the risk taking capacity of investors.

William E. Warren, Robert E. stevens and C. William McConkey, (1990). In this study, it is
found that Demographics characteristics are a good predictor of whether investors will be light or
heavy investors. None of the lifestyle characteristics proved to be a predictor of stock and bond
ownership. But demographics were found to be a strong predictor of whether investors would
have heavy or light concentrations in stocks and bonds. Not only do life style dimensions help
differentiate between investor behavior types (active/ passive), they may also be useful in
differentiating between light and heavy investors in particular investments (stock and bonds).

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Manish Mittal and R K Vyas,(2007) In this paper, it is investigated on how investment choice
gets affected by the demographics of the investor. Mutual funds, followed by equity were the
most preferred choices for investment and derivatives were least preferred. The results revealed
that the differences are not significant for mutual funds, debentures/bonds, real estate/bullions
and derivatives between male and female. However male’s preferred equities and females
preferred post office deposits. Young aged investors (26-35) invest in mutual fund, while
middle-aged investors (36-45) invest in debentures/bond. People with income less than Rs. 1
lakh per annum invest in low-risk investments like post office deposits, while investors with
income between Rs. 1 lakh-2.5 lakhs invest in mutual funds and people with income between Rs.
2.5-4 lakhs invest in equities. Investors with less education prefer high-risk investments, such as,
equity and derivatives. Undergraduate investors invest in high-risk, high-return investments,
such as, derivatives and real estate/bullion. Graduates prefer moderate risk and moderate return
investments like debentures/bonds, while postgraduates and professionals invest in mutual funds
and equity. The propensity to take risk decreases with increase in education level. Service class
people like to invest in equities and mutual funds while business class have shown an inclination
to invest in debentures/bonds and real estate/bullions. Housewives prefer safe investments like
real estate/bullions, while professionals invest their money in post office deposits and derivatives
and students prefer high investments like derivatives and equities. The study provided evidence
that the investment choice depends on and is affected by the demographic variables such as
gender, age, income, education and occupation.

Meenu Verma(2008) The author has observed that demographic profile and investor
personality can be the two determinants for making perception about the investor psychology.
The study revealed that real estate, followed by mutual funds are the most preferred choices for
investment among the investors. It was noted males prefer real estate, PPF and equity shares as
attractive avenues for investment, females prefer bank FD, insurance and bullions. Young
investors find investing in equity shares/derivatives more comfortable, while old investors prefer
PPF as their first choice. Middle aged investors prefer investing in mutual funds and NSC. Thus
it clearly shown that as age increases, the ability to take risks decreases and people go towards
safer investments. People with low income prefer investments in low risk investments like NSC.
People with high income like to invest in real estate. Middle income groups prefer investing in

13
bank FD and mutual funds. The study provides the evidence that the investment choice depends
on and is affected by the demographic variables such as gender, age, income, education,
occupation as well as various personality types such as conservative, medium moderate and
aggressive.

Abhijeet Chandra (2009) in this literature, the author has analyzed the impact of competence of
individual investors on their trading behavior in the stock market. Individual investors take
trading decisions based on their self-perceived competence that is influenced by several factors.
The study examined the factors that determine the competence level of individual investors. Age,
education, and income were found to be the most influencing factors of the individual investors'
competence in the stock market activities and trading behavior. The results of the study reveal
that a person invests as per his/her own judgments once he/she perceives himself/herself more
knowledgeable about investing. It finds that investors having high, high to moderate income and
professional qualification are supposed to be more confident about their competence when it
comes to trading in stock markets. Thus, it can be said that competence effect rules the trading
behavior of individual investors.

Abdulla Yameen (2001) delivered massage, investors will need to be alert to any new
development in capital market and take advantage of the Investor Education and Awareness
Campaign program which to be undertaken by the Capital Market Section to acquaint of the risks
and rewards of investing on the Capital market. Speech was also focused on to create a new
breed of financial intermediaries, which will deal on the market for their clients. These
intermediaries have to be professionals with quite advanced knowledge on stock exchange
operations, techniques, law and companies valuation. Investors depend to a large extent on their
professional advice when investing on the market. Furthermore, these intermediaries must be
men of integrity and honesty as they would deal with clients‟ money Confidence of investors in
these professionals is a key to the success of the capital market.

P. M. Deleep Kumar and G. Raju (2001) showed that the capital market is becoming more and
more risky and complex in nature so that ordinary investors are unable to keep track of its
movement and direction. The study revealed that the Indian market is probably more volatile

14
than developed country markets, which is probably why a much higher proportion of savings in
developed countries go into equities. More than half of individual shareowners in India belonged
to just five cities. The distribution of share ownership by States and Union Territories show that
just five States accounted for 74.7 per cent of the country’s share ownership population and 71.7
per cent of the aggregate value of the shareholdings of individuals in India. Among the five
States, Maharashtra tops the list with Gujarat as a distant second followed by West Bengal, Delhi
and Tamil Nadu. In the midpoint of the study also argued that introduction of derivatives is the
first step to hedge the risk of unfavourable movement in the market. This will also lower
transaction cost and provides depth and liquidity to the market.

Hong Kong Exchanges and Clearing Ltd. (2002) surveyed on derivatives retail investors, and
argued first based on empirical evidence that years of trading experience and usual deal size have
a positive correlation. Second, Male investors traded to trade more frequently than female
investors. Third, the usual deal size of investor with higher personal income traded to be larger.
Fourth majority of respondents are motivated by their stock trading experience to start
derivatives trading. Fifth, trading for profit is the key reason for derivatives trading other than
high rate of return, hedging, etc. Sixth, the most significant motivating factors are more liquid
market and more transparent market. Seventh, majority of traders are infrequent in trade- 3 times
or less in a month and Index futures is the most popular product to trade most frequently. Ninth,
a large proportion of the investors invest in exchange cash products than derivatives or
investment avenues. Through empirical evidence form investos’ opinion, study argued that the
liquidity of derivatives products other than futures is low. High transaction costs or margin
requirement is the barrier for active participation in derivatives market. But also shows that more
active traders do not have much complaint towards transaction costs and margin requirement.

S. M. Imamual Haque and Khan Ashfaq Ahmad (2002) argued that the sluggish trends in
primary equity markets need to be reverse by restoring investors‟ confidence in market. Savings
for retirement essential seek long term growth and for that investment in equity is desirable. It is
a well established fact that investments in equities give higher returns than debt and it would,
therefore, be in the interest of the banks to invest in equities

15
Swarup K. S. (2003) empirically found that equity investors first enter capital market though
investment in primary market. The main reason for slump in equity offering is lack of investor
confidence in the primary market. It appeared from the analysis that the investors give
importance to own analysis as compared to brokers‟ advice. They also consider market price as a
better indicator than analyst recommendations. Accordingly number of suggestive measures in
terms of regulatory, policy level and market oriented were suggested to improve the investor
confidence in equity primary markets.

Leyla Şenturk Ozer, Azize Ergeneli and Mehmet Baha Karan (2004) studied that the risk
factor is one of the main determinants of investment decisions. Market participants that are
rational investors ultimately should receive greater returns from more risky investments. They
also concluded that the crisis and resulting deep recession in 2002 changed many things,
including market confidence of investors and financial analysts. In addition to decreasing trading
volume of Istanbul Stock Exchange (ISE), the number of individual investors reduced and
investment horizon of investors shortened and liquid instruments.

Rajeswari, T. R. and Moorthy, V. E. R. (2005) said that expectations of the investors

influenced by their perception and human generally relate perception to action. The study
revealed that the most preferred vehicle is bank deposit with mutual funds and equity on fourth
and sixth respectively. The survey also revealed that the investment decision is made by
investors on their own, and other sources influencing their selection decision are news papers,
magazine, brokers, television and friends or relatives

Chris Veld and Yulia V. Veld-Merkoulova (2006) found that investors consider the original
investment returns to be the most important benchmark, followed by the risk-free rate of return
and the market return. Study found that investors with longer time horizon would generally be
better off investing in stocks compared to investors with shorter time horizon. They knew
through the question on risk perceptions that investors who are more risk tolerant would benefit
from relatively larger investment in stocks. Their study showed the investors optimize their
utility by choosing the alternative with the lowest perceived risk.

16
J. K. Nayak (2006) interpreted the preferred mode of investment is first equity, banks, mutual
fund and then any other in a descending order. It means Investor‟s faith has increased and their
risk taking ability has also increased. One thing that could be drawn from this study is that
problems are mostly broker related and therefore that is one area where reforms are required. The
investors feel that the amount of knowledge available on the equity market is not satisfactory.
Investors, it appears, need to be educated more. Investors still considered the capital market as
highly risky. But from the investment pattern from the descriptive statistics it seems that the
number of people willing to invest in capital market has increased.

Narender L. Ahuja (2006) expressed Futures and options trading helps in hedging the price risk
and also provides investment opportunity to speculators who are willing to assume risk for a
possible return. They can also help in building a competitive edge and enable businesses to
smoothen their earnings because non-hedging of the risk would increase the volatility of their
quarterly earnings. At the same time, it is true that too much speculative activity in essential
commodities would destabilize the markets and therefore, these markets are normally regulated
as per the laws of the country.

Randall Dodd and Stephany Griffith-Jones (2006) studied that derivatives markets serve two
important economic purposes: risk shifting and price discovery. Derivatives markets can serve to
determine not just spot prices but also future prices (and in the options the price of the risk is
determined). In the research, interviews with representatives from several major corporations
revealed that they sometimes prefer to use options as a means to hedge. They also argued
derivatives have a potential to encourage international capital inflows

K. Ravichandran (2007) argued the younger generation investors are willing to invest in capital
market instruments and that too very highly in Derivatives segment. Even though the knowledge
to the investors in the Derivative segment is not adequate, they tend to take decisions with the
help of the brokers or through their friends and were trying to invest in this market. He also
argued majority the investors want to invest in short-term funds instead of long-term funds that
prefer wealth maximization instruments followed by steady growth instruments. Empirical study

17
also shows that market risk and credit risk are the two major risks perceived by the investors, and
for minimizing that risk they take the help of news paper and financial experts. Derivatives acts
as a major tool for reducing the risk involved in investing in stock markets for getting the best
results out of it. The investors should be aware of the various hedging and speculation strategies,
which can be used for reducing their risk.
Awareness about the various uses of derivatives can help investors to reduce risk and increase
profits. Though the stock market is subjected to high risk, by using derivatives the loss can be
minimized to an extent.

Philipp Schmitz and Martin Weber (2007) exposed that the trading behavior is also influenced
if the underlying reaches some exceptional prices. The probability to buy calls is positively
related to the holding of the underlying in the portfolio, meaning that investors tend to leverage
their stock positions, while the relation between put purchases and portfolio holdings of the
underlying is negative. They also showed higher option market trading activity is positively
correlated with past returns and volatility, and negatively correlated with book-to-market ratios.
In addition they report that investors open and close long and short call positions if past week's
return is positive and write puts as well as close bought and written put positions if the past
returns are negative.

B. Das, Ms. S. Mohanty and N. Chandra Shil (2008) studied the behavior of the investors in
the selection of investment vehicles. Retail investors face a lot of problem in the stock market.
Empirically they found and concluded which are valuable for both the investors and the
companies having such investment opportunities. First, different investment avenues do not
provide the same level of satisfaction. And majority of investors are from younger group

Gupta and Naveen Jain (2008) found that majority of the investors are from younger group and
as per occupation, salaried persons are more inclined towards investment. Study also argued
education qualification is the major influenced factor in investment. Their most preferred
investment is found to be shares followed by mutual funds. Empirically they found and argued
the Indian stock market is considerably dominated by the speculating crowd, the large scale of
day trading and also fact the futures trading in individual stocks is several times the value of

18
trading in cash segment. They also found the largest proportions of the investors are worried
about too much volatility of the market. For trader and speculators, price volatility is an
opportunity to make quick profits. In the study, high proportions of investors have a very
favorable opinion about the capital market regulation.

Deleep Kumar P M and Deyanandan M N (2009) analyzed the opinion of retail investors on
the major market reforms as well as their investment performance. The study revealed
introduction of derivatives trading and internet trading are found useful by only a marginal group
of investors. The empirical results of the study concluded that even though SEBI claims itself to
be the champion of investor protection, it has not been successful in instilling a sense of
confidence in the minds of majority of investors.

G. Ramakrishna Reddy and Ch. Krishnudu (2009) summarized that a majority of the
investors are quite unaware of corporate investment avenues like equity, mutual funds, debt
securities and deposits. They are highly aware of traditional investment avenues like real estate,
bullion, bank deposits, life insurance schemes and small saving schemes. Study argued the
primary motive of investment among the small and individual investors is to earn a regular
income either in form of interest or dividend on the investment made. The other motives like
capital gains, tax benefits, and speculative profits are stated to be the secondary motives of
investment. From empirical research they argued to motivate the people to invest their savings in
the stock market to be achieved only if the regulatory authorities succeed in providing a
manipulation free stock market.

Vinay Mishra and Harshita Bhatnagar (2009) documented that Derivatives are considered to
be extremely versatile financial instruments, as they help to manage risks, lower funding costs,
enhance yields and diversify portfolios. The contributions made by derivatives have been so
great that they have been credited with having „changed the face of finance‟ in the world.
Derivatives markets are an integral part of capital markets in developed as well as in emerging
market economies. These instruments assist business growth by disseminating effective price
signals concerning exchange rates, indices and reference rates or other assets, thereby, rendering
both cash and derivatives markets more efficient.

19
Ashutosh Vashishtha and Satish Kumar (2010) studied encompasses scope an analysis of
historical roots of derivative market of India. The emergence of derivatives market is an
ingenious feat of financial engineering that provides an effective and less costly solution to the
problem of risk that is embedded in the price unpredictability of the underlying asset. In
India, since its inception derivatives market has exhibited exponential growth both in terms of
volume and number of traded contracts. They argued that NSE and BSE has added more
products in their derivatives segment but still it is far less than the depth and variety of products
prevailing across many developed capital markets

Gaurav Kabra, Prashant Mishra and Manoj Dash (2010) studied key factors influencing
investment behaviour and ways these factors impacts investment risk tolerance and decision
making process among men and women and those different age groups. They said that not all
investments will be profitable, as investor will not always make the correct investment decisions
over the period of years. Through evidence they proved that security as the most important
criterion; there is no significant difference of security, opinion, hedging in all age group. But
there is significant difference of awareness, benefits and duration in all age group. From the
empirical results they concluded the modern investor is a mature and adequately groomed
person.

R R Rajamohan (2010) analyzed the role of the financial knowledge is important in decision
making in information intensive assets like stocks and other risky securities. Hence, reading
habit, as a proxy for financial knowledge. Younger people have greater labor flexibility than
older people; if the returns on their investments turn out to be low, they could work more or
retire later. Hence age an important factor to be considered in household portfolio analysis.
Sheng-Hung Chen and Chun-Hung Tsai (2010) wanted to identifying key factors influencing
individual investor‟s decision to make portfolio choices is of importance to understand their
heterogeneous investment behavior. Through conjoint analysis examine how individual investors
derive their preferences for financial assets. Study stated female investors tend to be more detail
oriented; elder is more likely to have low level of risk tolerance; the level of education is thought
to impact on a person‟s ability to accept risk; increasing income level of individual investor is

20
associated with increased levels of risk tolerance. At last they argued single investors are more
risk tolerance than married investors.

Shyan-Rong Chou, Gow-Liang Huang and Hui-Lin Hsu (2010) expressed that faced with the
series of financial events leading to the current turmoil, unpleasant investor experience has
become common and personal experiences and reports of such are demonstrated in risk and
attitudes to risk. The paper showed that investors are able to choose an investment with potential
risk and returns to suit their own preferences. Products of lower potential profit are tolerated
when the risk associated with those products is similarly low. In their study they found that
attitude to risk is very similar for both the genders. The study shows most stock trading is
transacted by individual rather than institutional investors, therefore the capital gains and losses
from stock price fluctuations are felt first-hand by individual investors.

M. Sathish, K. J. Naveen and V. Jeevanantham (2011) studied in the options available to

investors are different and the factors motivating the investors to invest are governed by their
socio-economic. They argued that instead of investing directly, the investors particularly, small
investors may go for indirect investment because they may not be in a position to undertake
fundamental and technical analysis before they decide about their investment options. Their
empirical study showed that majority of the investors of mutual funds is also belongs to equities
who give the first preference to that avenue which gives good return. From the study, concluded
that lack of knowledge as the primary reason for not investing in investment vehicle.

21
EVOLUTION OF DERIVATIVE MARKET

Fixed exchange rate was in existence under the Bretton Woods system. According to Avadhani
(2000), Financial derivatives came into the spotlight, when during the post-1970 period, the US
announced its decision to give up gold-dollar parity, the basic king pin of the Bretton Wood
System of fixed exchange rates. With the dismantling of this system in 1971, exchange rates
couldn’t be kept fixed.
Interest rates became more volatile due to high employment and inflation rates. Less developed
countries like India opened up their economies and allowed prices to vary with market
conditions. Price fluctuations made it almost impossible for the corporate sector to estimate
future production costs and revenues. The derivatives provided an effective tool to the problem
of risk and uncertainty due to fluctuations in interest rates, exchange rates, stock market prices
and the other underlying assets. The derivative markets have become an integral part of modern
financial system in less than three decades of their emergence.

Time Line of Derivatives

The Ancient: Derivatives

1400s -Japanese rice futures
1500s- Dutch tulip bulb options
1800s- Puts and options

The Recent: Financial Derivatives Listed Markets

1972- Financial currency futures
1973 - Stock options
1977 - Treasury bond futures
1981- Eurodollar futures
1982- Index futures
1983- Stock index options
1990- Foreign index warrants and leaps
1991- Swap futures

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1992-Insurance futures

OTC Markets
1981- Currency Swaps
1982 - Interest rate swaps
1983- Currency and bond options
1987- Equity derivatives markets
1988 – Hybrid derivatives

EVOLUTION OF DERIVATIVES TRADING IN INDIA

Shapiro (2000) opines all markets face different kind of risks. The derivative is one of the
categories of risk management tools. As this consciousness about risk management capacity for
derivative grew, the market for derivatives developed. Derivatives markets are generally an
integral part of capital markets in developed as well as in emerging market economies. These
instruments support business growth by disseminating effective price signals concerning indices,
reference rates or other assets, exchange rates and thereby render both derivatives and cash
markets more efficient. Possible adverse market movements offer protection through these
instruments and can be used to offset or manage exposure by hedging or shifting risks
particularly during the periods of volatility thereby reducing costs. By allowing the transfer of
unwanted risk, derivatives can promote more efficient allocation of capital across the economy,
increasing productivity in the economy. Though the commodity features trading has been in
existence since 1953 and certain OTC derivatives such as Forward Rate Agreements (FRAs) and
Interest Rate Swaps (IRSs) were allowed by RBI through its guidelines in 1999, the trading in
“securities” based derivatives on stock exchange was permitted only in June 2000. The
discussion that follows is mainly focussed on “securities” based derivatives on stock exchanges.

According to Sahoo (1997) the legal framework for derivatives trading is a critical part of
overall regulatory framework of derivative markets. This will be clear when discussed later on
how the regulation and control of derivatives trading and settlement have been prescribed
through suitable amendment to the bye-laws of the stock exchanges where derivatives trading
were permitted. With the role of state intervention in the functioning of markets is a matter of
considerable debate, it is generally agreed that regulation has a very important and critical role to

23
ensure the efficient functioning if markets and avoidance of systemic failures. The purpose of
regulation is to promote the efficiency and competition rather than impeding it.

According to Hathaway (1998), while there is a perceived similarity of regulatory objective,

there is no single preferred model for regulation of derivative markets. The major contributory
factors for success or failure of derivatives market are market culture, the underlying market
including its depth and liquidity and financial infrastructure including the regulatory framework.
The efficiency of derivatives market can be impaired through government interventions. For
example, governmental trade agreements or price controls aimed at stabilizing prices, which do
not allow derivative market to flourish are such examples of government intervention. Further,
since the financial integrity, efficiency, market integrity, integrity and customer protection which
are the common regulatory objectives in all jurisdictions, are critical to the success of any
financial market. Anyone responsible for operating such a market would have strong incentives
independent of external regulation to ensure that these conditions are present in the market place.
The incentives for self-regulation can be complemented through the observation of a successful
regulatory system while reducing the incentives and opportunity for behaviour, which threatens
the success and integrity of market (International Organization of Securities Commission
1996a). The derivatives market that have emerged will require legislation normally, which
addresses issues regarding legality of derivatives instruments, specially protecting such contracts
from anti-gambling laws, because these involve contracts for differences to be settled by
exchange of cash, prescription of appropriate regulations and power to monitor compliance with
regulation and power to enforce regulations. The type and scope of regulation also change, as the
industry grows. Therefore, regulatory flexibility is critical to the long run success of both
regulation and industry it regulates. It would be interesting to observe the historical evolution of
development of derivatives market and then examine what needs to be done to build up these
markets.

Definition and Uses of Derivatives

A derivative security is a financial contract whose value is derived from the value of
something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or
even an index of prices. Some simple types of derivatives: forwards, futures, options and swaps.

24
 Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge
some preexisting risk by taking positions in derivatives markets that offset potential losses in the
underlying or spot market. In India, most derivatives users describe themselves as hedgers and
Indian laws generally require that derivatives be used for hedging purposes only. Another motive
for derivatives trading is speculation (i.e. taking positions to profit from anticipated price
movements). In practice, it may be difficult to distinguish whether a particular trade was for
hedging or speculation, and active markets require the participation of both hedgers and
speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the
relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and
Fernandes (2003) describe India’s long history in arbitrage trading, with line operators and
traders arbitraging prices between exchanges located in different cities, and between two
exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates
that markets were inefficient at that time. They argue that lack of knowledge, market frictions
and regulatory impediments have led to low levels of capital employed.

Price volatility may reflect changes in the underlying demand and supply conditions and
thereby provide useful information about the market. Thus, economists do not view volatility as
necessarily harmful.

Speculators face the risk of losing money from their derivatives trades, as they do with other
securities. There have been some well-publicized cases of large losses from derivatives trading.
In some instances, these losses stemmed from fraudulent behavior that went undetected partly
because companies did not have adequate risk management systems in place. In other cases,
users failed to understand why and how they were taking positions in the derivatives

Exchange-Traded and Over-the-Counter Derivative Instruments

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated
between two parties. The terms of an OTC contract are flexible, and are often customized to fit
the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk
that the counterparty that owes money defaults on the payment. In India, OTC derivatives are
generally prohibited with some exceptions: those that are specifically allowed by the Reserve

25
Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets
Commission), those that trade informally in “havala” or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardized format that specifies
the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They
trade on organized exchanges with prices determined by the interaction of many buyers and
sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE)
and the National Stock Exchange (NSE). Contract performance is guaranteed by a clearinghouse,
which is a wholly owned subsidiary of the NSE. Margin requirements and daily marking-to-
market of futures positions substantially reduce the credit risk of exchange traded contracts,
relative to OTC contracts
Factors Affecting Growth of Derivatives:
Growths of derivatives are affected by a number of factors. Some of the important factors are
stated below.
1. Increased volatility in asset prices in financial markets.
2. Increased integration of national financial markets with the international markets.
3. Marked improvement in communication facilities and sharp decline in their costs.
4. Development of more sophisticated risk management tools, providing economic agents, a
wider choice of risk management strategies.
5. Innovation in the derivative markets, which optimally combine the risk and returns, reduced
risks as well as transactions costs as compared to individual financial assets.

Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have
assets and liabilities of different maturities and in different currencies, and are exposed to
different risks of default from their borrowers. Thus, they are likely to use derivatives on interest
rates and currencies, and derivatives to manage credit risk. Non-financial institutions are
regulated differently from financial institutions, and this affects their incentives to use
derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the
use of derivatives by insurance companies.

26
 In India, financial institutions have not been heavy users of exchange-traded derivatives,
market insiders feel that this may be changing, as indicated by the growing share of index
derivatives (which are used more by institutions than by retail investors). In contrast to the
exchange-traded markets, domestic financial institutions and mutual funds have shown great
interest in OTC fixed income instruments. Transactions between banks dominate the market for
interest rate derivatives, while state-owned banks remain a small presence. Corporations are
active in the currency forwards and swaps markets, buying these instruments from banks.

Derivatives Products Traded in Derivatives Segment of BSE

BSE created history on June 9, 2000 by launching the first Exchange-traded Index Derivative
Contract in India i.e. futures on the capital market benchmark index - the BSE Sensex. The
inauguration of trading was done by Prof. J.R. Varma, member of SEBI and Chairman of the
committee which formulated the risk containment measures for the derivatives market.
In sequence of product innovation, BSE commenced trading in Index Options on Sensex on June
1, 2001, Stock Options were introduced on 31 stocks on July 9, 2001 and Single Stock Futures
were launched on November 9, 2002.

 Long Dated Options:

BSE also introduced 'Long Dated Options' on its flagship index - Sensex® -on February
29, 2008, whereby the Members can trade in Sensex (in the normal lot of 15 only and not
'mini' Sensex) Options contracts with an expiry of up to 3 years.

 CurrencyDerivatives:

Going ahead, on October 1, 2008 BSE launched its currency derivatives segment in
dollar-rupee currency futures as the exchange traded currency futures contracts facilitate
easy access, increased transparency, efficient price discovery, better counterparty credit
risk management, wider participation and reduced transaction costs.

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  Futures on BOLT

BSE re-launched its Derivatives Segment by enabling trading of Index and Stock Futures
on its BOLT Terminal. The change was in response to requests from trading members for
a common front end from which equities and equity derivatives could be traded. The
change will enable a trader to trade in cash scrips and futures products through BOLT
TWS/ IML while Option products would continue to trade through the DTSS
TWS/DIML. The risk management and settlement of futures and option trades will
continue to take place on DTSS.

Participants in the derivative market:

Patwari and Bhargava (2006) stated that there are three broad categories of participants in the
derivative market. They are: Hedgers, Speculators and Arbitrageurs. A Hedger is a trader who
enters the derivative market to reduce a pre-existing risk. In India, most derivatives users
describe themselves as hedgers (Fitch Ratings, 2004) and Indian laws generally require the use
of derivatives for hedging purposes only. Speculators, the next participant in the derivative
market, buy and sell derivatives to book the profit and not to reduce their risk. They wish to take
a position in the market by betting on future price movement of an asset. Speculators are
attracted to exchange traded derivative products because of their high liquidity, high leverage,
low impact cost, low transaction cost and default risk behavior. Futures and options both add to
the potential gain and losses of the speculative venture. It is the speculators who keep the market
going because they bear the risks, which no one else is willing to bear. The third participant,
Arbitrageur is basically risk-averse and enters into the contracts, having the potential to earn
riskless profits. It is possible for an arbitrageur to have riskless profits by buying in one market
and simultaneously selling in another, when markets are imperfect (long in one market and short
in another market). Arbitrageurs always look out for such price differences. Arbitrageurs fetch
enormous liquidity to the products which are exchanges traded. The liquidity in-turn results in
better price discovery, lesser market manipulation and lesser cost of transaction.

28
According to Murti 2000, “the hedgers, the speculators and the arbitrageurs all three must co-
exist. In simple words, all the three type of participants are required not only for the healthy
functioning of the derivative market, but also to increase the liquidity in the market. The market
would become mere tools of gambling without the hedgers, as they provide economic substance
to the market. Speculators provide depth and liquidity to the market. Arbitrageurs help price
discovery and bring uniformity in prices.

As mentioned above by diverse authors, that derivatives have various products/variants which
play a vital role in the market for any institution; they are Forwards, Futures, Options and
Swaps:-

Forwards
A forward contract is an agreement between two parties calling for delivery of, and payment for,
a specified quality and quantity of a commodity at a specified future date. The price may be
agreed upon in advance, or determined by formula at the time of delivery or other point in time”.
Beside other instruments, such as Options or Futures, it is used to control and hedge risk, for
example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices

29
(e.g. forward contracts on oil). The forward price usually gives a good estimation of the market
price in the future. D.C. Patwari and Anshul Bhargava explains in simple words that a forward
contract is an agreement between two persons for the purchase and sale of a commodity or
financial asset at a specified price to be delivered at a specified future date. One of the parties to
a forward contract assumes a long position and agrees to buy the underlying asset at a certain
future date for a certain price. The specified price is referred to as the delivery price. The parties
to the contract mutually agree upon the contract terms like delivery price and quantity.

Futures

A Futures Contract is a standardized contract, traded on a futures exchange, to buy or sell a

certain underlying instrument at a certain date in the future, at a pre-set price. The future date is
called the delivery date or final settlement date. The pre-set price is called the futures price.
The price of the underlying asset on the delivery date is called the settlement price. The futures
price, naturally, converges towards the settlement price on the delivery dat. In simple words
“futures contract is a standardized, transferable, exchange-traded contract that requires delivery
of a commodity, bond, currency, or stock index, at a specified price, on a specified future date.
Unlike options, futures convey an obligation to buy. The risk to the holder is unlimited, and
because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Dollars lost
and gained by each party on a futures contract are equal and opposite. In other words, a future
trading is a zero-sum game. Futures contracts are forward contracts, meaning they represent a
pledge to make a certain transaction at a future date. The exchange of assets occurs on the date
specified in the contract. Futures are distinguished from generic forward contracts in that they
contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies,
and are guaranteed by clearing houses. Also, in order to insure that payment will occur, futures
have a margin requirement that must be settled daily. Finally, by making an offsetting trade,
taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed.
Hedgers often trade futures for the purpose of keeping price risk in check also called futures”.
Sirisha (2001) continues explaining the Types of Futures which are as follows:

 Foreign Exchange Futures

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  Currency Futures
 Stock Index Futures
 Commodity Futures
 Interest Rate Futures

Options
An Options Contract is the right, but not the obligation, to buy (for a call option) or sell (for a
put option) a specific amount of a given stock, commodity, currency, index, or debt, at a
specified price (the strike price) during a specified period of time. For stock options, the amount
is usually 100 shares. Each option contract has a buyer, called the holder, and a seller, known as
the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of
the contract by delivering the shares to the appropriate party. In the case of a security that cannot
be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is
limited to the price paid to acquire the option. When an option is not exercised, it expires. No
shares change hands and the money spent to purchase the option is lost. For the buyer, the upside
is unlimited. Option contracts, like stocks, are therefore said to have an asymmetrical payoff
pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that
the writer already owns the security underlying the option. Option contracts are most frequently
as either leverage or protection. As leverage, options allow the holder to control equity in a
limited capacity for a fraction of what the shares would cost. The difference can be invested
elsewhere until the option is exercised. As protection, options can guard against price
fluctuations in the near term because they provide the right acquire the underlying stock at a
fixed price for a limited time risk is limited to the option premium (except when writing options
for a security that is not already owned). However, the costs of trading options (including both
commissions and the bid/ask spread) is higher on a percentage basis than trading the underlying
stock. In addition, options are very complex and require a great deal of observation and
maintenance also called option”.

Hull (1995) opines that there are two different types of options which are as follows:
􀂃 Call Option
􀂃 Put Option

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Edwards (2000) critically evaluates “Asian Options are different and are average rate options.
At the end of the contract period, the strike rate is compared with the average rate observed for
the currency exchange. If the strike price is favorable to the holder of the Asian Options, the
option is exercised by the way of cash settlement. Asian options are useful for hedging currency
exposure where management accounts are translated on an average rate for the accounting period
and are misleading cheaper that American or European options. They simply cost less because of
the statistical fact that an average of a price series is more stable than any particular price series.
Asian options are cash settled automatically”.

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

Swaps
A swap is a derivative, where two counterparties exchange one stream of cash flows against
another stream. These streams are called the legs of the swap. The cash flows are calculated over
a notional principal amount. The notional amount typically does not change hands and it is
simply used to calculate payments Swaps are often used to hedge certain risks, for instance
interest rate risk. Another use is speculation”.
The notional amount typically does not change hands and it is simply used to calculate payments.

Types of Swaps
There are two basic kinds of swaps:
 Currency Swaps
 Interest Rate Swaps

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Edward (2000) argues that Currency Swaps involve exchange of currencies at specified exchage
rates and to make a series of interest payments for the currency that is received at specified
intervals.Today, interest rate swaps account for the majority of banks’swap activity and the fixed
for floating rate swap is the most common interest rate swap. In such a swap one party agrees to
make a floating rate interest payment in return for fixed rate interest payments from the
counterparty, with the interest rate calculations based on hypothetical amouny of principal called
the notional amount.
Marlowe (2000) opines that the emergence of the derivative market products most notably
forwards, futures and options can be traced back to the willingness of risk-averse economic
agents to guard themselves against uncertainties arising out of fluctuations in asset prices.
Financial markets, by the very nature can be subject to a very high degree of volatility. Through
the use of the products of derivatives it is possible to fully or partially transfer risk of price by
looking-in the price of assets. As instruments of risk management, derivative products generally
do not influence the fluctuations in the underlying asset prices. However by locking –in the price
of assets, the products of derivatives minimize the impact of fluctuation in the price of assets on
the profitability and cash flow situation of risk-averse investor.

Unresolved Issues and Future Prospects

Even though the derivatives market has shown good progress in the last few years, the real issues
facing the future of the market have not yet been resolved. The number of products
allowed for derivative trading have increased and the volume and the value of business has
zoomed, but the objectives of setting up different derivative exchanges may not be achieved and
the growth rates witnessed may not be sustainable unless these real issues are sorted out as soon
as possible. Some of the main unresolved issues are as under.

1. Commodity Options: Trading in commodity options contracts has been stopped since
1952. The market for commodity derivatives is not completed without the presence of
this important derivative. Both futures and options are necessary for the healthy growth
of the market. There is an immediate need to bring about the necessary legal and
regulatory changes to introduce commodity options trading in the country. The matter is

33
 believed to be under the active consideration of the Government and the options trading
may be introduced in the near future

2. Issues for Market Stability and Development: The enormous size and fast growth of the
Over the Counter (OTC) derivatives market has attracted the attention of regulators and
supervisory bodies. Some OTC derivatives have been viewed as amplifiers of the stress
in the present global financial crisis. The more common criticisms relate to the fact that
the OTC markets are less transparent and highly leveraged, have weaker capital
requirements and contain elements of hidden systemic risk.

3. The Warehousing and Standardization: For commodity derivatives market to work

smoothly, it is necessary to have a sophisticated, cost-effective, reliable and convenient
warehousing system in the country. The Habibullah (2003) task force admitted, “A
sophisticated warehousing industry has yet to come about”. Further, independent labs or
quality testing centers should be set up in each region to certify the quality, grade and
quantity of commodities so that they are appropriately standardized and there are no
shocks waiting for the ultimate buyer who takes the physical delivery.

4. Cash vs. Physical Settlement: Only about 1% to 5% of the total commodity derivatives
trade in the country is settled in physical delivery. It is probably due to the inefficiencies
in the present warehousing system. Therefore the warehousing problem obviously has to
be handled on a war footing, as a good delivery system is the backbone of any
commodity trade. A major problem in cash settlement of commodity derivative contracts
is that at present, under the Forward Contracts (Regulation) Act 1952, cash settlement of
outstanding contracts at maturity is disallowed. In other words, all outstanding contracts
at maturity should be settled in physical delivery. To avoid this, participants settle their
positions before maturity. So, in practice, most contracts are settled in cash but before
maturity. There is a need to modify the law to bring it closer to the widespread practice
and save the participants from unnecessary hassles.

34
5. Increased Off-Balance Sheet Exposure of Indian Banks: The growth of derivatives as off-
balance sheet (OBS) items of Indian Banks has been an area of concern for the RBI. The
OBS exposure/risk has increased significantly in recent years. The notional principal
amount of OBS exposure increased from Rs.8,42,000 crore at the end of March 2002
(approximately $181 billion at the exchange rate of Rs.46.6 to a US $) to Rs.149,69,000
crore (approximately $321 billion) at the end of March 2008. (RBI, 2009)

6. The Regulator: As the market activity pick-up and the volumes rise, the market will
definitely need a strong and independent regulator; similar to the Securities and Exchange
Board of India (SEBI) that regulates the securities markets. Unlike SEBI which is an
independent body, the Forwards Markets Commission (FMC) is under the Department of
Consumer Affairs (Ministry of Consumer Affairs, Food and Public Distribution) and
depends on it for funds. It is imperative that the Government should grant more powers to
the FMC to ensure an orderly development of the commodity markets. The SEBI and
FMC also need to work closely with each other due to the inter-relationship between the
two markets

7. Competition of OTC derivatives with the Exchange-traded Derivatives: A general view

emerging after the recent financial crisis is that OTC derivatives trading should be moved
to an exchange platform. The proponents of this view hope that this would increase
liquidity and reduce significantly the opacity of the market. They argue that exchanges
provide transparent and reliable price formation mechanisms, neutrality, robust and
appropriate technology, better regulation and, above all, centralized clearing and
settlement system. These arguments are based on the assumption that the existing method
of trading in OTC products is all based on telephone trading and there is no clearing
system in place.

8. Lack of Economies of Scale: There are too many (3 national level and 21 regional)
commodity exchanges. Though over 80 commodities are allowed for derivatives trading,
in practice derivatives are popular for only a few commodities. Again, most of the trade
takes place only on a few exchanges. All this splits volumes and makes some exchanges

35
 unviable. This problem can possibly be addressed by consolidating some exchanges.
Also, the question of convergence of securities and commodities derivatives markets has
been debated for a long time now. The Government of India has announced its intention
to integrate the two markets. It is felt that convergence of these derivative markets would
bring in economies of scale and scope without having to duplicate the efforts, thereby
giving a boost to the growth of commodity derivatives market. It would also help in
resolving some of the issues concerning regulation of the derivative markets. However,
this would necessitate complete coordination among various regulating authorities such
as Reserve Bank of India, Forward Markets commission, the Securities and Exchange
Board of India, and the Department of Company affairs etc.

9. Strengthening the Centralized Clearing Parties: CCIL, which started functioning in 2002,
is the only centralized clearing party for trade processing and settlement services in India.
It currently provides a guaranteed settlement facility for government securities trading,
clearing of collateralized borrowing and lending obligations (CBLO), guaranteed
settlement of foreign exchange trading, and settlement of all Indian Revenue Service
(IRS). Though the concentration of business relating to money, securities and forex
markets with the CCIL helps in pooling risks and reducing the overall transactions costs
for the system, the Certified Financial Services Auditor’s (CFSA) report opined that the
concentration of such a wide spectrum of activities leads to concentration of risks in one
entity. Therefore, there is the need to strengthen more and more clearing parties.

10. Tax and Legal bottlenecks: In India, at present there are tax restrictions on the movement
of certain goods from one state to another. These need to be removed so that a truly
national market could develop for commodities and derivatives. Also, regulatory changes
are required to bring about uniformity in octroi and sales taxes etc. VAT has been
introduced in the country in 2005, but has not yet been uniformly implemented by all
states.

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 11. New Derivatives Products for Credit Risk Transfer (CRT): Credit risk transfer (CRT), in
a broad sense (including guarantees, loan syndication, and securitization) has a long
history. However, there has been a sustained and rapid growth of new and innovative
forms of CRT associated with credit derivatives. The most common credit derivatives are
credit default swaps (CDS) on single corporate entity (single-name CDS) and
collateralized debt obligations (CDOs). Since 2005, CRT activity became significant for
two additional underlying asset classes – asset backed securities (ABS) and leveraged
loans. Internationally, banks and financial institutions are able to protect themselves from
credit default risk through the mechanism of credit derivatives. However, credit
derivatives were not allowed in India until recently. The RBI has made an announcement
in its second-quarter monetary policy 2009-10 that it has considered it appropriate to
proceed with caution on this issue. To start with Ist December 2011, RBI has introduced
guidelines for a basic, over-the-counter, single name CDS for corporate bonds for
resident entities, subject to safeguards.

FACTORS DRIVING THE GROWTH OF DERIVATIVES

Over the last three decades, the derivatives market has seen a phenomenal growth. A
large variety of derivative contracts have been launched at exchanges across the world.
Some of the factors driving the growth of financial derivatives are:

1. Increased volatility in asset prices in financial markets:

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

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is called as an exchange rate. Prices are generally determined by market forces. In a market,
consumers have ‘demand’ and producers or suppliers have ‘supply’, and the collective
interaction of demand and supply in the market determines the price. These factors
are constantly interacting in the market causing changes in the price over a short period of time.
Such changes in the price are known as ‘price volatility’. This has three factors: the speed of
price changes, the frequency of price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments through
price changes. These price changes expose individuals, producing firms and governments
to significant risks. The breakdown of the BRETTON WOODS agreement brought an end to the
stabilizing role of fixed exchange rates and the gold convertibility
of the dollars. The globalization of the markets and rapid industrialization of manyunderdevelope
d countries brought a new scale and dimension to the markets. Nations that were poor suddenly
became a major source of supply of goods. The Mexican crisis in the south east- 47 Asian
currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of
telecommunication and data processing bought information very quickly to the markets.
Information which would have taken months to impact the market earlier can now be obtained in
matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates
rapidly. These price volatility risks pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against adverse price changes
in commodity, foreign exchange, equity shares and bonds.

2. Globalisation of markets:
Earlier, managers had to deal with domestic economic concerns; what happened in other part of
the world was mostly irrelevant. Now globalization has increased the size of markets and as
greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods
at a lower cost. It has also exposed the modern business to significant risks and, in many cases,
led to cut profit margins In Indian context, south East Asian
currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated
currencies. Export of certain goods from India declined because of this crisis. Steel industry in

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1998 suffered its worst set back due to cheap import of steel from south East Asian countries.
Suddenly blue chip companies had turned in to red. The fear of china
devaluing its currency created instability in Indian exports. Thus, it is evident that globalization
of industrial and financial activities, necessitates use of derivatives to guard against future losses.
This factor alone has contributed to the growth of derivatives to a significant extent.

3. Technological advances:
A significant growth of derivative instruments has been driven by technological Breakthrough.
Advances in this area include the development of high speed processors, network systems and
enhanced method of data entry. Closely related to advances in computer technology are
advances in telecommunications. Improvement in communications allow for instantaneous
worldwide conferencing, Data transmission by satellite. At the same time
therewere significant advances in software programmers’ without which computer andtelecomm
unication advances would be meaningless. These facilitated the more rapidmovement of informat
ion and consequently its instantaneous impact on market price.Although price sensitivity
to market forces is beneficial to the economy as a whole resources are rapidly relocated to more
productive use and better rationed overtime the greater price volatility exposes producers and
consumers to greater price risk. The effect of this risk can easily destroy a business which is
otherwise well managed. Derivatives can help a
firmmanage the price risk inherent in a market economy. To the extent the technologicaldevelop
ments increase volatility, derivatives and risk management products become thatmuch more
important

4. Advances in financial theories:

Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed by Black
and Scholes in 1973 were used to determine prices of call and put options. In late1970s, work of
Lewis Edeington extended the early work of Johnson and started the hedging of financial price
risks with financial futures. The work of economic theorists gave rise to

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new products for risk management which led to the growth of derivatives in financialmarkets.
The above factors in combination of lot many factors led to growth of derivatives instruments

SOME OTHER DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures,
options and swaps. We take a brief look at some other various derivatives contracts that have
come to be used:

 Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.
 LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These
are options having a maturity of upto three years.

 Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options are a form of
basket options
 Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the
opposite direction.
 Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.

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ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

Inspite of the fear and criticism with which the derivative markets are commonly looked at, these
markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level. The prices
of derivatives converge with the prices of the underlying at the expiration of the
derivative contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not
like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market witnessed higher trading
volumes because of participation by more players who would not otherwise participate
for lack of an arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the

absence of an organized derivatives market, speculators trade in the underlying cash
markets. Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kind of mixed markets
5. An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting
many bright, creative, well-educated people with an entrepreneurial attitude. They often
energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense. In a nut shell, derivatives markets help
increase savings and investment in the long run. Transfer of risk enables market
participants to expand their volume of activity.

RISK MANAGEMENT

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Risk Management is a process whereby an investor lays down a clear process of how its risks
should be managed. The process will include:

• Identifying risk
• Deciding the frequency of collection of margins
• Deciding how much risk is acceptable
• Controlling risk on continuous basis
• Monitoring risk taken on continuous basis
If you have bought Futures and the price goes up, you will make profits. If you have sold
Futures and the price goes down, you will make profits.

BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:

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

2. Price discovery –
Price discovery refers to the market’s ability to determine true equilibrium prices. Futures
pricesa r e b e l i e v e d t o c o n t a i n i n f o r m a t i o n a b o u t f u t u r e s p o t p r i c e s a n d h e l
p in disseminating suchinformation. As we have seen, futures markets pr
o v i d e a l o w c o s t t r a d i n g m e c h a n i s m . T h u s information pertaining to supply and

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demand easily percolates into such markets. Accurate prices are essential for ensuring the correct
allocation of resources in a free market economy. Options markets provide information about the
volatility or risk of the underlying asset

3. Operational advantages –
As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly,
the y offer greater liquidity. Lar ge spot transactions can often lead to
s i g n i f i c a n t p r i c e c h a n g e s . However, futures markets tend to be more liquid than spot
markets, because herein you can take large positions by depositing relatively small margins.
Consequently, a large position in derivatives markets is relatively easier to take and has
less of a price impact as opposed to a transaction of the same magnitude in the spot
market. Finally, it is easier to take a short position in derivatives markets than itis to sell short in
spot markets

4. Market efficiency –
The availability of derivatives makes markets more efficient; spot, futures and options market
share inextricably linked. Since it is easier and cheaper to trade in derivatives, it is
possible to exploit arbitrage opportunities quickly and to keep prices in alignment.
Hence these markets help to ensure that prices reflect true values.

5. Ease of speculation –
Derivative markets provide speculators with a cheaper alternative to engaging in
spot transactions. Also, the amount of capital required to take a comparable
position is less in this case. This is important because facilitation of speculation is
critical for ensuring free and fair markets. S p e c u l a t o r s a l w a y s t a k e c a l c u l a t e d
r i s k s . A s p e c u l a t o r w i l l a c c e p t a l e v e l o f r i s k o n l y i f h e i s convinced that the
associated expected return is commensurate with the risk that he is taking. The derivative market
performs a number of economic functions. Those are:

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 The prices of the derivatives converge with the prices of the underlying at
the expiration of derivative contract. Thus derivatives help in discovery of future as
well as current prices.

 An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity.

 Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity

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