Project - Abhi - Derivatives

Derivative in stock market
“DERIVATIVE IN STOCK MARKET”

At
“India”
Submitted in partial fulfillment of the requirements for the award of
The degree of
Master of Business Administration

Submitted to:
Punjab Technical University

Jalandhar
By:
“Abhishek Kumar Srivastava”
“Regd No-9212400078
Under the guidance of
“Dr. V.B. Padmanabhan”
Ph.D (B&F),AICWA,CAIIB,AMFI,LL.B,,B.Sc.
#70, 2nd Main Road, 3rd Cross, Kanaka Nagar, Nagawara,
BANGALORE – 560 032
International Institute Of Business Studies Page 1

2009 - 11
DECLARATION
I hereby declared that this project titled “ derivative in stock market“ , is submitted to the
Punjab Technical University as a partial requirement for the award of Degree of Master of
Business Administration, during the year 2010-2011.
It is the record of an original & independent study carried out by me, under the total guidance
and supervision of Dr.V.B Padmnabhan.This project report has not been submitted earlier by
me or by anybody else for the award of any other degree in any University in India or abroad.
Date: Signature of the Student
Place: (Abhishek kumar srivastava)

CERTIFICATE
This is to certify that Mr. Abhishek kumar srivastav of International Institute of Business
Studies, Bangalore, has completed the Project titled “Derivative in stock market” under the
guidance of Dr.V B Padmanabhan during the year 2010-2011.
During the stay in our organization, Mr. A bhishek kumar srivastava was very useful to our
organization, with her Managerial knowledge & has successfully completed the dissertation. We
wish him best of luck in all future endeavors.
For __________________Ltd,
(Name & Designation of the Signatory)
(Acknowledgement by the Student on Plain Paper)

ACKNOWLEDGEMENT
I would like to express my sincere thanks to the Director & Management of International
Institute of Business Studies, Bangalore, for their valuable guidance & support. I am extremely
thankful & grateful to Dr.V.B Padmnabhan for his constant guidance & encouragement
throughout the study.
I would also like to express my devoted thanks to my beloved parents & my friends for their
relentless support & assistance to make this project a reality. Last but not the least; I would like
to thank all my respondents for their co-operation & participation in data collection, which has
enabled me to complete the project successfully.
Date: Signature of the Student
Place: (Abhishek kumar srivastava)

EXECUTIVE SUMMARY
Firstly I am briefing the current Indian market and comparing it with it past. Derivatives trading
in the stock market have been a subject of enthusiasm of research in the field of finance the most
desired instruments that allow market participants to manage risk in the modern securities
trading are known as derivatives.
The derivatives are defined as the future contracts whose value depends upon the underlying
assets. If derivatives are introduced in the stock market, the underlying asset may be anything as
component of stock market like, stock prices or market indices, interest rates, etc.
The main logic behind derivatives trading is that derivatives reduce the risk by providing an
additional channel to invest with lower trading cost and it facilitates the investors to extend their
settlement through the future contracts. It provides extra liquidity in the stock
market. Derivatives are assets, which derive their values from an underlying asset. These
underlying assets are of various categories like
• Commodities including grains, coffee beans, etc.
• Precious metals like gold and silver.
• Foreign exchange rate.
•Bonds of different types, including medium to long-term negotiable debt
securities issued by governments, companies, etc.
• Short-term debt securities such as T-bills.
• Over-The-Counter (OTC) money market products such as loans or deposits.
• Equities
For example, a dollar forward is a derivative contract, which gives the buyer a right & an
obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot
prices of these underlying assets. However, the most important use of derivatives is in
transferring market risk, called Hedging, which is a protection against losses resulting from
unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk
management.
There are various derivative products traded. They are;
1. Forwards
2. Futures
3. Options
4. Swaps
“A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of
a specific quality and quantity of asset usually a commodity at a specified future date. The price
may be agreed on in advance or in future.”
“A Future contract is a firm contractual agreement between a buyer and seller for a specified as
on a fixed date in future. The contract price will vary according to the market place but it is fixed
when the trade is made. The contract also has a standard specification so both parties know
exactly what is being done”.

“An Options contract confers the right but not the obligation to buy (call option) or sell (put
option) a specified underlying instrument or asset at a specified price – the Strike or Exercised
price up until or an specified future date – the Expiry date. The Price is called Premium and is
paid by buyer of the option to the seller or writer of the option.”
A call option gives the holder the right to buy an underlying asset by a certain date for a certain
price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is
called "the call option premium or call option price".
A put option, on the other hand gives the holder the right to sell an underlying asset by a certain
date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price
for this, which is called "the put option premium or put option price".
“Swaps are transactions which obligates the two parties to the contract to exchange a series of
cash flows at specified intervals known as payment or settlement dates. They can be regarded as
portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)
payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only
the payment flows are exchanged and not the principle amount” I had conducted this research to
find out whether investing in the derivative market is beneficial or not? You will be glad to know
that derivative market in India is the most booming now days.
So the person who is ready to take risk and want to gain more should invest in the derivative
market. On the other hand RBI has to play an important role in derivative market. Also SEBI
must encourage investment in derivative market so that the investors get the benefit out of it.
Sorry to say that today even educated persons are not willing to invest in derivative market
because they have the fear of high risk.
So, SEBI should take necessary steps for improvement in Derivative Market so that more
investors can invest in Derivative market. I am also giving brief data about foreign market.
Then at the last I am giving my suggestions and recommendations. With over 25 million
shareholders, India has the third largest investor base in the world after USA and Japan. Over
7500 companies are listed on the Indian stock exchanges (more than the number of companies
listed in developed markets of Japan, UK, Germany, France, Australia, Switzerland, Canada and
Hong Kong.).
The Indian capital market is significant in terms of the degree of development, volume of
trading, transparency and its tremendous growth potential. India’s market capitalization was the
highest among the emerging markets. Total market capitalization of The Bombay Stock
Exchange (BSE), which, as on July 31, 1997, was US$ 175 billion has grown by 37.5% percent
every twelve months and was over US$ 834 billion as of January, 2007. Bombay Stock
Exchanges (BSE), one of the oldest in the world, accounts for the largest number of listed
companies transacting their shares on a nationwide online trading system.

TABLE
CHAPTERS CONTENTS PAGE NOS.
1.
INTRODUCTION 8-29
2.
OBJECTIVE OF STUDY 30-31
3. R
ESEARCH METHODOLOGY 32-34
4.
REVIEW OF LITERATURE 35-36
5.
HISTORY OF THE DERIVATIVES 37-68
6. ANALYSIS & INTERPRETATION OF

DATA 69-77
7. SUMMARY OF FINDINGS, CONCLUSIONS

& RECOMMENDATIONS 78-82
8. 83
BIBLIOGRAPHY

Chapter -1
introduction
Introduction
What are derivatives
Derivatives are financial instruments whose price is determined by some underlying variables.
Derivatives can be traded directly between the two parties as well as through exchanges. There
are different types of derivatives based on the type of assets that it deals in such as commodity,
equity, bond, interest rate, index and so on. Mainly there are four types of derivatives that are
traded –
Future, Forward, Options and Swaps. In case of stock market derivative trading essentially
means trading in future contracts and options. In derivative trading, stocks are bought in the form
of contracts and in a lot.
The biggest advantage of derivative trading is that you can buy huge amount of stock by paying
only a part of the total value of the stock. As in derivative trading you have to buy the stocks in a
lot the price of the lot is relatively lower than the total amount stock you get. So, this means you
have a chance of making profit even by investing a comparatively less money.
Derivative trading also lets you short sell the stocks. That means you can sell the stocks even
before you actually own them. This is beneficial when you have an idea that the price of a
particular stock is going to reduce. In derivative trading you can first sell the stock at a higher
price and then buy the equal number of stocks when the price has gone down. In that way you
can make profit in derivative trading even if the price is going down.
There are newer derivatives that are becoming popular like weather derivatives and natural
calamity derivatives. These are used as a hedge against any untoward happenings because of
natural causes. In derivative trading the brokerage is relatively lower than the cash segment. If
you consider the number of stock that you purchase in the form of future contracts then you will
find that you have to pay less brokerage compared to the cash segment.
A derivative is not a stand-alone asset, since it has no value of its own. However, more common
types of derivatives have been traded on markets before their expiration date as if they were
assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice
Exchange since the eighteenth century.
The emergence of the market for derivative 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. 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 products minimize
the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-
averse investors.
The following factors have been driving the growth of financial derivatives: Increased volatility
in asset prices in financial markets, Increased integration of national financial markets with the
international markets, Marked improvement in communication facilities and sharp decline in

their costs, Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and Innovations in the derivatives markets,
which optimally combine the risks and returns over a large number of financial assets, leading to
higher returns, reduced risk as well as trans-actions costs as compared to individual financial
assets.
The most common types of derivatives that ordinary investors are likely to come across are
futures, options, warrants and convertible bonds. Beyond this, the derivatives range is only
limited by the imagination of investment banks. It is likely that any person who has funds
invested an insurance policy or a pension fund that they are investing in, and exposed to,
derivatives-wittingly or unwittingly.
Contracts agreement

CASH DERIVATIVES
OTHERS LIKE SWAPS,

FORWARD FRAs etc.
MERCHANDISIN FUTURES
(Standardized) OPTIONS
g, CUSTOMIZED
NTSD TSD
UNDERSTANDING DERIVATIVES
The primary objectives of any investor are to maximize returns and minimize risks. Derivatives
are contracts that originated from the need to minimize risk. The word’ derivative' originates
from mathematics and refers to a variable, which has been derived from another variable.
Derivatives are so called because they have no value of their own. They derive their value from
the value of some other asset, which is known as the underlying. For example, a derivative of the

shares of Infosys (underlying), will derive its value from the share price (value) of Infosys.
Similarly, a derivative contract on soybean depends on the price of soybean.
Derivatives are specialized contracts which signify an agreement or an option to buy or sell the
underlying asset of the derivate up to a certain time in the future at a prearranged price, the
exercise price.
The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date
of commencement of the contract. The value of the contract depends on the expiry period and
also on the price of the underlying asset.
For example, a farmer fears that the price of soybean (underlying), when his crop is ready for
delivery will be lower than his cost of production.
Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the
selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy
the crop at a certain price (exercise price), when the crop is ready in three months time (expiry
period). In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value
of this derivative contract will increase as the price of soybean decreases and vice-a-versa. If the
selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more
valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes
even more valuable.
This is because the farmer can sell the soybean he has produced at Rs .9000 per tone even
though the market price is much less. Thus, the value of the derivative is dependent on the value
of the underlying.
If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver,
precious stone or for that matter even weather, then the derivative is known as a commodity
derivative. If the underlying is a financial asset like debt instruments, currency, share price
index, equity shares, etc, the derivative is known as a financial derivative. Derivative contracts
can be standardized and traded on the stock exchange. Such derivatives are called exchange-
traded derivatives. Or they can be customized as per the needs of the user by negotiating with the
other party involved.
Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of
the farmer above, if he thinks that the total production from his land will be around 150 quintals,
he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of
soybean in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities
exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standard
contract on soybean.
The standard contract on soybean has a size of 100 quintals. So the farmer will be left with 50
quintals of soybean uncovered for price fluctuations. However, exchange traded derivatives have
some advantages like low transaction costs and no risk of default by the other party, which may
exceed the cost associated with leaving a part of the production
uncovered.

TYPES OF DERIVATIVES:-
The most commonly used derivatives contracts are forwards, futures and options which we shall
discuss in detail later. Here we take a brief look at various derivatives contracts that have come
to be used.
types
forword future option swaps
FORWARD CONTRACTS;-
A forward contract is a customized contract between two entities, where settlement takes place
on a specific date in the future at today’s pre-agreed price 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 n o rma l l y
traded outside the exchanges.
BASIC FEATURES OF FORWARD CONTRACT:-
• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party,
which often results in high prices being charged. However forward contracts in
certain markets have become very standardized, as in the case of foreign exchange, thereby
reducing transaction costs and increasing transactions volume. This process of standardization
reaches its limit in the organized futures market. Forward contracts are often confused with
futures contracts. The confusion is primarily because both serve essentially the same economic
functions of allocating risk in the presence of future price uncertainty. However futures are a
significant improvement over the forward contracts as they eliminate counterparty risk and offer
more liquidity.
(ii) FUTURE CONTRACT
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or

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

BASIC FEATURES OF FUTURE CONTRACT
1. Standardization :
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:
• The underlying. This can be anything from a barrel of sweet crude oil to a
Short term interest rate.
 The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the notional amount of
bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the
deposit over which the short term interest rate is traded, etc.
The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds
can be delivered. In case of physical commodities, this specifies not only
the quality of the underlying goods but also the manner and location of
Delivery. The delivery month.
The last trading date.
O  ther details such as the tick, the minimum permissible price fluctuation.
2. Margin :
Although the value of a contract at time of trading should be zero, its price constantly fluctuates.
This renders the owner liable to adverse changes in value, and creates a credit risk to the
exchange, who always acts as counterparty. To minimize this risk, the exchange demands that
contract owners post a form of collateral, commonly known as Margin requirements are waived
or reduced in some cases for hedgers who have physical ownership of the covered commodity or
spread traders who have offsetting contracts balancing the position. Initial Margin is paid by
both buyer and seller. It represents the loss on that contract, as determined by historical price
changes, which is not likely to be
exceeded on a usual day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin:
Because a series of adverse price changes may exhaust the initial margin, a further margin,
usually called variation or maintenance margin, is required by the exchange. This is calculated
by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or
mark-to-market price of the contract. To understand the original practice, consider that a futures
trader, when taking a position, deposits money with the exchange, called a "margin". This is
intended to protect the exchange against loss. At the end of every trading day, the contract is
marked to its present market value. If the trader is on the winning side of a deal, his contract has
increased in value that day, and the exchange pays this profit into his account. On the other hand,
if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is
used as the collateral from which the loss is paid.

3. Settlement
Settlement is the act of consummating the contract, and can be done in one of
two ways, as specified per type of futures contract:
• Physical delivery - the amount specified of the underlying asset of the contract is delivered
by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In
practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a
covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or
selling a contract to liquidate an earlier purchase (covering a long).
• Cash settlement - a cash payment is made based on the underlying reference rate, such as a
short term interest rate index such as Euribor, or the closing value of a stock market index. A
futures contract might also opt to settle against an index based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For many equity index and
interest rate futures contracts, this happens on the Last Thursday of certain trading month. On
this day the t+2 futures contract becomes the t forward contract.
PRICING OF FUTURE CONTRACT:-
In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward
price) must be the same as the cost (including interest) of buying and storing the asset. In other
words, the rational forward price represents the expected future value of the underlying
discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the
future/forward(t) , will be found by discounting the present value S(t)at time t to maturity by the
rate of risk-free return r
F(t)=S(t)*(1+r)(T-t) .
This relationship may be modified for storage costs, dividends, dividend yields,
and convenience yields. Any deviation from this equality allows for arbitrage as
follows.
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today
(on the spot market) with borrowed money.
2. On the delivery date, the arbitrageur hands over the underlying, and
receives the agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.
In the case where the forward price is lower:
1. The arbitrageur buys the futures contract and sells the underlying today

(on the spot market); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has
appreciated at the risk free rate.
3. He then receives the underlying and pays the agreed forward price using
the matured investment. [If he was short the underlying, he returns it now.]
4. The difference between the two amounts is the arbitrage profit.
What the terminologies used in a Futures contract?
• Spot price: The price at which an asset trades in the spot market.
• Futures price: The price at which the futures contract trades in the futures market.
• Contract cycle: The period over which a contract trades. The index futures contracts on
the NSE have one-month, two-months and three-months expiry cycles, which expire on the
last Thursday of the month. Thus a January expiration contract expires on the last Thursday
of January and a February expiration contract ceases trading on the last Thursday of
February. On the Friday following the last Thursday, a new contract having a three-month
expiry is introduced for trading.
• Expiry date: It is the date specified in the futures contract. This is the last day on which
the contract will be traded, at the end of which it will cease to exist.
• Contract size: The amount of asset that has to be delivered under one contract. For in-
stance, the contract size on NSE’s futures market is 200 Nifties.
• Basis: In the context of financial futures, basis can be defined as the futures price minus the
spot price. There will be a different basis for each delivery month for each contract. In a
normal market, basis will be positive. This reflects that futures prices normally exceed spot
prices.
• Cost of carry: The relationship between futures prices and spot prices can be summarized
in terms of what is known as the cost of carry. This measures the storage cost plus the
interest that is paid to finance the asset less the income earned on the asset.
• Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin.
• Marking-to-market: In the futures market, at the end of each trading day, the margin ac-
count is adjusted to reflect the investor’s gain or loss depending upon the futures closing
price. This is called marking–to–market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure
that the balance in the margin account never becomes negative. If the balance in the margin
account falls below the maintenance margin, the investor receives a margin call and is expected
to top up the margin account to the initial margin level before trading commences on the next
day.
How is a future useful for me to hedge my position?
One can hedge one’s position by taking an opposite position in the futures

market. For example, If you are buying in the spot price, the risk you carry is that of prices
falling in the future. You can lock this by selling in the futures price.
Even if the stock continues falling, your position is hedged as you have firmed the price at which
you are selling. Similarly, you want to buy a stock at a later date but face the risk of prices rising.
You can hedge against this rise by buying futures.
You can use a combination of futures too to hedge yourself. There is always a correlation
between the index and individual stocks. This correlation may be negative or positive, but there
is a correlation. This is given by the beta of the stock.
In simple terms, what b indicates is the change in the price of a stock to the
change in index. For example, if b of a stock is 0.8, it means that if the index
goes up by 10, the price of the stock goes up by 8. It will also fall by a similar level when the
index falls. A negative b means that the price of the stock falls when the index rises. So, if you
have a position in a stock, you can hedge the same by buying the index at b times the value of
the stock.
Example :-
The b of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I can hedge my
position by selling 8000 of Nifty. Ie I will sell 8 Nifties.
Scenario 1-
If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800 The value of my
stock however goes up by 8 % ie it becomes Rs 10800 ie a gain of Rs 800.
Thus my net position is zero and I am perfectly hedged.
Scenario 2-
If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800 But the value of
the stock also falls by 8 %. The value of this stock becomes Rs 9200 a loss of Rs 800.
Thus my net position is zero and I am perfectly hedged.
But again, b is a predicted value based on regression models. Regression is
Nothing but analysis of past data. So there is a chance that the above position may not be fully
hedged if the b does not behave as per the predicted value.
DISTINCTION BETWEEN FUTURES AND FORWARDSCONTRACTS
FEATURES FORWARD CONTRACT FUTURE CONTRACT

Operational Traded directly between two Traded on the exchanges.

Mechanism parties (not traded on the
exchanges).
Contract Differ from trade to trade. Contracts are standardized contracts.

Specifications
Counter-party Exists. Exists. However, assumed by the clearing

risk corp., which becomes the counter party to
all the trades or unconditionally guarantees
their settlement.
Liquidation Low, as contracts are tailor High, as contracts are standardized

Profile made contracts catering to the exchange traded contracts.
needs of the needs of the
parties.
Price discovery Not efficient, as markets are Efficient, as markets are centralized and all
scattered. buyers and sellers come to a common
platform to discover the price.
Examples Currency market in India. Commodities, futures, Index Futures and

Individual stock Futures in India.
Price discovery Not efficient, as markets are scattered. Efficient, as markets are centralized
and all buyers and sellers come to a common platform to discover the price.
Examples Currency market in India. Commodities, futures, Index Futures
and Individual stock Futures in India.
OPTIONS –

A derivative transaction that gives the option holder the right but not the obligation to buy or sell
the underlying asset at a price, called the strike price, during a period or on a specific date in
exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset
that is traded. The price at which the underlying is traded is called the ‘strike price’. There are
two types of options i.e., CALL OPTION & PUT OPTION.
CALL OPTION:
A contract that gives its owner the right but not the obligation to buy an underlying asset-stock
or any financial asset, at a specified price on or before a specified date is known as a ‘Call
option’. The owner makes a profit provided he sells at a higher current price and buys at a lower
future price.
PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or
any financial asset, at a specified price on or before a specified date is known as a ‘Put option’.
The owner makes a profit provided he buys at a lower current price and sells at a higher future
price. Hence, no option will be exercised if the future price does not increase. Put and calls are
almost always written on equities, although occasionally
preference shares, bonds and warrants become the subject of options.
What are the options that are currently traded in the market?
The options that are currently traded in the market are index options and stock
options on the 30 stocks. The index options are European options. They are
settled on the last day. The stock options are American options.
There are 3 options-1, 2,3 month options. There can be a series of option within
the above time span at different strike prices.
Another lingo in option is Near and Far options. A near option means the option
is closer to expiration date. A Far option means the option is farther from
expiration date. A 1 month option is a near option while a 3 month option is a far
option. In option trading, what gets quoted in the exchange is the premium and all that
people buy and sell is the premium.
SWAPS -
Swaps are transactions which obligates the two parties to the contract to exchange a series of
cash flows at specified intervals known as payment or settlement dates. They can be regarded as
portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)
payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only
the payment flows are exchanged and not the principle amount. The two commonly used swaps
are:
INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed
rate interest payments to a party in exchange for his variable rate interest payments. The fixed

rate payer takes a short position in the forward contract whereas the floating rate payer takes a
long position in the forward contract.
CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and the interest on loan in
one currency are swapped for the principle and the interest payments on loan in another
currency. The parties to the swap contract of currency generally hail from two different
countries. This arrangement allows the counter parties to borrow easily and cheaply in their
home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot
rate at a time when swap is done. Such cash flows are supposed to remain unaffected by
subsequent changes in the exchange rates.
FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to access one market
and then exchange the liability for another type of liability. It also allows the investors to
exchange one type of asset for another type of asset with a preferred income stream.
The needs of the players and how currency swaps help meet these needs
To manage the exchange rate risk
Since the international trade implies returns and payments in a variety of currencies whose
relative values may fluctuate it involves taking foreign exchange risk. The players mentioned
above are facing this risk. A key question facing the players then is whether these exchange risks
are so large as to affect their business. A related question is what, if any, special strategies should
be followed to reduce the impact of foreign exchange risk.
One-way to minimize the long-term risk of one currency being worth more or less in the future is
to offset the particular cash flow stream with an opposite flow in the same currency. The
currency swap helps to achieve this without raising new funds; instead it changes existing cash
flows.
To lower financing cost –

Currency swaps can be used to reduce the cost of loan. The following example deals with such a
case. Consider two Indian corporate A & B. Corporate A is an exporter with a rupee loan at 14%
fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in the credit
rating of the two companies, the rates at which the loans are available to them are different. A
has access to 14% rupee loan and dollar loan at LIBOR + 0.25%. A would like to convert its
rupee loan into a dollar loan, to reverse its revenue in dollars and B would like to convert the
dollar loan into a fixed rupee loan thus crystallizing its cost of borrowing. They can enter into a
swap and reduce the cost compared to what it would have been if they had taken a direct loan in
the desired currencies.
OTHER KINDS OF DERIVATIVES:-

The other kind of derivatives, which are not, much popular are as follows:
BASKETS -
Baskets options are option on portfolio of underlying asset. Equity Index Options
are most popular form of baskets.
LEAPS -
Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce
option contracts with a maturity period of 2-3 years. These long-term option contracts are
popularly known as Leaps or Long term Equity Anticipation Securities.
WARRANTS -
Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called warrants
and are generally traded over-the-counter.
SWAPTIONS -
Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
Option Terminology:-
• Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options contracts
are also cash settled.
• Stock options: Stock options are options on individual stocks. Options currently trade on
over 500 stocks in the United States. A contract gives the holder the right to buy or sell
shares at the specified price.
• Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the seller/writer.
• Writer of an option: The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are
two basic types of options, call options and put options. Call option: A call option gives the
holder the right but not the obligation to buy an asset by a certain date for a certain price. Put
option: A put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.

• Expiration date: The date specified in the options contract is known as the expiration date,
the exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the strike price or the
exercise price. American options: American options are options that can be exercised at any
time upto the expiration date. Most exchange-traded options are American. In-the-money
option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to
the holder if it were exercised immediately. A call option on the index is said to be in-the-
money when the current index stands at a level higher than the strike price (i.e. spot price >
strike price). If the index is much higher than the strike price, the call is said to be deep ITM.
In the case of a put, the put is ITM if the index is below the strike price.
• At-the-money option: An at-the-money (ATM) option is an option that would lead to zero
cash flow if it were exercised immediately. An option on the index is at-the-money when the
current index equals the strike price (i.e. spot price = strike price)._
• Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead

to negative cash flow it it were exercised immediately. A call option on the index is out-of-
the-money when the current index stands at a level which is less than the strike price (i.e.
spot price < strike price). If the index is much lower than the strike price, the call is said to be
deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the amount the option
is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the
intrinsic value of a call isN½P which means the intrinsic value of a call is Max [0, (S t – K)]
which means the intrinsic value of a call is the (St – K). Similarly, the intrinsic value of a put is
Max [0, (K -St)], i.e. the greater of 0 or (K - St). K is the strike price and St is the spot price.
Options undertakings:-
S tocks
ForeignCurrencies
StockIndices
Commodities
 Others - Futures Options, are options on the futures contracts or underlying assets are futures
contracts. The futures contract generally matures shortly after the options expiration
Options Classifications:-
Options are often classified as
In the money - These result in a positive cash flow towards the investor
At the money - These result in a zero-cash flow to the investor
Out of money - These result in a negative cash flow for the investor

Example:
Calls
Reliance 350 Stock Series
Naked Options: These are options which are not combined with an offsetting contract to cover
the existing positions.
Covered Options: These are option contracts in which the shares are already owned by an
investor (in case of covered call options) and in case the option is exercised then the offsetting of
the deal can be done by selling these shares held.
OPTIONS PRICING:-
Prices of options are commonly depend upon six factors. Unlike futures which derives there
prices primarily from prices of the undertaking. Option's prices are far more complex. The table
below helps understand the affect of each of these factors and gives a broad picture of option
pricing keeping all other factors constant. The table presents the case of European as well as
American Options.
EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION

PRICES:-
EUROPEAN OPTIONSAMERICAN OPTIONS
Buying Buying
PARAMETERS CALL PUT CALL PUT
Spot Price (S)
Strike Price (Xt)
Time to Expiration (T) ? ?
Volatility ()
Risk Free Interest Rates (r)
Dividends (D)
Favourable
Unfavourable
STRIKE PRICE: In case of a call option the payoff for the buyer is shown above. As
per this relationship a higher strike price would reduce the profits for the holder of the
call option.
TIME TO EXPIRATION: More the time to Expiration more favorable is the option.
This can only exist in case of American option as in case of European Options the
Options Contract matures only on the Date of Maturity.

Futures Options
Exchange traded,with novation Same as futures.

Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
What are the options that are currently traded in the market?
The options that are currently traded in the market are index options and stock
options on the 30 stocks. The index options are European options. They are
settled on the last day. The stock options are American options. There are 3 options-1, 2,3 month
options. There can be a series of option within the above time span at different strike prices.
Another lingo in option is Near and Far options. A near option means the option is closer to
expiration date. A Far option means the option is farther from expiration date. A 1 month option
is a near option while a 3 month option is a far
option. In option trading, what gets quoted in the exchange is the premium and all that
people buy and sell is the premium.
How do I use options in my trading strategy?

Options are a great tool to use for trading. If you feel the market will go up. You should buy a
call option at a level lower than what you expect the market to go up. If you think that the market
will fall, you should buy a put option at a level higher than the level to which you expect the
market fall.
When we say market, we mean the index. The same strategy can be used for
individual stocks also.
A combination of futures and options can be used too, to make profits.
We have seen that the risk for an option holder is the premium
amount. But what should be the strategy for an option writer to
cover himself?
An option writer can use a combination strategy of futures and options to protect his position.
The risk for an option writer arises only when the option is exercised. This will be very clear
with an
Example:-
Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium of Rs 20. The
risk arises only when the option is exercised. The option will be exercised when the price
exceeds Rs 300. I start making a loss only after the price exceeds Rs 320(Strike price plus
premium).

More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver the
stock to the other party and also make entire profit on premium,
I buy a future of Reliance at Rs 300.
This is just one leg of the risk. The earlier risk was of the call being exercised.
The risk now is that of the call not being exercised. In case the call is not
Exercised, what do I do? I will have to take delivery as I have bought a future. So minimize this
risk, I buy a put option on Reliance at Rs 300. But I also need to Pay a premium for buying the
option. I pay a premium of Rs 10.Now I am fully Covered and my net cash flow would be
Premium earned from selling call option : Rs 20
Premium paid to buy put option : (Rs 10)
Net cash flow : Rs 10
But the above pay off will be possible only when the premium I am paying for the put option is
lower than the premium that I get for writing the call.
Similarly, we can arrive at a covered position for writing a put option too,
Another interesting observation is that the above strategy in itself presents an
opportunity to make money. This is so because of the premium differential in the put and the call
option. So if one tracks the derivative markets on a continuous basis, one can chance upon
almost risk less money making opportunities.
Different option series at various strike prices. How is this strike price
arrived at?
The strike price bands are specified by the exchange. This band is dependent on
the market price.
Market Price Rs. Strike Price Intervals Rs.
<50 2.5
50-150 5
150-250 10
250-500 20
500-1000 30
>1000 50
Thus if a stock is trading at Rs. 100 then there can be options with strike price of
Rs 105,110,115, 95, 90 etc.
Futures and options
An interesting question to ask at this stage is - when would one use options instead of futures?
Options are different from futures in several interesting senses. At a practical level, the option
buyer faces an interesting situation. He pays for the option in full at the time it is purchased.
After this, he only has an upside. There is no possibility of the options position generating any
further losses to him (other than the funds already paid for the option). This is different from
futures, which is free to enter into, but can generate very large losses. This characteristic makes
options attractive to many occasional market participants, who cannot put in the time to closely
monitor their futures positions. Buying put options is buying insurance. To buy a put option on
Nifty is to buy insurance, which reimburses the full extent to which Nifty drops below the strike
price of the put option. This is attractive to many people, and to mutual funds creating
“guaranteed return products”. The Nifty index fund industry will find it very useful to make a

bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund,
which gives the investor protection against extreme drops in Nifty.
How can I arbitrage and make money in derivatives?
Arbitrage is making money on price differentials in different markets. For

example, future is nothing but the future value of the spot price. This future value is obtained by
factoring the interest rate.
But if there are differences in the money market and the interest rates change then the future
price should correct itself to factor the change in interest. But if there is no factoring of this
change then it presents an opportunity to make money- an arbitrage opportunity.
Example:-
A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005. The risk free
interest rate is 12%. What should be the trading strategy?
Solution:
The strategy for trading should be : Sell Spot and Buy Futures
Sell the stock for Rs 1000. Buy the future at Rs 1005.
Invest the Rs1000 at 12 %. The interest earned on this stock will be
1000(1+.012)(1/12)
=1009
So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4
Thus one can make a risk less profit of Rs 4 because of arbitrage But an important point is that
this opportunity was available due to mix-pricing and the market not correcting itself. Normally,
the time taken for the market to adjust to corrections is very less. So the time available for
arbitrage is also less. As everyone rushes to cash in on the arbitrage, the market corrects itself.
Definition:-

Derivatives defined:-
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying
asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish
to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is driven by the spot price
of wheat which is the “underlying”. In the Indian context the Securities Contracts (Regulation)
Act, 1956 (SC(R) A) defines “equity derivative” to include –
A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
A contract, which derives its value from the prices, or index of prices, of underlying securities.
What are financial derivatives?
Financial derivatives are instruments that derive their value from financial assets.
These assets can be stocks, bonds, currency etc. These derivatives can be forward rate
agreements, futures, options swaps etc. As stated earlier, the most traded instruments are futures
and options. In derivative trading the brokerage is relatively lower than the cash segment. If you
consider the number of stock that you purchase in the form of future contracts then you will find
that you have to pay less brokerage compared to the cash segment.
ADVANTAGES:-
The use of derivatives also has its benefits:

• provide leverage (or gearing), such that a small movement in the underlying value can
cause a large difference in the value of the derivative;
• Derivatives facilitate the buying and selling of risk, and many people consider this to
have a positive impact on the economic system. Although someone loses money while
someone else gains money with a derivative, under normal circumstances, trading in
derivatives should not adversely affect the economic system because it is not zero sum in
utility.
• speculate and make a profit if the value of the underlying asset moves the way they
expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a
certain level);
• hedge or mitigate risk in the underlying, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and cancels part or all
of it out;
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g.,
weather derivatives);
• create option ability where the value of the derivative is linked to a specific condition or
event (e.g., the underlying reaching a specific price level.

DISADVANTAGES:-
Because of their ability to provide leveraging, derivative disasters are pretty common in
international markets. Just as there is huge potential of earning higher returns, it also exposes
individuals and corporations alike to lose money in case the market moves against the positions
held by them.
Does that mean derivatives are badla revisited?

The derivative product that comes closest to Badla is futures. Futures is not
badla, though a lot of people confuse it with badla. The fundamental difference is badla
consisted of contango and backwardation (undha badla and vyaj badla) in the same market.
Futures is a different market segment altogether. Hence Derivatives is not the same as badla,
though it is similar.
How do I raise funds from the derivatives market?

This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You have shares lying
with you and are in urgent need of liquidity. Instead of pledging your shares and borrowing from
banks at a margin, you can sell the stock at Rs3000. Suppose you need this liquidity only for a
month and also do not want to part with Infosys. You can buy a 1 month future at Rs 3050. After
a month you get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the financing
cost for the liquidity.
The other beauty about this is you have already locked in your purchase cost at Rs 3050. This
fixes your liquidity cost also and you are protected against further price losses.
How do I lend into the market?

The lending into the market is exactly the reverse of borrowing. You have money to lend. You
can buy a stock and sell its future. Say, you buy Infosys at Rs 3000 and sell a 1 month future at
Rs 3100. In effect what you have done is lent Rs 3000 to the market for a month and earned Rs
100 on it.
Suppose I don’t want to lend/borrow money. I want to speculate and make

profits?
When you speculate, you normally take a view on the market, either bullish or bearish. When
you take a bullish view on the market, you can always sell futures and buy in the spot market. If
you take a bearish view on the market, you can buy futures and sell in the spot market. Similarly,
in the options market, if you are bullish, you should buy call options. If you are bearish, you
should buy put options Conversely, if you are bullish, you should write put options. This is so
because, in a bull market, there are lower chances of the put option being exercised and you can
profit from the premium.
If you are bearish, you should write call options. This is so because, in a bear market, there are
lower chances of the call option being exercised and you can profit from the premium.

Chapter-2
Objective of
study
OBJECTIVE OF STUDY :-
The objective of the research means the purpose for which the research is being carried out. The
objectives of this research are as follows:

 To understand the futures and options.

 To know the RISK MANAGEMENT IN DERIVATIVES
 To know the role of derivatives market in economic development.
 To analyze the growth pattern in derivatives market
Chapter-3

Research
methodology
 Quantitative aspect:-
Primarily various books on derivative in stock market were read to know various
features and principle used in working of the industry. Moreover, various magazines were read
to know about the latest happening in this field.

Websites were visited and information regarding different aspect, to get a better
knowledge on the topic was collected. Various websites were visited so as to study the important
of derivative in stock market in the ever rising competition in today’s world.
 Qualitative aspect:-
Dr.padmanabhan was approached and implementation and scope of derivative in stock
as understood through his expertise in the field. Some analysis was done for different cases so as
to understand different strategies in different situation,
He was also approached to give an insight on the future of derivative in stock in India
and the current scenario.
Method of data collection:-

Secondary sources:-
It is the data which has already been collected by some one or an
organization for some other purpose or research study .The data for study has
been collected from various sources:
 Books
 Journals
 Magazines
 Internet sources
Time:
3 months
Statistical Tools Used:.
LIMITAITONS OF STUDY
1. LIMITED TIME:
The time available to conduct the study was only 3 months. It being a wide topic, had a
limited time..
2. LIMITED RESOURCES:
Limited resources are available to collect the information about the commodity trading
3. VOLATALITY:
Share market is so much volatile and it is difficult to forecast anything about it whether you
trade through online or offline.
4. ASPECTS COVERAGE:
Some of the aspects may not be covered in my study.
SCOPE OF THE PROJECT:-

The project covers the derivatives market and its instruments. For better understanding various
strategies with different situations and actions have been given. It includes the data collected in
the recent years and also the market in the derivatives in the recent years. This study extends to
the trading of derivatives done in the National Stock Markets.

CHAPTER-4
REVIEW OF
LITERATURE
LITERATURE REVIEW:-

The emergence of the market for derivative 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. 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 products minimize
the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-
averse investors.
Derivative products initially emerged, as hedging devices against fluctuations in commodity

prices and commodity-linked derivatives remained the sole form of such products for almost
three hundred years.
The financial derivatives came into spotlight in post-1970 period due to growing instability in
the financial markets. However, since their emergence, these products have become very popular
and by 1990s, they accounted for about two-thirds of total transactions in derivative products.
In recent years, the market for financial derivatives has grown tremendously both in terms of
variety of instruments available,
their complexity and also turnover. In the class of equity derivatives, futures and options on
stock indices have gained more popularity than on individual stocks, especially among
institutional investors, who are major users of index-linked derivatives. Even small investors find
these useful due to high correlation of the popular indices with various portfolios and ease of
use.
The lower costs associated with index derivatives vis-vis derivative products based on individual
securities is another reason for their growing use. As in the present scenario, Derivative Trading
is fast gaining momentum, I have chosen this topic.

CHAPTER -5
HISTORY OF
DERIVATIVES
HISTORY OF DERIVATIVES:-
The history of derivatives is surprisingly longer than what most people think. Some texts
even find the existence of the characteristics of derivative contracts in incidents of

Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the
ages before Jesus Christ. However, the advent of modern day derivative contracts is attributed to
the need for farmers to protect themselves from any decline in the price of their crops due to
delayed monsoon, or overproduction.
The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around
1650. These were evidently standardized contracts, which made them much like today's futures.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardized
around 1865. From then on, futures contracts have remained more or less in the same form, as
we know them today.
Derivatives have had a long presence in India. The commodity derivative market has been
functioning in India since the nineteenth century with organized trading in cotton through the
establishment of Cotton Trade Association in 1875. Since then contracts on various other
commodities have been introduced as well.
Exchange traded financial derivatives were introduced in India in June 2000 at the two
major stock exchanges, NSE and BSE. There are various contracts currently traded on these
exchanges. The National Stock Exchange of India Limited (NSE) commenced trading in
derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on
the popular benchmark S&P CNX Nifty Index.
The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001.
NSE also became the first exchange to launch trading in options on individual securities
from July 2, 2001. Futures on individual securities were introduced on November 9, 2001.
Futures and Options on individual securities are available on 227 securities stipulated by SEBI.
The Exchange provides trading in other indices i.e. CNX-IT, BANK NIFTY, CNX NIFTY
JUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange is now introducing mini
derivative (futures and options) contracts on S&P CNX Nifty index. National Commodity &
Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a
platform for commodities trading. The derivatives market in India has grown exponentially,
especially at NSE. Stock Futures are the most highly traded contracts.
The size of the derivatives market has become important in the last 15 years or so. In 2007 the
total world derivatives market expanded to $516 trillion. With the opening of the economy to
multinationals and the adoption of the liberalized economic policies, the economy is driven more
towards the free market economy.
The complex nature of financial structuring itself involves the utilization of multi currency
transactions. It exposes the clients, particularly corporate clients to various risks such as
exchange rate risk, interest rate risk, economic risk and political risk. With the integration of the
financial markets and free mobility of capital, risks also multiplied. For instance, when countries
adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates.
Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk

of default or counter party risk. Apart from it, every asset—whether commodity or metal or
share or currency—is subject to depreciation in its value. It may be due to certain inherent
factors and external factors like the market condition, Government’s policy, economic and
political condition prevailing inthe country and so on.
In the present state of the economy, there is an imperative need of the corporate clients to
protect there operating profits by shifting some of the uncontrollable financial risks to those who
are able to bear and manage them.
Thus, risk management becomes a must for survival since there is a high volatility in the present
financial markets
In this context, derivatives occupy an important place as risk reducing machinery.

Derivatives are useful to reduce many of the risks discussed above. In fact, the financial
service companies can play a very dynamic role in dealing with such risks. They can ensure that
the above risks are hedged by using derivatives like forwards, future, options, swaps etc.
Derivatives, thus, enable the clients to transfer their financial risks to the financial service
companies. This really protects the clients from unforeseen risks and helps them to get there due
operating profits or to keep the project well within the budget costs. To hedge the various risks
that one faces in the financial market today, derivatives are absolutely essential.
What are the other strategies using derivatives?

The other strategies are also various permutations of multiple puts, calls and
futures. They are also called by exotic names , but if one were to observe them closely, they are
relatively simple instruments.
Some of these instruments are:
· Butter fly spread: It is the strategy of simultaneous buying of put and call
· Calendar Spread - An option strategy in which a short-term option is sold and a longer-term
option is bought both having the same striking price. Either puts or calls may be used.
· Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at
a premium, at the strike price
· Straddle – The simultaneous purchase and sale of option of the same
Specification to different periods.
· Tandem Options – A sequence of options of the same type, with variable
strike price and period.
· Bermuda Option – Like the location of the Bermudas, this option is located somewhere
between a European style option which can be exercised only at maturity and an American style
option which can be exercised any time the option holder chooses. This option can be
exercisable only on predetermined dates
What kind of people will use derivatives?

Derivatives will find use for the following set of people: · Speculators: People who buy or sell in
the market to make profits. For example, if you will the stock price of Reliance is expected to go
upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits
· Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay
US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can
minimize his losses by buying a currency future at Rs 49/$ · Arbitrageurs: People who buy or
sell to make money on price differentials in Different markets. For example, a futures price is
simply the current price plus the interest cost. If there is any change in the interest, it presents an
arbitrage Opportunity. We will examine this in detail when we look at futures in a Separate
chapter. Basically, every investor assumes one or more of the above roles and derivatives Are a
very good option for him.
How has this market developed over time?
Derivatives have been a recent development in the Indian financial markets. But there have been
derivatives in the commodities market. There is Cotton and Oilseed futures in Mumbai, Soya
futures in Bhopal, Pepper futures in Cochin,Coffee futures in Bangalore etc. But the players in
these markets are restricted to big farmers and industries, who need these as an input to protect
themselves from the vagaries of agriculture sector. Globally too, the first derivatives started with
the commodities, way back in 1894. Financial derivatives are a relatively late development,
coming into existence only in the 1970’s. The first exchange where derivatives were traded is the
Chicago Board of Trade (CBOT).
In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000.
The first derivatives were index futures. The index used was Nifty. Option trading was started in
June 2001, for index as well as stocks. In November 2001, futures on stocks were allowed.
Currently, there are 30 stocks on which derivative trading is allowed The 30 stocks on which
trading is allowed currently are:
IMPACT OF DERIVATIVE MARKET ON FINANCIAL MARKETS:

Derivatives are becoming increasingly popular, so the obvious question is whether, and how,
they affect the stability of financial markets. Generally, derivatives improve the overall
allocation of risks within financial systems.
They do so in two ways:
• Derivatives make risk management more efficient and flexible especially at banks.
• Derivatives allow a more efficient distribution of individual risks and a related reduction of
aggregate risk within an economy. Nevertheless, a number of risk factors must be taken into
account:
• Poor market transparency makes it difficult at present to give an adequate assessment of
risk distribution. Initiatives to gain additional market information and set appropriate reporting
rules which reflect the interests of both the supervisory bodies and the market participants are
therefore to be welcomed.
• Risks attributable to poor contract wording (documentation risk) have already been largely
overcome thanks to the steadily ongoing development of standardized rules (ISDA).
• A high market concentration currently hinders the economically optimal allocation of risks,
although it does not directly endanger the stability of the financial markets. But the high
degree of concentration is expected to last only temporarily.
• There is no clear evidence so far that credit derivatives have systematically been wrongly
priced. However, this cannot be ruled out entirely at present –
Especially given the inexperience of some of the participants entering the market.
Systematically wrong pricing would result primarily in a misallocation of resources.
• The use of derivatives may change traditional incentive structures. This is mainly a theoretical
phenomenon. In practice, various mechanisms help to deal with the incentive problems which
could potentially increase risk. Risks associated with the use of credit derivatives will merit
special attention until The market has matured. Banks and financial markets will then benefit
additionally from their use and become more stable.
While derivatives are being used more and more in operative financial and risk management,
their long-term implications for the credit and financial markets are only beginning to
emerge. For the overall economy, the growing use of derivatives affects the stability of
Financial markets.
ROLE OF DERIVATIVES;-
Derivative markets help investors in many different ways:
RISK MANAGEMENT –
Derivatives are high-risk instruments and hence the exchanges have put up a lot of measures to
control this risk. he most critical aspect of risk management is the daily monitoring of price and
position and the margining of those positions. NSE uses the SPAN (Standard Portfolio Analysis
of Risk). SPAN is a system that has origins at the Chicago Mercantile Exchange, one of the
oldest derivative exchanges in the world. The objective of SPAN is to monitor the positions and
determine the maximum loss that a stock can incur in a single day. This loss is covered by the
exchange by imposing mark to market margins. SPAN evaluates risk scenarios, which are
nothing but market conditions.
The specific set of market conditions evaluated, are called the risk scenarios, and these are
defined in terms of: (a) how much the price of the underlying instrument is expected to change
over one trading day, and (b) how much the volatility of that underlying price is expected to
change over one trading day. Based on the SPAN measurement, margins are imposed and risk
covered. Apart from this, the exchange will have a minimum base capital of Rs 50 lacs and
brokers need to pay additional base capital if they need margins above the permissible limits
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.
Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk,
can transfer some of that risk to a person who wants to take more risk. Consider a risk averse
individual. He can obviously reduce risk by hedging. When he does so, the opposite position in
the market may be taken by a speculator who wishes to take more risk. Since people can alter
their risk exposure using futures and options, derivatives markets help in the raising of capital.
As an investor, you can always invest in an asset and then change its risk to a level that is more
acceptable to you by using derivatives.
PRICE DISCOVERY –
Price discovery refers to the markets ability to determine true equilibrium prices. Futures
prices are believed to contain information about future spot prices and help in disseminating such
information. As we have seen, futures markets provide a low cost trading mechanism. Thus
information pertaining to supply and demand easily percolates into such markets. Accurate
prices are essential for ensuring the correct allocation of resources in a free market. economy.
Options markets provide information about the volatility or risk of the underlying asset.
OPERATIONAL ADVANTAGES –
As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they
offer greater liquidity. Large spot transactions can often lead to significant price changes.
However, futures markets tend to be more liquid than spot markets, because herein you can take
large positions by depositing relatively small margins. Consequently, a large position in
derivatives markets is relatively easier to take and has less of a price impact as
opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take
a short position in derivatives markets than it is to sell short in spot markets.
MARKET EFFICIENCY –
The availability of derivatives makes markets more efficient; spot, futures and options
markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is
possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these
markets help to ensure that prices reflect true values.
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
fairmarkets. Speculators always take calculated risks. A speculator will accept a level of riskonly
if he is convinced that the associated expected return, is commensurate with the risk that he is
taking.
The derivative market performs a number of economic functions.

 The prices of derivatives converge with the prices of the underlying at the
expiration of derivative contract. Thus derivatives help in discovery of
future as well as current prices.
A  n important incidental benefit that flows from derivatives trading is that it
acts as a catalyst for new entrepreneurial activity.
D  erivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of
activity.
DEVELOPMENT OF DERIVATIVES MARKET IN INDIA:-

The first step towards introduction of derivatives trading in India was the promulgation of the
Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in
securities.
The market for derivatives, however, did not take off, as there was no regulatory framework to
govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of
Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for
derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing
necessary pre–conditions for introduction of derivatives trading in India.
The committee recommended that derivatives should be declared as ‘securities’ so that

regulatory framework applicable to trading of ‘securities’ could also govern trading of securities.
SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India. The report, which was
submitted in October 1998, worked out the operational details of margining system,
methodology for charging initial margins, broker net worth, deposit requirement and real–time
monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in
December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory
framework were developed for governing derivatives trading.
The act also made it clear that derivatives shall be legal and valid only if such contracts are
traded on a recognized stock exchange, thus precluding OTC derivatives. The government also
rescinded in March 2000, the three decade old notification, which prohibited forward trading in
securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to
this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE
and BSE, and their clearing house/corporation to commence trading and settlement in approved
derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on
S&P CNX Nifty and BSE–30 (Sense) index. This was followed by approval for trading in
options based on these two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on
individual stocks were launched in November 2001. The derivatives trading on NSE commenced
with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced
on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futures and options contract
on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in
accordance with the rules, byelaws, and regulations of the respective exchanges and their
clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign
Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.
The following are some observations based on the trading statistics provided in the NSE report
on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O segment. It
constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this
phenomenon is that traders are comfortable with single-stock futures than equity options, as the
former closely resembles the
erstwhile badla system.
• On relative terms, volumes in the index options segment continue to remain poor. This may be
due to the low volatility of the spot index. Typically, options are considered more valuable when
the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do
not earn high commissions by recommending index options to their clients, because low
volatility leads to higher waiting time for round-trips. Put volumes in the index options and
equity options segment have increased since January 2002. The call-put volumes in index
options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes
ratio suggests that the traders are increasingly becoming pessimistic on the
market.
• Farther month futures contracts are still not actively traded. Trading in equity options on most
stocks for even the next month was non-existent.
• Daily option price variations suggest that traders use the F&O segment as a less risky
alternative (read substitute) to generate profits from the stock price movements. The fact that the
option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as
just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one
impact on the option premiums.
The spot foreign exchange market remains the most important segment but the derivative
segment has also grown. In the derivative market foreign exchange swaps account for the largest
share of the total turnover of derivatives in India followed by forwards and options. Significant
milestones in the development of derivatives market have been (i) permission to banks to
undertake cross currency derivative transactions subject to certain conditions (1996) (ii) allowing
corporates to undertake long term foreign currency swaps that contributed to the development of
the term currency swap market (1997) (iii) allowing dollar rupee options (2003) and (iv)
introduction of currency futures (2008). I would like to emphasise that currency swaps allowed
companies with ECBs to swap their foreign currency liabilities into rupees. However, since
banks could not carry open positions the risk was allowed to be transferred to any other resident
corporate. Normally such risks should be taken by corporates who have natural hedge or have
potential foreign exchange earnings. But often corporate assume these risks due to interest rate
differentials and views on currencies.

SETTLEMENT OF DERIVATIVES:-
How are futures settled on the stock exchange?
Mark to market settlement:-
There is a daily settlement for Mark to Market .The profits/ losses are computed as the difference
between the trade price or the previous day’s settlement price, as the case may be, and the
current day’s settlement price. The party who have suffered a loss are required to pay the mark-
to-market loss amount to exchange which is in turn passed on to the party who has made a profit.
This is known as daily mark-to-market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not traded during
the last half an hour on a day, is currently the price computed as per the formula detailed below:
F = S * e rt where :
F = theoretical futures price
S = value of the underlying index/ stock
r = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)
t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may
be Specified.
After daily settlement, all the open positions are reset to the daily settlement price.
The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =
Trade day). The mark to market losses or profits are directly debited or credited to the broker
account from where the broker passes to the client account
Final Settlement:-
On the expiry of the futures contracts, exchange marks all positions to the final settlement price
and the resulting profit / loss is settled in cash.
The final settlement of the futures contracts is similar to the daily settlement process except for
the method of computation of final settlement price. The final settlement profit / loss is
computed as the difference between trade price or the previous day’s settlement price, as the case
may be, and the final settlement price of the relevant futures contract. Final settlement loss/
profit amount is debited/ credited to the relevant broker’s clearing bank account on T+1 day (T=
expiry day). This is then passed on the client from the broker. Open positions in futures contracts
cease to exist after their expiration day

How are options settled on the stock exchange?

Daily Premium Settlement
Premium settlement is cash settled and settlement style is premium style. The premium payable
position and premium receivable positions are netted across all option contracts for each broker
at the client level to determine the net premium payable or receivable amount, at the end of each
day. The brokers who have a premium payable position are required to pay the premium amount
to exchange which is in turn passed on to the members who have a premium receivable position.
This is known as daily premium settlement.
The brokers in turn would take this from their clients.
The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day). The
premium payable amount and premium receivable amount are directly debited or credited to the
broker, from where it is passed on to the client.
REGULATORY AND TAXATION ASPECTS OF DERIVATIVES
Since derivatives are a highly risky market, as experience world over has shown, there are tight
regulatory controls in this market. The same is true of India. In India, a committee was set up
under Dr L C Gupta to study the introduction of the derivatives market in India.
This committee formulated the guidelines and framework for the derivatives market and paved
the way for the derivatives market in India. There other committee that has far reaching
implications in the derivatives market is the J R Verma Committee. This committee has
recommended norms for trading in the exchange. A lot of emphasis has been laid on margining
and surveillance so as to provide a strong backbone in systems and processes and ensure
stringent controls in a risky market. As for the taxation aspect, the CBDT is treating gains from
derivative transactions as profit from speculation. Similarly losses in derivative transactions can
be treated as speculation losses for tax purpose.
India has started the innovations in financial markets very late. Some of the recent
developments initiated by the regulatory authorities are very important in this respect.
Futures trading have been permitted in certain commodity exchanges. Mumbai Stock
Exchange has started futures trading in cottonseed and cotton under the BOOE and under the
East India Cotton Association. Necessary infrastructure has been created by the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures and
the commencement of operations in selected scripts. Liberalized exchange rate management
system has been introduced in the year 1992 for regulating the flow of foreign exchange. A
committee headed by S.S.Tarapore was constituted to go into the merits of full convertibility on
capital accounts. RBI has initiated measures for freeing the interest rate structure. It has also
envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of London Inter Bank
Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest Rates and Forex.

Badla transactions have been banned in all 23 stock exchanges from July 2001. NSE has started
trading in index options based on the NIFTY and certain Stocks.
A. EQUITY DERIVATIVES IN INDIA
In the decade of 1990’s revolutionary changes took place in the institutional infrastructure in
India’s equity market. It has led to wholly new ideas in market design that has come to dominate
the market. These new institutional arrangements, coupled with the widespread knowledge and
orientation towards equity investment and speculation, have combined to provide an
environment where the equity spot market is now India’s most sophisticated financial market.
One aspect of the sophistication of the equity market is seen in the levels of market liquidity that
are now visible. The market impact cost of doing program trades of Rs.5 million at the NIFTY
index is around 0.2%. This state of liquidity on the equity spot market does well for the market
efficiency, which will be observed if the index futures market when trading commences. India’s
equity spot market is dominated by a new practice called ‘Futures – Style settlement’ or account
period settlement. In its present scene, trades on the largest stock exchange (NSE) are netted
from Wednesday morning till Tuesday evening, and only the net open position as of Tuesday
evening is settled.
The future style settlement has proved to be an ideal launching pad for the skills that are
required for futures trading. Stock trading is widely prevalent in India, hence it seems easy to
think that derivatives based on individual securities could be very important. The index is the
counter piece of portfolio analysis in modern financial economies. Index fluctuations affect all
portfolios.
The index is much harder to manipulate. This is particularly important given the weaknesses of
Law Enforcement in India, which have made numerous manipulative episodes possible. The
market capitalization of the NSE-50 index is Rs.2.6 trillion. This is six times larger than the
market capitalization of the largest stock and 500 times larger than stocks such as Sterlite, BPL
and Videocon. If market manipulation is used to artificially obtain 10% move in the price of a
stock with a 10% weight in the NIFTY, this yields a 1% in the NIFTY. Cash settlements, which
are universally used with index derivatives, also helps in terms of reducing the vulnerability to
market manipulation, in so far as the ‘short-squeeze’ is not a problem. Thus, index derivatives
are inherently less vulnerable to market manipulation.
A good index is a sound trade of between diversification and liquidity. In India the
traditional index- the BSE – sensitive index was created by a committee of stockbrokers in 1986.
It predates a modern understanding of issues in index construction and recognition of the pivotal
role of the market index in modern finance.
The flows of this index and the importance of the market index in modern finance motivated the
development of the NSE- 50 index in late 1995. Many mutual funds have now adopted the
NIFTY as the benchmark for their performance evaluation efforts. If the stock derivatives have
to come about, the should restricted to the most liquid stocks. Membership in the NSE-50 index

appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are assuredly the most liquid
stocks in India.
The choice of Futures vs. Options is often debated. The difference between these instruments is
smaller than, commonly imagined, for a futures position is identical to an appropriately chosen
long call and short put position. Hence, futures position can always be created once options exist.
Individuals or firms can choose to employ positions where their downside and exposure is
capped by using options. Risk management of the futures clearing is more complex when
options are in the picture. When portfolios contain options, the calculation of initial price
requires greater skill and more powerful computers. The skills required for pricing options are
greater than those required in pricing futures.
COMMODITY DERIVATIVES TRADING IN INDIA:-
In India, the futures market for commodities evolved by the setting up of the “Bombay Cotton
Trade Association Ltd.”, in 1875. A separate association by the name"Bombay Cotton Exchange
Ltd” was established following widespread discontent amongst leading cotton mill owners and
merchants over the functioning of the Bombay Cotton Trade Association. With the setting up of
the ‘Gujarati Vyapari Mandali” in 1900, the futures trading in oilseed began. Commodities like
groundnut, castor seed and cotton etc began to be exchanged. Raw jute and jute goods began to
be traded in Calcutta with the establishment of the “Calcutta Hessian Exchange Ltd.” in 1919.
The most notable centres for existence of futures market for wheat were the Chamber of
Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar,
Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar,
Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in U.P. The
Bullion Futures market began in Bombay in 1990. After the economic reforms in 1991 and the
trade liberalization, the Govt. of India appointed in June 1993 one more committee on Forward
Markets under Chairmanship of Prof. K.N. Kabra.
The Committee recommended that futures trading be introduced in basmati rice, cotton, raw
jute and jute goods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed,
safflower seed, copra and soybean, and oils and oilcakes of all of them, rice bran oil, castor oil
and its oilcake, linseed, silver and onions. All over the world commodity trade forms the major
backbone of the economy. In India, trading volumes in the commodity market have also seen a
steady rise - to Rs 5,71,000 crore in FY05 from Rs 1,29,000 crore in FY04. In the current fiscal
year, trading volumes in the commodity market have already crossed Rs 3,50,000 crore in the
first four months of trading. Some of the commodities traded in India include Agricultural
Commodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute, Rubber, Spices, Cotton,
Precious Metals like Gold & Silver, Base Metals like Iron Ore, Aluminium, Nickel, Lead, Zinc
and Energy Commodities like crude oil, coal. Commodities form around 50% of the Indian
GDP. Though there are no institutions or banks in commodity exchanges, as yet, the market for
commodities is bigger than the market for securities. Commodities market is estimated to be
around Rs 44,00,000 Crores in future. Assuming a future trading multiple is about 4 times the
physical market, in many countries it is much higher at around 10 times.

National Exchanges
In enhancing the institutional capabilities for futures trading the idea of setting up of National
Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National
Multi-Commodity Exchange of India Ltd., (NMCE), Ahmadabad, National Commodity &
Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai
have become operational. “National Status” implies that these exchanges would be automatically
permitted to conduct futures trading in all commodities subject to clearance of byelaws and
contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading
in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December
2003 respectively
SPECIAL ENTRY RULES FOR DERIVATIVES:-
BROKERS/DEALERS:-
No automatic entry for existing stock brokers

1. The Committee feels that the derivatives market will have to be subjected to more
stringent requirements than is the case with present cash markets. This implies that when
an existing exchange decides to start derivatives trading, the members of the existing
cash market will not automatically become members of the derivatives market. Only
those who satisfy the stricter eligibility conditions of the derivatives market will be
admitted to derivatives trading.
CAPITAL ADEQUACY:-
2. The experience of Indian exchanges has been that the credibility of the broker firm’s
balance sheet figures of net worth is questionable and that, in any case, a broker’s or
dealer’s stated net worth is very often not available to meet the claims payable to the
exchange. Hence, for effectively ensuring capital adequacy, principal reliance has to be
placed on the capital and margins actually deposited by the brokers/dealers with the
exchange. Taking note of the above, the views of the Committee regarding capital
adequacy requirements for derivatives brokers/dealers are presented below:
GUIDING CONSIDERATIONS:-
a. The absolute amount of minimum capital adequacy requirement for derivative

brokers/dealers has to be much higher than for cash market. Further, if a broker/dealer is
involved both in cash and futures segments, or in several exchanges, the capital adequacy
requirement should be satisfied for each exchange/segment separately. A decision on
minimum capital adequacy requirement involves balancing the need for ensuring
market’s integrity against the need for having sufficient participation of brokers/dealers

and sufficient competition. Too high a requirement may keep most Indian firms out of
the derivatives market.
CLEARING AND NON-CLEARING MEMBERS:-
b. In order to somewhat ease the constraint on participation in the derivatives market due to high
capital adequacy requirements, the Committee recommends that consideration may be given to a
two-level system of members, viz., Clearing Members and Non-Clearing Members, as found in
several countries, an example being the Singapore International Monetary Exchange. Under such
a system, net worth requirement for the Clearing Members is higher than for the Non-Clearing
members. The Non-Clearing members have to depend on the Clearing Members for settlement
of trades. The Clearing Member has to take responsibility for the non-clearing member’s
position so far as the Clearing Corporation is concerned. The Clearing Member thus becomes the
guarantor for the Non-Clearing members. In a sense, a Clearing Member has a number of
satellite traders for whom he takes financial responsibility towards the Clearing Corporation. The
advantage of the two-level system is that it can help to bring in more traders into derivatives
trading, thus enhancing the market’s liquidity.
NETWORTH AND INITIAL MARGIN:-

1. The Committee recommends that the Clearing Members of the derivatives exchange should
have a minimum net worth of Rs. 300 lakh as per SEBI’s definition and shall make a deposit of
Rs.50 lakh with the Exchange/Clearing Corporation in the form of liquid assets, such as Cash,
Fixed Deposits pledged in the name of the Exchange, or other securities. Bank Guarantee in lieu
of such deposit may also be accepted. The Clearing Corporation can permit clearing members to
clear the trades of non-clearing trading members. The regulations for the non-clearing trading
members shall be specified by the Derivatives Exchange/Division. The Committee further
recommends that the requirement of minimum net worth and deposit in case of Option writers
will need to be still higher. Certification Requirement.
2. The broker-members, sales persons/dealers in the derivatives market must have passed a
certification programmer which is considered adequate by SEBI.Registration with SEBI
3. Brokers/dealers of Derivatives Exchange/Division should be required to be registered as such
with SEBI. This would be in addition to their registration as brokers/dealers of any stock
exchange. SEBI may require registration of sales persons working at Derivatives brokerage
firms.

. Indian Market is not ready for derivative trading :-

While the fact is...Often the argument put forth against derivatives trading is that the Indian
capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which
are needed for the introduction of derivatives, and how Indian market fares:
PRE-REQUISITES INDIAN SCENARIO

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

functioning in the year 1997 has revolutionalised the security
settlement in our country.
A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of
India) today the Indian capital market enjoys a strong,
independent, and innovative legal guardian who is helping the
market to evolve to a healthier place for trade practices.

Disasters prove that derivatives are very risky and highly leveraged
instruments
While the fact is...
Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are
not necessarily due to dealing in derivatives, but derivatives make headlines... Here I have tried
to explain some of the important issues involved in disasters related to derivatives. Careful
observation will tell us that these disasters have occurred due to lack of internal controls and/or
outright fraud either by the employees or promoters.
Barings Collapse :-
1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index futures
of Nikkei 225 .
5. Market falls by more than 15% in the first two months of ’95 and Barings suffers huge
losses.
6. Bank looses $1.3 billion from derivative trading
7. Loss wipes out the entire equity capital of Barings The reasons for the collapse:
• Leeson was supposed to be arbitraging between Osaka Securities Exchange and SIMEX -- a
risk less strategy, while in truth it was an unhedged position.
• Leeson was heading both settlement and trading desk -- at most other banks the functions are
segregated, this helped Leeson to cover his losses -- Leeson was unsupervised.
• Lack of independent risk management unit, again a deviation from prudential norms.
There were no proper internal control mechanisms leading to the discrepancies going
unnoticed – Internal audit report which warned of "excessive concentration of power in
Leeson’s hands" was ignored by the top management.
The conclusion as summarised by Wall Street Journal article
" Bank of England officials said they did not regard the problem in this case as one peculiar to
derivatives. In a case where a trader is taking unauthorized positions, they said, the real question
is the strength of an investment houses’ internal controls and the external monitoring done by
Exchanges and Regulators. "

Metallgesellschaft
1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered
through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of oil products to its
clients -- commitments were quite large, equivalent to 85 days of Kuwait’s oil output .
3. MGRM created a hedge position for these long term contracts with short term futures
market through rolling hedge --, As there was no viable long term contracts available
4. Company was exposed to basis risk -- risk of short term oil prices temporarily deviating
from long term prices.
5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in cash. The
Company was faced with temporary funds crunch.
6. New management team decides to liquidate the remaining contracts, leading to a loss of
1.3 billion.
7. Liquidation has been criticized, as the losses could have decreased over time.
Auditors’ report claims that the losses were caused by the size of the trading exposure.
Reasons for the losses:

• The transactions carried out by the company were mainly OTC in nature and hence lacked
transparency and risk management system employed by a derivative exchange
• Large exposure
• Temporary funds crunch
Lack of matching long-term contracts, which necessitated the company to use rolling short term
hedge -- problem arising from the hedging strategy Basis risk leading to short term loss .
THE DERIVATIVES MARKETS PERFORM A NUMBER OF ECONOMIC

FUNCTIONS:
1. Price Discovery: - Prices in organized derivatives markets reflects the perception of

market participants about the future and lead the prices of underlying to 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
current price.
2. Transfer of risk: - The derivative market helps to transfer to the risks from those who
have them but may like them those who have an appetite for them. We can also term the
derivative market as the insurance company, whereby certain players assumes the risk by
receiving premium amount.
3. Increased volume in the cash market :- Derivatives due to their inherent nature are linked to
the underlying cash markets. With the introduction of derivative, the underlying market, witness
higher trading volumes because of participation by more players who would not otherwise
participate for lack of an arrangement to transfer risk.
4. New Entrepreneurial activities :- Derivatives have a history of attracting many bright,

creative, well-educated people with an entrepreneurial, new products and new employment
opportunities, the benefits of which are immense.
5. Increase in saving :- Derivatives market helps increase savings and investments in the
long run Transfer of risk enables market participants to expand their volume of activities.
6. Trading in controlled environment :- The introduction of the derivatives has shifted the
trading in speculative dealings in controlled market and the counter party risk has been
eliminated.
Participants in derivative market:-
1. Exchange, trading members, clearing members.

2. Hedgers, arbitrageurs, speculators.
3. Clearing, clearing bank.
4. Financial institutions.
5. Stock lenders and borrowers.
REASON FOR STARTING DERIVATIVES:-

1. Counter party risk on the part of broker, in case it ask money from us but
before giving delivery of shares goes bankrupt.
2. Liquidity risk in the form that the particular scrip might not be traded on
exchange.
3. Unsystematic risk in the form that the price of scrip may go up or down
due to “Company Specific Reasons”.
4. Mutual funds may find it difficult to invest the funds raised by them
properly as the scrip in which they want to invert might not be available at
• the right price.

THE TYPES OF DERIVATIVES MARKET:-

The Derivative Market can be classified as Exchange Traded Derivatives Market and Over the
Counter Derivative Market. Exchange Traded Derivatives are those derivatives which are traded
through specialized derivative exchanges whereas Over the Counter Derivatives are those which
are privately traded between two parties and involves no exchange or intermediary. Swaps,
Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC
market.
The main participants of OTC market are the Investment Banks, Commercial Banks, Govt.
Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through
traders to the clients like hedge funds and the rest. In the Exchange Traded Derivatives Market
or Future Market, exchange acts as the main party and by trading of derivatives actually risk is
traded between two parties. One party who purchases future contract is said to go “long” and the
person who sells the future contract is said to go “short”.
The holder of the “long” position owns the future contract and earns profit from it if the price of
the underlying security goes up in the future. On the contrary, holder of the “short” position is in
a profitable position if the price of the underlying security goes down, as he has already sold the
future contract. So, when a new future contract is introduced, the total position in the contract is
zero as no one is holding that for short or long.
The trading of foreign exchange traded derivatives or the future contracts has emerged as very
important financial activity all over the world just like trading of equity-linked contracts or
commodity contracts. The derivatives whose underlying assets are credit, energy or metal, have
shown a steady growth rate over the years around the world. Interest rate is the parameter which
influences the global trading of derivatives, the most.
IMPORTANCE OF DERIVATIVES TRADING:-

1. Reduction of borrowing cost.
2. Enhancing the yield on assets.
3. Modifying the payment structure of assets to correspond to investor market view.
4. No physical delivery of share certificate so reduction in cost by stampduty.
5. Increase in hedger, speculator and arbitrageurs.
6. It does not totally eliminate speculation, which is basic need of Indian
investors.

MARKET PLAYERS IN DERIVATIVE MARKET

The participants in the derivatives market are as follows:
TRADING PARTICIPANTS:
1.] HEDGERS
The process of managing the risk or risk management is called as hedging. Hedgers are
those individuals or firms who manage their risk with the help of derivative products.
Hedging does not mean maximizing of return. The main purpose for hedging is to reduce the
volatility of a portfolio by reducing the risk.
2.] SPECULATORS
Speculators do not have any position on which they enter into futures and options Market
i.e., they take the positions in the futures market without having position in the underlying cash
market. They only have a particular view about future price of a commodity, shares, stock index,
interest rates or currency. They consider various factors like demand and supply, market
positions, open interests, economic fundamentals, international events, etc. to make predictions.
They take risk in turn from high returns. Speculators are essential in all markets – commodities,
equity, interest rates and currency. They help in providing the market the much desired volume
and liquidity.
3.] ARBITRAGEURS
Arbitrage is the simultaneous purchase and sale of the same underlying in two different
markets in an attempt to make profit from price discrepancies between the two markets.
Arbitrage involves activity on several different instruments or assets simultaneously to take
advantage of price distortions judged to be only temporary.
Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps
prices of futures contracts aligned properly with prices of underlying assets. The objective is
simply to make profits without risk, but the complexity of arbitrage activity is such that it is
reserved to particularly well-informed and experienced professional traders, equipped with
powerful calculating and data processing tools. Arbitrage may not be as easy and costless as
presumed.
INTERMEDIARY PARTICIPANTS:
BROKERS
For any purchase and sale, brokers perform an important function of bringing buyers and
Sellers together. As a member in any futures exchanges, may be any commodity or finance, one
need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or
financial futures exchange one get a right to transact with other members of the same exchange.
This transaction can be in the pit of the trading hall or on online computer terminal. All persons
hedging their transaction exposures or speculating on price movement, need not be and for that
matter cannot be members of futures or options exchange.

A nonmember has to deal in futures exchange through member only. This provides a member the
role of a broker. His existence as a broker takes the benefits of the futures and options exchange
to the entire economy all transactions are done in the name of the member who is also
responsible for final settlement and delivery.
This activity of a member is price risk free because he is not taking any position in his account,
but his other risk is clients default risk. He cannot default in his obligation to the clearing house,
even if client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and
more involvement of nonmembers in hedging and speculation in futures and options market will
increase brokerage business for member and more volume in turn reduces the brokerage. Thus
more and more participation of traders other than members gives liquidity and depth to the
futures and options market. Members can attract involvement of other by providing efficient
services at a reasonable cost. In the absence of well functioning broking houses, the futures
exchange can only function as a club.
5.] MARKET MAKERS AND JOBBERS
Even in organized futures exchange, every deal cannot get the counter party immediately. It is
here the jobber or market maker plays his role. They are the members of the exchange who takes
the purchase or sale by other members in their books and Then Square off on the same day or the
next day. They quote their bid-ask rate regularly. The difference between bid and ask is known
as bid-ask spread. When volatility in price is more, the spread increases since jobbers price risk
increases. In less volatile market, it is less. Generally, jobbers carry limited risk. Even by
incurring loss, they square off their position as early as possible. Since they decide the market
price considering the demand and supply of the commodity or asset, they are also known as
market makers. Their role is more important in the exchange where outcry system of trading is
present.
A buyer or seller of a particular futures or option contract can approach that particular jobbing
counter and quotes for executing deals. In automated screen based trading best buy and sell rates
are displayed on screen, so the role of jobber to some extent. In any case, jobbers provide
liquidity and volume to any futures and option market.

INSTITUTIONAL FRAMEWORK:-
6.] EXCHANGE
Exchange provides buyers and sellers of futures and option contract necessary infrastructure to
trade. In outcry system, exchange has trading pit where members and their representatives
assemble during a fixed trading period and execute transactions. In online trading system,
exchange provide access to members and make available real time information online and also
allow them to execute their orders. For derivative market to be successful exchange plays a very
important role, there may be separate exchange for financial instruments and commodities or
common exchange for both commodities and financial assets.
7.] CLEARING HOUSE

A clearing house performs clearing of transactions executed in futures and option
exchanges. Clearing house may be a separate company or it can be a division of exchange. It
guarantees the performance of the contracts and for this purpose clearing house becomes counter
party to each contract. Transactions are between members and clearing house. Clearing house
ensures solvency of the members by putting various limits on him. Further, clearing house
devises a good managing system to ensure performance of contract even in volatile market. This
provides confidence of people in futures and option exchange. Therefore, it is an important
institution for futures and option market.
8.] CUSTODIAN / WARE HOUSE

Futures and options contracts do not generally result into delivery but there has to be smooth and
standard delivery mechanism to ensure proper functioning of market. In stock index futures and
options which are cash settled contracts, the issue of delivery may not arise, but it would be there
in stock futures or options, commodity futures and options and interest rates futures. In the
absence of proper custodian or warehouse mechanism, delivery of financial assets and
commodities will be a cumbersome task and futures prices will not reflect the equilibrium price
for convergence of cash price and futures price on maturity, custodian and warehouse are very
relevant.
9.] BANK FOR FUND MOVEMENTS

Futures and options contracts are daily settled for which large fund movement from
members to clearing house and back is necessary. This can be smoothly handled if a bank
works in association with a clearing house. Bank can make daily accounting entries in the
accounts of members and facilitate daily settlement a routine affair. This also reduces a
possibility of any fraud or misappropriation of fund by any market intermediary.
10.] REGULATORY FRAMEWORK

A regulator creates confidence in the market besides providing Level playing field to all
Concerned, for foreign exchange and money market, RBI is the regulatory authority so it can
take initiative in starting futures and options trade in currency and interest rates. For capital
market, SEBI is playing a lead role, along with physical market in stocks; it will also regulate the
stock index futures to be started very soon in India. The approach and outlook of regulator

New System Vs Existing System for Market Players
Speculators
Existing SYSTEM New
Approach Peril &Prize Approach Peril

&Prize
1) Deliver based 1) both profit & 1) Buy &Sell stocks 1) Maximum
Trading, margin loss to extent of on delivery basis loss possible
Trading& carry price change. 2) Buy Call &Put to premium
Forward transactions. By paying paid
2) Buy Index Futures premium
Hold till expiry.
Advantages
• Greater Leverage as to pay only the premium.
• Greater variety of strike price options at a given time.
Arbitrageurs
Existing SYSTEM New

&Prize
1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free
one and selling in whichever way the promising as still game.
Another exchange. Market moves. In weekly settlement
Forward transactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
More or less than Fair price

• Fair Price = Cash Price + Cost of Carry.
Hedgers
Existing SYSTEM New

&Prize
1) Difficult to 1) No Leverage 1) Fix price today to buy 1) Additional
Offload holding available risk latter by paying premium. Cost is only
During adverse reward dependant 2) For Long, buy ATM Put premium.
Market conditions on market prices Option. If market goes up,
as circuit filters long position benefit else
Limit to curtail losses. Exercise the option.
3) Sell deep OTM call option
With underlying shares, earn
Premium + profit with increase price
Advantages
Availability of Leverage
Small Investors
Existing SYSTEM New

&Prize
1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downside
Stocks else sell it. Implies unlimited based on market outlook remains
Profit/loss. 2) Hedge position if protected &
Holding underlying upside

Stock unlimited.
Advantages
• Losses Protected.
FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:-
The derivatives market in India has rapidly grown and is fast becoming very popular. It is
offering an alternate source for people to deploy investible surplus and make money out of it The
table below indicates the growth witnessed in the derivatives market. Factors contributing to the
explosive growth of derivatives are price volatility, globalization of the markets, technological
developments and advances in the financial theories.
A. PRICE VOLATILITYA price is what one pays to acquire or use something of value.
The objects having value maybe commodities, local currency or foreign currencies. The
concept of price is clear to almost everybody when we discuss commodities. There is a
price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays
for use of a unit of another persons money is called interest rate. And the price one pays
in one’s own currency for a unit of another currency is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers have ‘demand’ and
producers or suppliers have ‘supply’, and the collective interaction of demand and supply in the
market determines the price
.
These factors are constantly interacting in the market causing changes in the price over a short
period of time. Such changes in the price are known as ‘price volatility’. This has three factors:
the speed of price changes, the frequency of price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The break down of the BRETTON WOODS agreement
brought and 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 many
underdeveloped countries brought a new scale and dimension to the markets. Nations that were
poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-
Asian currency crisis of 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.
This price volatility risk pushed the use of derivatives like futures and options increasingly as
these instruments can be used as hedge to protect against adverse price changes in commodity,
foreign exchange, equity shares and bonds.

B. GLOBALISATION OF MARKETS :-
Earlier, managers had to deal with domestic economic concerns; what happened in other part of
the world was mostly irrelevant. Now globalization has increased the size of markets and as
greatly enhanced competition .it has benefited consumers who cannot obtain betterquality 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 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.
C. TECHNOLOGICAL ADVANCES :-
A significant growth of derivative instruments has been driven by technological break
through. Advances in this area include the development of high speed processors, network
systems and enhanced method of data entry. Closely related to advances in computer technology
are advances in telecommunications. Improvement in communications allow for instantaneous
world wide conferencing, Data transmission by satellite. At the same time there were significant
advances in software programmed without which computer and telecommunication advances
would be meaningless. These facilitated the more rapid movement of information and
consequently its instantaneous impact on market price. Although price sensitivity to market
forces is beneficial to the economy as a whole resources are rapidly relocated to more productive
use and better rationed overtime the greater price volatility exposes producers and consumers to
greater price risk.
The effect of this risk can easily destroy a business which is otherwise well managed.
Derivatives can help a firm manage the price risk inherent in a market economy. To the extent
the technological developments increase volatility, derivatives and risk management products
become that much more important.
D. ADVANCES IN FINANCIAL THEORIES –

Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed by Black
and Scholes in 1973 were used to determine prices of call and put options. In late 1970’s, work
of Lewis Edeington extended the early work of Johnson and started thehedging of financial price
risks with financial futures. The work of economic theorists gave rise to new products for risk
management which led to the growth of derivatives in financial markets. The above factors in
combination of lot many factors led to growth of derivatives instruments.

THE TREND OF DERIVATIVE MARKET IN INDIA:-
Derivative products made a debut in the Indian market during 1998 and overall progress of
derivatives market in India has indeed been impressive.
The Indian equity derivatives market has registered an "explosive growth" and is expected to
continue its dream run in the years to come with the various pieces that are crucial for the
market's growth slowly falling in place. Over the counter derivatives market in Interest Rate and
Foreign Exchange has also witnessed impressive growth with RBI allowing the local banks to
run books in Indian Rupee Interest Rate and FX derivatives.
The complexity of market continues to increase as clients have become savvier, demanding more
fine tuned solution to meet their risk management objectives, rather than using the vanilla
products. Besides Rupee derivatives offered by the local players, RBI has also allowed the client
to use more exotic products like barrier options. These products are offered by the local bank on
back-to-back basis, wherein they buy similar product from market maker from the offshore
markets.
The complexity of derivatives market has increased, but the growth in deployment of risk
management systems required to manage such complex business has not grown at the same pace.
The reason being, the very high cost of such system and absence of any local player who could
offer the solution, which could compete with product offered by the international
vendors.
TYPES OF DERIVATIVES MARKET
Exchange Traded Derivatives Over The Counter Derivatives
National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange

Index Future Index option Stock option Stock future Interest
rate Futures
DERIVATIVES MARKET GROWTH;-

The Derivatives Market Growth was about 30% in the first half of 2007 when it reached a size of
$US 370 trillion. This growth was mainly due to the increase in the participation of the bankers,
investors and different companies. The derivative market instruments are used by them to hedge
risks as well as to satisfy their speculative needs. The derivative market growth for different
derivative market instruments may be discussed under the following heads.
• Derivative Market Growth for the Exchange-traded-Derivatives:-

The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the
futures and options market grew by 38 % while the interest rate futures grew by 42%. Hence the
derivative market size for the futures and the options market was $49 trillion.
• Derivative Market Growth for the Global Over-the-Counter Derivatives:-

The contracts traded through Over-the-Counter market witnessed a 24 % increase in its face
value and the over-the -counter derivative market size reached $70,000 billion. This shows that
the face value of the derivative contracts has multiplied 30 times the size of the US economy.
Notable increases were recorded for foreign exchange, interest rate, equity and commodity based
derivative following an increase in the size of the Over-the Counter derivative market. The
Derivative Market Growth does not necessitate an increase in the risk taken by the different
investors. Even then, the overshoot in the face value of the derivative contracts shows that these
derivative instruments played a pivotal role in the financial market of today.
• Derivative Market Growth for the Credit Derivatives

The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market
growth is attributed to the increase in the trading in the synthetic collateral Debt obligations and
also to the electronic trading systems that have come into existence.
The Bank of International Settlements measures the size and the growth of the derivative market.
According to BIS, the derivative market growth in the over the counter derivative market
witnessed a slump in the second half of 2006. Although the credit derivative market grew at a
rapid pace, such growth was made offset by a slump somewhere else. The notional amount of the
Credit Default Swap witnessed a growth of 42%. Credit derivatives grew by 54%. The single
name contracts grew by 36%. The interest derivatives grew by 11%. The OTC foreign exchange
derivatives slowed by 5%, the OTC equity derivatives slowed by 10%. Commodity derivatives
also experienced crawling growth pattern.

How are options settled on the stock exchange?

Daily Premium Settlement
Premium settlement is cash settled and settlement style is premium style. The premium payable
position and premium receivable positions are netted across all option contracts for each broker
at the client level to determine the net premium payable or receivable amount, at the end of each
day. The brokers who have a premium payable position are required to pay the premium amount
to exchange which is in turn passed on to the members who have a premium receivable position.
This is known as daily premium settlement.
The brokers in turn would take this from their clients.
The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day). The
premium payable amount and premium receivable amount are directly debited or credited to the
broker, from where it is passed on to the client.
REGULATORY AND TAXATION ASPECTS OF DERIVATIVES:-

Since derivatives are a highly risky market, as experience world over has shown, there are tight
regulatory controls in this market. The same is true of India. In India, a committee was set up
under Dr L C Gupta to study the introduction of the derivatives market in India.
This committee formulated the guidelines and framework for the derivatives market and paved
the way for the derivatives market in India. There other committee that has far reaching
implications in the derivatives market is the J R Verma Committee. This committee has
recommended norms for trading in the exchange. A lot of emphasis has been laid on margining
and surveillance so as to provide a strong backbone in systems and processes and ensure
stringent controls in a risky market. As for the taxation aspect, the CBDT is treating gains from
derivative transactions as profit from speculation. Similarly losses in derivative transactions can
be treated as speculation losses for tax purpose.
India has started the innovations in financial markets very late. Some of the recent
developments initiated by the regulatory authorities are very important in this respect.
Futures trading have been permitted in certain commodity exchanges. Mumbai Stock
Exchange has started futures trading in cottonseed and cotton under the BOOE and under the
East India Cotton Association. Necessary infrastructure has been created by the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures and
the commencement of operations in selected scripts. Liberalized exchange rate management
system has been introduced in the year 1992 for regulating the flow of foreign exchange. A
committee headed by S.S.Tarapore was constituted to go into the merits of full convertibility on
capital accounts. RBI has initiated measures for freeing the interest rate structure. It has also
envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of London Inter Bank
Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest Rates and Forex.
Badla transactions have been banned in all 23 stock exchanges from July 2001. NSE has started
trading in index options based on the NIFTY and certain Stocks.
A. EQUITY DERIVATIVES IN INDIA:-
In the decade of 1990’s revolutionary changes took place in the institutional infrastructure in
India’s equity market. It has led to wholly new ideas in market design that has come to dominate
the market. These new institutional arrangements, coupled with the widespread knowledge and
orientation towards equity investment and speculation, have combined to provide an
environment where the equity spot market is now India’s most sophisticated financial market.
One aspect of the sophistication of the equity market is seen in the levels of market liquidity that
are now visible. The market impact cost of doing program trades of Rs.5 million at the NIFTY
index is around 0.2%. This state of liquidity on the equity spot market does well for the market
efficiency, which will be observed if the index futures market when trading commences. India’s
equity spot market is dominated by a new practice called ‘Futures – Style settlement’ or account
period settlement. In its present scene, trades on the largest stock exchange (NSE) are netted
from Wednesday morning till Tuesday evening, and only the net open position as of Tuesday
evening is settled. The future style settlement has proved to be an ideal launching pad for the
skills that are required for futures trading. Stock trading is widely prevalent in India, hence it
seems easy to think that derivatives based on individual securities could be very important.
The index is the counter piece of portfolio analysis in modern financial economies. Index
fluctuations affect all portfolios. The index is much harder to manipulate. This is particularly
important given the weaknesses of Law Enforcement in India, which have made numerous
manipulative episodes possible.
The market capitalization of the NSE-50 index is Rs.2.6 trillion. This is six times larger than the
market capitalization of the largest stock and 500 times larger than stocks such as Sterlite, BPL
and Videocon. If market manipulation is used to artificially obtain 10% move in the price of a
stock with a 10% weight in the NIFTY, this yields a 1% in the NIFTY. Cash settlements, which
are universally used with index derivatives, also helps in terms of reducing the vulnerability to
market manipulation, in so far as the ‘short-squeeze’ is not a problem. Thus, index derivatives
are inherently less vulnerable to market manipulation.
A good index is a sound trade of between diversification and liquidity. In India the
traditional index- the BSE – sensitive index was created by a committee of stockbrokers in 1986.
It predates a modern understanding of issues in index construction and recognition of the pivotal
role of the market index in modern finance.

The flows of this index and the importance of the market index in modern finance motivated the
development of the NSE- 50 index in late 1995. Many mutual funds have now adopted the
NIFTY as the benchmark for their performance evaluation efforts. If the stock derivatives have
to come about, the should restricted to the most liquid stocks. Membership in the NSE-50 index
appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are assuredly the most liquid
stocks in India.
The choice of Futures vs. Options is often debated. The difference between these instruments is
smaller than, commonly imagined, for a futures position is identical to an appropriately chosen
long call and short put position. Hence, futures position can always be created once options exist.
Individuals or firms can choose to employ positions where their downside and exposure is
capped by using options. Risk management of the futures clearing is more complex when
options are in the picture. When portfolios contain options, the calculation of initial price
requires greater skill and more powerful computers. The skills required for pricing options are
greater than those required in pricing futures.

CHAPTER 6
ANALYSIS AND
INTERPRITATION
OF DATA

1.
Education No. of result

Under graduate 6
Graduate 10
Post graduate 23
professional 11

2.
Income range No. of Result

below 1,50,000 1
1,50,000-3,00,000 9
3,00,000-5,00,000 14
above 5,00,000 26

3.
Investment No. of result

Between 5% to 10% 2
Between 11% to 15% 6
More than 25% 11

4.
Risk in stock market No.of result

Uncertainty of returns 19
Slump in stock market 22
Fear of windup of company 6
Others 3

5.
Reasons No.of result

Lack of knowledge & understanding 27
Increase speculation 2
Risky & highly leveraged 17
Counter party risk 4

6.
OPTIONS NO. of Result

Relative level of stability in overall investment
portfolio. 17
increasing investment value while minimizing
potential for loss of principal 19
Investment growth with moderate high levels of risk. 4
Maximum long term returns with high risk . 10

7.
Participate in No. of Result
Stock index futures 19
Stock index Options 13
Future on individual stock 6
Currency futures 9
Options on individual
stock 3

INTERPRETATION:-
 Most of the investors who invest in derivatives market are post graduate.
 Investors who invest in derivative market have a income of above 5,00,000
 Investors generally perceive slump in stock market kind of risk while investing in
derivative market.
 People are generally not investing in derivative market due to lack of knowledge and
difficulty in understanding and it is very risky also.
 Most of investor purpose of investing in derivative market is to hedge their fund.
 People generally participate in derivative market as a investor or hedger.
 People generally prefer to take advice from news network before investing in derivative
market.
 Most of investors participate in stock index futures.

CHAPTER-7

FINDINGS, CONCLUSIONS
AND
RECOMMENDATIONS
FINDING
Business Growth in Derivatives segment (NSE)
PER YEAR NUMBER OF CONTRACTS
2009-10 8516649
2008-09 156598579
2007-08 81487424
2006-07 58537886

2005-06 21635449
2004-05 17191668
2003-04 2126763
2002-03 1025580
2001-02 5533424
INTERPRETATION: From the data and the bar diagram above, there is high
business growth in the derivative segment in India. In the year 2001-02, the number of contracts
in Index Future were 5533424 where as a significant increase of 8516649 is observed in the year
2009-10.
From the above analysis I found that:
1. Derivative market is growing very fast in the Indian Economy. The turnover of Derivative
Market is increasing year by year in the India’s largest stock exchange NSE. In the case of
index future there is a phenomenal increase in the number of contracts. But whereas the
turnover is declined considerably. In the case of stock future there was a slow increase

observed in the number of contracts whereas a decline was also observed in its turnover. In
the case of index option there was a huge increase observed both in the number of contracts
and turnover.
2. After analyzing data it is clear that the main factors that are driving the growth of Derivative
Market are Market improvement in communication facilities as well as long term saving &
investment is also possible through entering into Derivative Contract. So these factors
encourage the Derivative Market in India.
3. It encourages entrepreneurship in India. It encourages the investor to take more risk & earn
more return. So in this way it helps the Indian Economy by developing entrepreneurship.
Derivative Market is more regulated & standardized so in this way it provides a more controlled
environment. In nutshell, we can say that the rule of High risk & High return apply in
Derivatives. If we are able to take more risk then we can earn more profit under Derivatives.
RELIANCE is the most active future contracts on individual securities traded with 90090
contracts and RNRL is the next most active futures
CONCLUSION:-
From the above analysis i can conclude that:
1. Derivatives like forwards, futures, options, swaps etc are extensively used in the country.
After this study we know however, the commodity derivatives have been utilized in a

very limited scale. Only forwards and futures trading are permitted in certain commodity
items.
2. Derivative Market is more regulated & standardized so in this way it provides a more
controlled environment. In nutshell, we can say that the rule of High risk & High return
apply in Derivatives. If we are able to take more risk then we can earn more profit under
3. No doubt that derivative growth towards the progress of economy is positive. But the problem
confronting the derivative market segment is giving its low customer base. Commodity
derivatives have a crucial role to play in the price risk management process for the
commodities in which it deals. And it can be extremely beneficial in agriculture-
dominated economy, like India, as the commodity market also involves agricultural
produce.
4. Derivative market is growing very fast in the Indian Economy . derivative products
initially emerged as hedging devices against fluctuation and commodity prices
5. After analyzing data it is clear that the main factors that are driving the growth of
Derivative Market are Market improvement in communication facilities as well as long
term saving & investment is also possible through entering into Derivative Contract. So
these factors encourage the Derivative Market in India.
RECOMMENDATION-
 RBI should play a greater role in supporting derivatives.
 Derivatives market should be developed in order to keep it at par with other derivative
markets in the world.
 Speculation should be discouraged.

 There must be more derivative instruments aimed at individual investors.

 SEBI should conduct seminars regarding the use of derivatives to educate Individual
investors.
 After study it is clear that Derivative influence our Indian Economy up to much extent.
So, SEBI should take necessary steps for improvement in Derivative Market so that more
investors can invest in Derivative market.
 There is a need of more innovation in Derivative Market because in today scenario even
educated people also fear for investing in Derivative Market Because of high risk
involved in Derivatives.
BIBLIOGRAPHY-
Books referred:
  Options Futures, and other Derivatives by John C Hull
  Derivatives in stock market by Aparna bellur.
  Financial Markets & Services by Gordon & Natarajan
 financial services


Reports:
Report of the RBI-SEBI standard technical committee on exchange traded
Currency Futures.
 Regulatory Framework for Financial Derivatives in India by Dr.L..C.GUPTA
Websites visited:
 www.nse-india.com
 www.bseindia.com
 www.sebi.gov.in
 www.ncdex.com
 www.google.com
 www.derivativesindia.com

QUESTINOIRE:-
1. Educational Qualification
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Undergraduate
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Graduate
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Post Graduate
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Professional Degree Holder
2. Income Range:
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Below 1,50,000
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 1,50,000 – 3,00,000
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 3,00,000 – 5,00,000
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Above 5,00,000
3. Normally what percentage of your monthly household income could be available for
investment?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Between 5% to 10%
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect More than 25%
4. What kind of risk do you perceive while investing in the stock market?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Uncertainty of returns
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Slump in stock market
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Fear of being windup of company
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Other (Specify)
_________________
5. Why people do not invest in derivative market?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Lack of knowledge and difficulty
in understanding
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Increase speculation
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Very risky and highly leveraged
instrument
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Counter party risk
6. What is the purpose of investing in derivative market?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect To hedge their fund
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Risk control
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect More stable
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Direct investment without buying
and holding assets
7. From where you prefer to take advice before investing in derivative market?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Brokerage houses
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Research analyst
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Websites
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect News Networks
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Other (Specify)
_________________
8. In which of the following would you like to participate?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Stock Index Futures
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Stock Index Options
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Future on individual stock
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Options on individual stock
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Currency futures
9. What contract maturity period would interest you for trading in?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect 1 month

10. Which of the following statements best describes your overall approach to invest as a mean
of achieving your goals?
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Having a relative level of stability
in my overall investment portfolio.
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Moderately increasing my
investment value while minimizing potential for loss of
principal.
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Pursue investment growth,
accepting moderate to high levels of risk and
principal fluctuation.
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Seek maximum long-term returns,
accepting maximum risk with principal
fluctuation.
11. What was the result of your investment?

<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Great results
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Moderate but acceptable
<INPUT TYPE=\ RADIO > MACROBUTTON HTMLDirect Disappointed

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Derivative in stock market

“DERIVATIVE IN STOCK MARKET”

Submitted in partial fulfillment of the requirements for the award of

Master of Business Administration

Punjab Technical University

“Abhishek Kumar Srivastava”

Under the guidance of

“Dr. V.B. Padmanabhan”

#70, 2nd Main Road, 3rd Cross, Kanaka Nagar, Nagawara,

BANGALORE – 560 032

International Institute Of Business Studies Page 1

Date: Signature of the Student

Place: (Abhishek kumar srivastava)

International Institute Of Business Studies Page 2

(Name & Designation of the Signatory)

(Acknowledgement by the Student on Plain Paper)

International Institute Of Business Studies Page 3

Date: Signature of the Student

Place: (Abhishek kumar srivastava)

International Institute Of Business Studies Page 4

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CHAPTERS CONTENTS PAGE NOS.

HISTORY OF THE DERIVATIVES 37-68

6. ANALYSIS & INTERPRETATION OF

7. SUMMARY OF FINDINGS, CONCLUSIONS

International Institute Of Business Studies Page 7

International Institute Of Business Studies Page 9

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OTHERS LIKE SWAPS,

International Institute Of Business Studies Page 11

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forword future option swaps

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BASIC FEATURES OF FORWARD CONTRACT:-

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

(ii) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or

International Institute Of Business Studies Page 14

BASIC FEATURES OF FUTURE CONTRACT

The currency in which the futures contract is quoted.

Mark to market Margin:

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PRICING OF FUTURE CONTRACT:-

In the case where the forward price is higher:

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(on the spot market); he invests the proceeds.

What the terminologies used in a Futures contract?

How is a future useful for me to hedge my position?

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DISTINCTION BETWEEN FUTURES AND FORWARDSCONTRACTS

FEATURES FORWARD CONTRACT FUTURE CONTRACT

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Operational Traded directly between two Traded on the exchanges.

Contract Differ from trade to trade. Contracts are standardized contracts.

Counter-party Exists. Exists. However, assumed by the clearing

Liquidation Low, as contracts are tailor High, as contracts are standardized

Examples Currency market in India. Commodities, futures, Index Futures and

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INTEREST RATE SWAPS:

International Institute Of Business Studies Page 20

To lower financing cost –

OTHER KINDS OF DERIVATIVES:-