RESEARCH PROJECT REPORT

ON
“A STUDY OF DERIVATIVES – THE INDIAN
CAPITALMARKET”
By
“Raj Srivastav”
“2300520700048”

Under the guidance of

“Dr. Shilpi Jauhari”

In partial fulfilment of the requirement for the award of the Degree

of aster of Business Administration

Submitted at

DEPARTMENT OF BUSINESS ADMINISTRATION

INSTITITUTE OF ENGINEERING AND TECHNOLOGY JANKIPURAM
LUCKNOW, UP-226021

1
 Department of Business Administration
Institute of Engineering & Technology Lucknow
STUDENT DECLARATION

I undersigned, hereby declare that the project titled “A STUDY OF DERIVATIVES – THE INDIAN

CAPITAL MARKET”submitted in partial fulfilment for the award of Degree of Master of Business

Administration is a bonafide record of work done by me under the guidance of Dr. Shilpi Jauhari. This report

has not previously formed the basis for the award of any degree, diploma, or similar title of any

University.

Place : LUCKNOW

Date :

Signature of the Student

Raj Srivastav
2300520700048

2
 Department of Business Administration
Institute of Engineering & Technology Lucknow

CERTIFICATE FROM INSTITUTE

This is to certify that Mr. Raj Srivastav , Fourth semester student of Master of Business

Administration, Institute of Engineering & Technology, Sitapur Road, Lucknow has completed the

project report entitled in partial fulfilment of the requirements for the award of the Degree of Master of

Business Administration.

Place: LUCKNOW

Date:

Dr. Shilpi Jauhari

Convener

3
 Department of Business Administration
Institute of Engineering & Technology Lucknow

CERTIFICATE FROM FACULTY GUIDE

This is to certify that Mr. Raj Srivastav , Fourth semester student of Master of Business

Administration, Institute of Engineering & Technology, Sitapur Road, Lucknow has completed the

project report entitled “A STUDY OF DERIVATIVES – THE INDIAN CAPITAL MARKET”

towards partial fulfilment of the requirement for the award of the Degree of Master of Business

Administration under my supervision.

Place: LUCKNOW

Date:

Signature of the Faculty Guide

Dr. Shilpi Jauhari

4
 PREFACE

The Indian capital market has undergone significant transformations over the past few decades,

evolving into a dynamic and sophisticated financial system. Among the various instruments that

have contributed to this evolution, derivatives stand out for their role in enhancing market

efficiency, providing avenues for risk management, and fostering liquidity. This study aims to

delve into the intricate world of derivatives within the context of the Indian capital market. It seeks

to provide a comprehensive understanding of the types, functions, and impacts of derivatives on

the market's overall stability and growth. By examining the historical development, regulatory

framework, and current trends, this study endeavors to offer insights into how derivatives have

shaped, and continue to shape, the financial landscape in India. The research presented herein is a

product of extensive analysis and synthesis of data from various sources, including academic

literature, market reports, and expert interviews. It aims to cater to a diverse audience comprising

academics, practitioners, policymakers, and students who are keen to understand the nuances of

derivative instruments and their implications for the Indian capital market. As the Indian economy

continues to integrate with the global financial system, understanding derivatives becomes

increasingly crucial. This study not only highlights the opportunities presented by derivatives but

also underscores the risks and challenges associated with them. By doing so, it aspires to contribute

to the ongoing discourse on financial market development and stability in India. We hope that this

study will serve as a valuable resource for those interested in the dynamics of the Indian capital

market and will inspire further research and discussion in this field.

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 TABLE OF CONTENT

S. NO. Topic Page No.

1 Introduction 6-12

2 Objective 13

3 Research Methodology 14-16

4 Indian Capital Market 17-26

5 Global Derivatives Market 27-60

6 Indian Derivatives Market 61-71

7 Users of Derivatives 72-92

8 Analysis of Derivatives In Indian Capital Market 93-94

9 Findings & Conclusion 95-98

10 Limitation 99-100

11 Recommendation 101-102

12 Bibliography 103-104

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INTRODUCTION OF
DERIVATIVES

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INTRODUCTION OF DERIVATIVES:-

The origin of derivative can be traced back to the need of formers to protect themselves against

fluctuation in the price of their crops. From the time it was sown to the time it was ready for

harvest, farmers would face price uncertainty. Through the use of simple derivatives products, it

was possible for the farmers to partially or fully transfer price risk by locking – in assets prices.

These were simple contracts developed to meet the needs of farmers and basically a means of

reducing risks.

A farmer who sowed his crops in June face uncertainty over the price of he would receive for his

harvest in September. In years of scarcity, he would probably obtain attractive prices. However,

during times of over supply, he would have to dispose off his harvest at a very low price. Clearly

this meant that the farmer and his family were expose to a high risk of uncertainty.

On the other hand, a merchant with an ongoing requirement of grain too would face a price risk

and that of having to pay exorbitant prices during dearth, although favorable prices could be

obtained during period of over supply. Under such circumstances, it clearly made sense for the

farmer and the merchant to come together and enter in a contract whereby the price of the grain to

be delivered in September could be decided earlier. What they would then negotiate happened to

be a futures-type contract, which would enable both parties to eliminate the price risk.

In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchant

together. A group of traders got together and create the ‘to-arrive’ contract that permitted farmers

to lock in to price un front and deliver the grain later. These to-arrive contracts proved useful as a

device for hedging and speculation on price changes. These were eventually standardized, and in

1925 the first futures clearing house came into existence.

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Today, derivative contract exist on a variety of commodities such as corn, pepper, cotton, wheat,

silver, etc. besides commodities, derivatives contracts also exist on a lot of financial underlying

like, interest rate, exchange rate etc.

Derivatives Defined:-

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived

from the value of an underlying primary financial instrument, commodity or index, such as:

interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes

in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.

Hedging is the most important aspect of derivatives and also its basic economic purpose. There has

to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives as

means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers in

pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.

Participants in Derivatives Markets:-

Hedgers

These are markets players who wish to protect an existing asset position from future adverse price

movements.

Speculator

A speculator is a one who accepts the risk that hedgers wish to transfer. Speculators have no

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position to protect and do not necessarily have the physical resources to make delivery of the

underlying asset nor do they necessarily need to take delivery of the underlying asset. They take

positions on their expectations of futures price movements and in order to make a profit. In general

they buy futures contracts when they expect futures prices to rise and sell futures contract when

they expect futures prices to fall.

Arbitrageurs

These are traders and market makers who deal in buying and selling futures contracts hoping to

profit from price differentials between markets and/or exchanges.

Types of Derivatives :-

The common derivatives are futures, options, forward contracts, swaps etc. These are described

below.

Futures

A Future represents the right to buy or sell a standard quantity and quality of an asset or security

at a specified date and price. Futures are similar to Forward Contracts, but are standardized and

traded on an exchange, and settlement of financial obligation happens at the end of each trading

day under the terms of future. Unlike Forward Contracts, the counterparty to a Futures contract is

the clearing Corporation on the appropriate exchange. Futures often are settled in cash or cash

equivalents, rather than requiring physical delivery of the underlying asset.

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Options

An Option gives holder the right (but not the obligation) to buy or sell a security or other asset

during a given time for a specified price called the 'Strike' price. An Option to buy is known as a

Call Option and an Option to sell is called a Put Option. One can purchase Options (the right to

buy or sell the security) or sell (write) Options. As a seller, one would become obligated to sell a

security to or buy a security from the party that purchased the Option. In order to acquire the right

of option, the option buyer pays to the option seller (known as "option writer") an Option

Premium. The buyer of an option can lose an amount no more than the option premium paid but

his possible gain in unlimited. On the other hand, the option writer’s possible loss is unlimited but

his maximum gain is limited to the option premium charged by him to the holder. Option premium

is calculated using option pricing models like Black Scholes Model etc.

Forwards

In a Forward Contract, the purchaser and its counter party are obligated to trade a security or other

asset at a specified date in the future. The price paid for the security or asset is agreed upon at the

time the contract is entered into, or may be determined at delivery. Forward Contracts generally

are traded OTC.

Swaps

A Swap is a simultaneous buying and selling of the same security or obligation. It can be an

agreement in which two parties exchange interest payments based on an identical principal

amount, called the notional principal amount. This is the most common type of Swap and also

known as plain vanilla swap.

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Warrant

Options generally have the life of up to one year, the majority of options traded on options

exchange having a maximum maturity of nine months. Longer-dated options are called warrants

and are generally traded over the counter.

Leaps

The acronym LEAPS means long term Equity Anticipation Securities. These are option having a

maturity of up to thee years.

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 swaption and payer Swaptions. A receiver swaption is an opinion to receive

fixed and pay floating. A payer swaption is an option to pay fixed and received floating.

Factors driving the growth of financial derivatives:-

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

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3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks anreturns over

large number of financial assets leading to higher returns, reduced risk as well as

transactions costs as compared to individual financial assets.

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 OBJECTIVES

 To study Indian derivatives market.

 To study different constituents of Indian derivatives market e.g. commodity derivatives

market, foreign exchange derivatives market and exchange traded financial derivatives

market.

 To study the various regulatory requirements of derivatives market of India.

 Comparative study of cash market and derivatives market of India.

 Comparative study of Indian derivatives market and global derivatives market.

 It is analyze the changes in trading after the exchange shifted from country to online

trading system.

 To know about the latest and future development in the stock exchange trading system.

 To know frequency of trading.

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 RESEARCH
METHODOLOGY

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 RESEARCH METHODOLOGY

Research problem

“A Study of Derivatives in the Indian capital market”

Research Objective

The main objective of the study is to do the detailed analysis of the trading of derivatives in the

capital market in Indian context and this is also includes the study of:

 Meaning

 Type

 Trading

 Clearing & settlement

 Regulatory framework

Research Design

A research design specifies the methods and procedure for conducting a particular study. One has

to specify the approach he intends to use with respect to the proposed study. Broadly speaking,

research design can be grouped into three categories.

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EXPLORATORY: Focuses on discovery on ideas and generally based on secondary data.

DISCRIPTIVE: It is undertaken when the research wants to know the characteristics of certain

groups such as age, sex, educational level, income, occupation etc.

CASUAL: It is undertaken when the researcher is interested in knowing the cause and effect

relationship between two or more variables.

The research design of my study is “DISCRIPTIVE”

DATA SOURCES

Research is based on secondary data that has been collected from various sources like internet,

journals, magazines and books etc. (see Bibliography also)

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INDIAN CAPITAL
MARKET

18
 INDIAN CAPITAL MARKET: AN OVERVIEW:-

Evolution

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago.

The earliest records of security dealings in India are meager and obscure. The East India Company

was the dominant institution in those days and business in its loan securities used to be transacted

towards the close of the eighteenth century.

By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in

Bombay. Thou the trading list was broader in 1839, there were only half a dozen brokers

recognized by banks and merchants during 1840 and 1850.

The 1850's witnessed a rapid development of commercial enterprise and brokerage business

attracted many men into the field and by 1860 the number of brokers increased into 60.

In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was

stopped; thus, the 'Share Mania' in India begun. The number of brokers increased to about 200 to

250. However, at the end of the American Civil War, in 1865, a disastrous slump began (for

example, Bank of Bombay Share which had touched Rs 2850 could only be sold at Rs. 87).

At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a

place in a street (now appropriately called as Dalal Street) where they would conveniently

assemble and transact business. In 1887, they formally Maple established in Bombay, the "Native

Share and Stock Brokers' Association" (which is alternatively known as “The Stock Exchange ").

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In 1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899.

Thus, the Stock Exchange at Bombay was consolidated.

Other leading cities in stock market operations:-

Ahmedabad gained importance next to Bombay with respect to cotton textile industry. After 1880,

many mills originated from Ahmedabad and rapidly forged ahead. As new mills were floated, the

need for a Stock Exchange at Ahmedabad was realized and in 1894 the brokers formed "The

Ahmedabad Share and Stock Brokers' Association".

What the cotton textile industry was to Bombay and Ahmedabad, the jute industry was to Calcutta.

Also tea and coal industries were the other major industrial groups in Calcutta. After the Share

Mania in 1861-65, in the 1870's there was a sharp boom in jute shares, which was followed by a

boom in tea shares in the 1880's and 1890's; and a coal boom between 1904 and 1908. On June

1908, some leading brokers formed "The Calcutta Stock Exchange Association".

In the beginning of the twentieth century, the industrial revolution was on the way in India with the

Swadeshi Movement; and with the inauguration of the Tata Iron and Steel Company Limited in

1907, an important stage in industrial advancement under Indian enterprise was reached.

Indian cotton and jute textiles, steel, sugar, paper and flour mills and all companies generally

enjoyed phenomenal prosperity, due to the First World War.

In 1920, the then demure city of Madras had the maiden thrill of a stock exchange functioning in

its midst, under the name and style of "The Madras Stock Exchange" with 100 members. However,

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when boom faded, the number of members stood reduced from 100 to 3, by 1923, and so it went

out of existence.

In 1935, the stock market activity improved, especially in South India where there was a rapid

increase in the number of textile mills and many plantation companies were floated. In 1937, a

stock exchange was once again organized in Madras - Madras Stock Exchange Association (Pvt)

Limited. (In 1957 the name was changed to Madras Stock Exchange Limited).

Lahore Stock Exchange was formed in 1934 and it had a brief life. It was merged with the Punjab

Stock Exchange Limited, which was incorporated in 1936.

Indian Stock Exchanges - An Umbrella Growth:-

The Second World War broke out in 1939. It gave a sharp boom which was followed by a slump.

But, in 1943, the situation changed radically, when India was fully mobilized as a supply base.

On account of the restrictive controls on cotton, bullion, seeds and other commodities, those

dealing in them found in the stock market as the only outlet for their activities. They were anxious

to join the trade and their number was swelled by numerous others. Many new associations were

constituted for the purpose and Stock Exchanges in all parts of the country were floated.

The Uttar Pradesh Stock Exchange Limited (1940), Nagpur Stock Exchange Limited (1940) and

Hyderabad Stock Exchange Limited (1944) were incorporated.

In Delhi two stock exchanges - Delhi Stock and Share Brokers' Association Limited and the Delhi

Stocks and Shares Exchange Limited - were floated and later in June 1947, amalgamated into the

Delhi Stock Exchange Association Limited.

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Post-independence Scenario:-

Most of the exchanges suffered almost a total eclipse during depression. Lahore Exchange was

closed during partition of the country and later migrated to Delhi and merged with Delhi Stock

Exchange.

Bangalore Stock Exchange Limited was registered in 1957 and recognized in 1963. Most of the

other exchanges languished till 1957 when they applied to the Central Government for recognition

under the Securities Contracts (Regulation) Act, 1956. Only Bombay, Calcutta, Madras,

Ahmedabad, Delhi, Hyderabad and Indore, the well established exchanges, were recognized under

the Act. Some of the members of the other

Associations were required to be admitted by the recognized stock exchanges on a confessionals

basis, but acting on the principle of unitary control, all these pseudo stock exchanges were refused

recognition by the Government of India and they thereupon ceased to function.

Thus, during early sixties there were eight recognized stock exchanges in India (mentioned above).

The number virtually remained unchanged, for nearly two decades. During eighties, however,

many stock exchanges were established: Cochin Stock Exchange (1980), Uttar Pradesh Stock

Exchange Association Limited (at Kanpur, 1982), and Pune Stock Exchange Limited (1982),

Ludhiana Stock Exchange Association Limited (1983), Gauhati Stock Exchange Limited (1984),

Kanara Stock Exchange Limited (at Mangalore, 1985), Magadh Stock Exchange Association (at

Patna, 1986), Jaipur Stock Exchange Limited (1989), Bhubaneswar Stock Exchange Association

Limited (1989), Saurashtra Kutch Stock Exchange Limited (at Rajkot, 1989), Vadodara Stock

Exchange Limited (at Baroda, 1990) and recently established exchanges - Coimbatore and Meerut.

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Thus, at present, there are totally twenty one recognized stock exchanges in India excluding the

Over the Counter Exchange of India Limited (OTCEI) and the National Stock Exchange of India

Limited (NSEIL).

The Table given below portrays the overall growth pattern of Indian stock markets since

independence. It is quite evident from the Table that Indian stock markets have not only grown just

in number of exchanges, but also in number of listed companies and in capital of listed companies.

The remarkable growth after 1985 can be clearly seen from the Table, and this was due to the

favoring government policies towards security market industry.

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 GROWTH PATTERN OF THE INDIAN STOCK MARKET:-

As on 31st 1946 1961 1971 1975 1980 1985 1991 1995 2013
Sl.No.
December

No. of 7 7 8 8 9 14 20 22 25
1
Stock Exchanges

No. of 1125 1203 1599 1552 2265 4344 6229 8593 11212
2
Listed Cos.

No. of Stock 1506 2111 2838 3230 3697 6174 8967 11784 13215

3 Issues of

Listed Cos.

Capital of Listed 270 753 1812 2614 3973 9723 32041 59583 68732
4
Cos. (Cr. Rs.)

Market value of 971 1292 2675 3273 6750 25302 110279 478121 524112

5 Capital of Listed

Cos. (Cr. Rs.)

Capital per 24 63 113 168 175 224 514 693 798

6 Listed Cos. (4/2)

(Lakh Rs.)

Market Value of 86 107 167 211 298 582 1770 5564 9958

Capital per Listed

7
Cos. (Lakh Rs.)

(5/2)

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Trading Pattern of the Indian Stock Market:-

Trading in Indian stock exchanges are limited to listed securities of public limited companies.

They are broadly divided into two categories, namely, specified securities (forward list) and non-

specified securities (cash list). Equity shares of dividend paying, growth-oriented companies with a

paid-up capital of at least Rs.50 million and a market capitalization of at least Rs.100 million and

having more than 20,000 shareholders are, normally, put in the specified group and the balance in

non-specified group.

Two types of transactions can be carried out on the Indian stock exchanges: (a) spot delivery

transactions "for delivery and payment within the time or on the date stipulated when entering into

the contract which shall not be more than 14 days following the date of the contract” and (b)

forward transactions "delivery and payment can be extended by further period of 14 days each so

that the overall period does not exceed 90 days from the date of the contract". The latter is

permitted only in the case of specified shares. The brokers who carry over the outstanding pay

carry over charges (can tango or backwardation) which are usually determined by the rates of

interest prevailing.

A member broker in an Indian stock exchange can act as an agent, buy and sell securities for his

clients on a commission basis and also can act as a trader or dealer as a principal, buy and sell

securities on his own account and risk, in contrast with the practice prevailing on New York and

London Stock Exchanges, where a member can act as a jobber or a broker only.

The nature of trading on Indian Stock Exchanges are that of age old conventional style of face-to-

face trading with bids and offers being made by open outcry. However, there is a great amount of

effort to modernize the Indian stock exchanges in the very recent times.

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National Stock Exchange (NSE):-

With the liberalization of the Indian economy, it was found inevitable to lift the Indian stock

market trading system on par with the international standards. On the basis of the

recommendations of high powered Pherwani Committee, the National Stock Exchange was

incorporated in 1992 by Industrial Development Bank of India, Industrial Credit and Investment

Corporation of India, Industrial Finance Corporation of India, all Insurance Corporations, selected

commercial banks and others.

Trading at NSE can be classified under two broad categories:

(a) Wholesale debt market and

(b) Capital market.

Wholesale debt market operations are similar to money market operations - institutions and

corporate bodies enter into high value transactions in financial instruments such as government

securities, treasury bills, public sector unit bonds, commercial paper, certificate of deposit, etc.

There are two kinds of players in NSE:

(a) Trading members and (b) participants.

Recognized members of NSE are called trading members who trade on behalf of themselves and

their clients. Participants include trading members and large players like banks who take direct

settlement responsibility.

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Trading at NSE takes place through a fully automated screen-based trading mechanism which

adopts the principle of an order-driven market. Trading members can stay at their offices and

execute the trading, since they are linked through a communication network. The prices at which

the buyer and seller are willing to transact will appear on the screen. When the prices match the

transaction will be completed and a confirmation slip will be printed at the office of the trading

member.

NSE has several advantages over the traditional trading exchanges. They are as follows:

 NSE brings an integrated stock market trading network across the nation.

 Investors can trade at the same price from anywhere in the country since inter-market

operations are streamlined coupled with the countrywide access to the securities.

 Delays in communication, late payments and the malpractice’s prevailing in the traditional

trading mechanism can be done away with greater operational efficiency and informational

transparency in the stock market operations, with the support of total computerized

network.

Unless stock markets provide professionalized service, small investors and foreign investors will

not be interested in capital market operations. And capital market being one of the major sources

of long-term finance for industrial projects, India cannot afford to damage the capital market path.

In this regard NSE gains vital importance in the Indian capital market system

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 GLOBAL
DERIVATIVES
MARKET

28
INTRODUCTION TO “FUTURES & OPTIONS”:-

Forward Contracts

A forward contract is a simple derivative – It is an agreement to buy or sell an asset at a certain

future time for a certain price. The contract is usually between two financial institutions or

between a financial institution and its corporate client. A forward contract is not normally traded

on an exchange.

One of the parties in a forward contract assumes a long position i.e. agrees to buy the underlying

asset on a specified future date at a specified future price. The other party assumes a short position

i.e. agrees to sell the asset on the same date at the same price. This specified price is referred to as

the delivery price. This delivery price is chosen so that the value of the forward contract is equal to

zero for both transacting parties. In other words, it costs nothing to the either party to hold the long

or the short position.

A forward contract is settled at maturity. The holder of the short position delivers the asset to the

holder of the long position in return for cash at the agreed upon rate. Therefore, a key determinant

of the value of the contract is the market price of the underlying asset. A forward contract can

therefore, assume a positive or negative value depending on the movements of the price of the

asset. For example, if the price of the asset rises sharply after the two parties have entered into the

contract, the party holding the long position stands to benefit, i.e. the value of the contract is

positive for her. Conversely, the value of the contract becomes negative for the party holding the

short position.

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The concept of Forward price is also important. The forward price for a certain contract is defined

as that delivery price which would make the value of the contract zero. To explain further, the

forward price and the delivery price are equal on the day that the contract is entered into. Over the

duration of the contract, the forward price is liable to

change while the delivery price remains the same. This is explained in the following note on

payoffs from forward contracts.

Options

A options agreement is a contract in which the writer of the option grants the buyer of the option

the right purchase from or sell to the writer a designated instrument for a specified price within a

specified period of time.

The writer grants this right to the buyer for a certain sum of money called the option premium. An

option that grants the buyer the right to buy some instrument is called a call option. An option that

grants the buyer the right to sell an instrument is called a put option. The price at which the buyer

an exercise his option is called the exercise price, strike price or the striking price.

Options are available on a large variety of underlying assets like common stock, currencies, debt

instruments and commodities. Also traded are options on stock indices and futures contracts –

where the underlying is a futures contract and futures style options.

Options have proved to be a versatile and flexible tool for risk management by themselves as well

as in combination with other instruments. Options also provide a way for individual investors with

limited capital to speculate on the movements of stock prices, exchange rates, commodity prices

etc. The biggest advantage in this context is the limited loss feature of options.

30
Options Terminology:-

Call Option

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of

the underlying asset at the strike price on or before expiration date.

Put Option

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of

the underlying asset at the strike price on or before an expiry date.

Strike Price (also called exercise price)

The price specified in the option contract at which the option buyer can purchase the currency

(call) or sell the currency (put) Y against X.

Maturity Date

The date on which the option contract expires is the maturity date. Exchange traded options have

standardized maturity dates.

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American Option

An option, call or put that can be exercised by the buyer on any business day from initiation to

maturity.

European Option

A European option is an option that can be exercised only on maturity date.

Premium (Option price, Option value)

The fee that the option buyer must pay the option writer at the time the contract is initiated. If the

buyer does not exercise the option, he stands to lose this amount.

Intrinsic value of the option

The intrinsic value of an option is the gain to the holder on immediate exercise of the option. In

other words, for a call option, it is defined as Max [(S-X), 0], where s is the current spot rate and X

is the strike rate. If S is greater than X, the intrinsic value is positive and is S is less than X, the

intrinsic value will be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In the case of

European options, the concept of intrinsic value is notional as these options are exercised only on

maturity.

32
Time value of the option

The value of an American option, prior to expiration, must be at least equal to its intrinsic value.

Typically, it will be greater than the intrinsic value. This is because there is some possibility that

the spot price will move further in favor of the option holder. The difference between the value of

an option at any time "t" and its intrinsic value is called the time value of the option.

At-the-Money, In-the-Money and Out-of-the-Money Options

A call option is said to be at-the-money if S=X i.e. the spot price is equal to the exercise price. It is

in-the-money is S>X and out-of-the-money is S<X. Conversely, a put option is at-the-money is

S=X, in-the-money if S<X and out-of-the-money if S>X.

FUTURES

A futures contract is an agreement between two parties to buy or sell an asset at a certain specified

time in future for certain specified price. In this, it is similar to a forward contract. However, there

are a number of differences between forwards and futures. These relate to the contractual features,

the way the markets are organized, profiles of gains and losses, kinds of participants in the markets

and the ways in which they use the two instruments. Futures contracts in physical commodities

such as wheat, cotton, corn, gold, silver, cattle, etc. have existed for a long time. Futures in

financial assets, currencies, interest bearing instruments like T-bills and bonds and other

innovations like futures contracts in stock indexes are a relatively new development dating back

mostly to early seventies in the United States and subsequently in other markets around the world.

33
Major Features of Futures Contracts:-

The principal features of the contract are as follows:

 Organized Exchanges

 Standardization

 Clearing House

 Marking To Market

 Actual Delivery Is Rare

DISTINCTION BETWEEN FORWARD AND FUTURES CONTRACTS

FORWARDS FUTURES

1. Are traded on an exchange 1. Are not traded on an exchange

2. Use a Clearing House which provides 2. Are private and are negotiated between the

protection for both parties parties with no exchange guarantee

3. Require a margin to be paid 3. Involve no margin payments

4. Are used for hedging and speculating 4. Are used for hedging and physical delivery

5. Are standardized and published 5. Are dependent on the negotiated contract

Conditions

6. Are transparent - futures contracts are 6. Are not transparent as they are all private

reported by the exchange deals

34
FUTURES & OPTIONS:-
An interesting question to ask at this stage is – when could one use options instead of futures?
Options are different from future in several interesting senses. At a practical level, the option buyer
faces a interesting situation. He pays for 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 fund already paid for 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 can not 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
product”.

Distinction between futures and options

Futures Options
 Exchange traded with innovation  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 use always positive.

 Linear payoff  Nonlinear payoff.

 Both long and short at risk  Only short at risk.

35
PAYOFF FOR DERIVATIVES CONTRACTS:-

A pay off is likely profit/loss that would accrue to a market participants with change in the price of

the underlying asset. This is generally depicted in the form of payoff diagrams, which show the

price of the underlying asset on the X-axis and the profit/loss on the Y-axis. In this section we shall

take a look at the payoffs for buyers and sellers of futures and options.

Payoff for Futures

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits

for the buyer and the sellers of a future contract are unlimited. These linear payoffs are fascinating

as they can be combined with options and the underlying to generate various complex payoffs.

Payoff for a Buyer on Nifty Future:-

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts

an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take

the case of speculator who sells two-month Nifty index futures contracts when the Nifty stands at

1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the

short futures positions start making profits and when the index moves up, it starts making losses

.the following diagram shows the payoff diagram for the seller of a futures contract.

36
Payoff for a seller on Nifty Futures:-

The pay off for a person who sells a future contract is similar to the payoff for a person who shorts

assets. He has a potentially unlimited upsides as well as a potentially unlimited downside. Take the

case of a speculator who sells the two-month Nifty index future contract when the nifty stands at

1220. The underlying asset in this case is the Nifty portfolio.

Profit

Loss 1220 Nifty

Fig. Payoff for a seller on Nifty futures

37
Option Payoffs:-

The optionally characteristics of options results in a non –linear payoff for the options. In simple

words, it means that the losses for the buyer of an option are limited; however the profits are

potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the

options premium; however his losses are potentially unlimited. These non-linear payoffs are

assonating as they lend themselves to be used to generate various payoffs by using combination of

options and underlying. We look here at the six basic payoffs.

Payoff profile of buyer of asset: Long asset:-

In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells

it at a future date at a unknown price. Once it is purchased, the investor is said to be “long” the

asset. Following figure show the pay off for a long position of Nifty.

Profit

+60---------------------------------------------------------

Loss

1160 1220 1280 Nifty

Fig. Payoff for investor who went long nifty at 1220

38
Payoff profile for seller of asset: Short asset:-

In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220 and buys

it back at a future date at an unknown price. Once it is sold, the investor is said to be “short” the

asset. Following figure show the pay off for a long position of Nifty.

Profit

Loss

1160 1220 1280 Nifty

Fig. Payoff for investor who went short Nifty at 1220

39
Payoff profile for buyer of call option: Long run:-

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the

option. The profit/loss that the buyer makes on the options depends on the spot price of the

underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the

spot price more is the profit he makes. If the spot price of the underlying is less than the strike

price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying

the option.

Profit

Loss

1250 Nifty

Fig. Payoff for buyer of a call

Payoff for the buyer of a three-month call option (often referred to as long call) with a strike of

1250 bought at a premium of 86.60

40
Payoff profile for buyer of call option: Short call:-

Call option gives the buyer the right to buy the underlying at the strike price specified in the

option. For selling the option, the writer of the option charges a premium. The profit/loss that the

buyer makes on the option depends upon the spot price of the underlying. Whatever is the buyer’s

profit/loss? If upon expiration, the spot price exceeds the strike price, the buyer wills exercise the

option on the writer. Hence as the spot price increase the writer of option starts making losses.

Hired the spot price, more is the loss he makes. If upon expiration the spot price of the underlying

is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep

the premium. Figure gives the pay off for the writer of three-month call option (often referred to as

short call) with the strike of 1250sold at premium of 86.60

Profit

86.60

1250 Nifty

loss

Fig. Payoff for a writer of calls options

41
Payoff for buyer of put option: Long put:-

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the

option. The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the

spot price more is the profit he makes. If the spot price is higher than the stake price, he let his

option expire un-exercised. His loss in this case is the premium he paid for buying the option.

Profit

1250 Nifty

Loss

61.70

Fig. Payoff for buyer of put option

42
Payoff profile for writer of put option: short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the

option. For selling the options, the writer of the option charges a premium. The profit/loss that the

buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer’

profit is the seller loss. If upon expiration, the spot prices happen to be below the strike price, the

buyer will exercise the option at write. If upon the expiration the pot price of the underlying is

more than the strike price, the buyer lets his option expired unexercised and the writer gets to keep

the premium.

Profit

61.70

0 1250 Nifty

Loss

Fig. Payoff for writer of put option

Fig shows the payoff for the writer of a three-month put option (often referred as short put) with a

strike price of 1250 sold at a premium of 61.70

43
CLEARING AND SETTLEMENT:-

National Securities Clearing council Limited (NSCCL) undertakes clearing and settlement of all

trades executed on the futures and options (O&P) segment of the NSE. It also act as legal counter

party to all trades on the F&O segment and guarantees their financial settlement.

Clearing Entities

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help of

the following entities:

Clearing Members

A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals

executed by Trading Members (TM) on NSE, who clear and settle such deals through them.

Primarily, the CM performs the following functions:

1. Clearing – Computing obligations of all his TM's i.e. determining positions to settle.

2. Settlement - Performing actual settlement. Only funds settlement is allowed at present in

Index as well as Stock futures and options contracts.

3. Risk Management – Setting position limits based on upfront deposits / margins for

each TM and monitoring positions on a continuous basis.

44
Types of Clearing Members:-

 Trading Member Clearing Member (TM-CM)

A Clearing Member who is also a TM. Such CMs may clear and settle their

own proprietary trades, their clients’ trades as well as trades of other TM’s.

 Professional Clearing Member (PCM)

A CM who is not a TM. Typically banks or custodians could become a PCM and clear

and settle for TM’s.

 Self Clearing Member (SCM)

A Clearing Member who is also a TM. Such CMs may clear and settle only their own

proprietary trades and their clients’ trades but cannot clear and settle trades of other TM’s.

Clearing Banks

NSCCL has empanelled 11 clearing banks namely Canara Bank, HDFC Bank, IndusInd Bank,

ICICI Bank, UTI Bank, Bank of India, IDBI Bank, Hong Kong & Shanghai Banking Corporation

Ltd., Standard Chartered Bank, Kotak Mahindra Bank and Union Bank of India.

45
Every Clearing Member is required to maintain and operate a clearing account with any one of the

empanelled clearing banks at the designated clearing bank branches. The clearing account is to be

used exclusively for clearing & settlement operations.

Settlement Mechanism

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for

index futures /options of the Nifty index cannot be delivered. These contracts, therefore, have to be

settled in cash. Futures and options on individual securities can be delivered as in the spot market.

However, it has been currently mandated that stock options and futures would also be cash settled.

The settlement amount for a CM is netted across all their TMs/ clients, with respect to their

obligations on MTM, premium and exercise settlement.

Settlement of future contracts

Futures contracts have two types of settlement, the MTM settlement, which happen on a

continuous basis at the end of each day, and the final settlement, which happens on the last trading

day of the futures contracts.

Daily Mark-to-Market Settlement

The position in the futures contracts for each member is marked-to-market to the daily settlement

price of the futures contracts at the end of each trade day.

The profits/ losses are computed as the difference between the trade price or the previous day’s

46
settlement price, as the case may be, and the current day’s settlement price. The CMs who have

suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn

passed on to the members who have 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=Sxert

where:

F=theoretical futures price

S=value of the underlying index

r=rate of interest (MIBOR)

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. CMs are responsible to

collect and settle the daily mark to market profits / losses incurred by the TMs and their clients

clearing and settling through them. The pay-in and payout 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 clearing bank account.

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Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM 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 CMs clearing bank account

on T+1 day (T= expiry day). Open positions in futures contracts cease to exist after their

expiration day

SETTLEMENT OF OPTIONS CONTRACTS:-

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 CM at the

client level to determine the net premium payable or receivable amount at the end of each day. The

CMs who have a premium payable position is required to pay the premium amount to NSCCL

which is in turn passed on to the members who have a premium receivable position. This is known

as daily premium settlement.CMs is responsible to collect and settle for the premium amounts

from the TMs and their clients clearing and settling through them. 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 CMs clearing bank account.

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Interim Exercise Settlement

Interim exercise settlement for Option contracts on Individual Securities is effected for valid

exercised option positions at in-the-money strike prices, at the close of the trading hours, on the

day of exercise. Valid exercised option contracts are assigned to short positions in option contracts

with the same series, on a random basis. The interim exercise settlement value is the difference

between the strike price and the settlement price of the relevant option contract. Exercise

settlement value is debited/ credited to the relevant CMs clearing bank account on T+1 day (T=

exercise date).

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike prices existing at

the close of trading hours, on the expiration day of an option contract. Long positions at in-the

money strike prices are automatically assigned to short positions in option contracts with the same

series, on a random basis. For index options contracts, exercise style is European style, while for

options contracts on individual securities, exercise style is American style. Final Exercise is

Automatic on expiry of the option contracts. Option contracts, which have been exercised, shall be

assigned and allocated to Clearing Members at the client level. Exercise settlement is cash settled

by debiting/ crediting of the clearing accounts of the relevant Clearing Members with the

respective Clearing Bank. Final settlement loss/ profit amount for option contracts on Index is

debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Final

settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to

the relevant CMs clearing bank account on T+1 day (T = expiry day).

Open positions, in option contracts, cease to exist after their expiration day.

49
The pay-in / pay-out of funds for a CM on a day is the net amount across settlements and all TMs/

clients, in F&O Segment.

PROS & CONS OF DERIVATIVES:-

Financial innovation that led to the issuance and trading of derivatives products has been an

important boost to the development of financial market. Derivatives products such as options,

futures or swaps contract have become a standard risk management tool that enable risk sharing

and thus facilitate the efficient allocation of capital to productive investment opportunities. While

the benefits stemming from the economic function performed by derivative securities have been

discussed and proven by academics, there is increasing concern within the financial community

that the growth of the derivative markets-whether standardize or not-destabilize the economy. In

particular, one often hears that the widespread use of derivatives have been reduced long term

investment since it concentrates capital in short term speculative transactions. In this study, I have

tried to look at the various pros and cons that the derivatives trading pose.

BENEFITS OF DERIVATIVES FOR FIRMS, MARKETS AND

THE ECONOMY

The recent studies of derivatives activity have led to a broad consensus, both in the private and

public sectors that derivatives provide numerous and substantial benefits to end –users.

50
 Derivatives as means of hedging

Derivatives provide a low cost, effective method for end users to hedge and manage their

exposure to interest rate, commodity price, or exchange rates. Interest rate future and swaps, for

example, help banks for all sizes better manage the re-pricing mismatches in funding long term

assets, such as mortgages, with short term liabilities, such a certificate of deposits. Agricultural

futures and options helps farmers and processors hedge against commodity price risk. Similarly,

multi national corporations can hedge against currency risk using foreign exchange forwards,

futures and options.

 Improves market efficiency and liquidity

Well functioning derivatives improves the efficiency and liquidity of the cash market. The launch

of derivatives has been associated with substantial improvements in the market quality on the

underlying equity market. This happens because of the law transaction cost involved and

arbitrageurs will face low cost when they are eliminating the misprisions. Traders in individual

stock who supply liquidity to these stock use index futures to offset their exposure and hence able

to function at lower level of risk.

 Allows institution to raise capital at lower costs

Corporations, governmental entities, and financial institutions also benefit from derivatives

through lower funding costs and more diversified funding sources. Currency and interest rate

51
derivatives provide the ability to borrow in the cheapest capital market, domestic or foreign,

without regard to currency in which the debt is denominated or the form in which interest is paid.

Derivatives can convert the foreign borrowing into a synthetic domestic currency financing with

their fixed or floating interest rate.

 Allows exchange to offer differentiated products

In spot market, the ability for the exchanges to differentiate their product is limited by the fact that

they are trading the same paper. In contrast, in the case of derivatives, there are numerous avenues

for product differentiation. Each exchange trading index option has to take major decision like

choice of index, choice of contract size, choice of expiration dates, American Vs European

options, rules governing strike price etc.

 Assists in capital formation in the Economy

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

capital, derivatives improve the allocation of credit and sharing of risk in the global economy,

lowering the cost of capital formation and stimulating economic growth. It improves the market’s

ability to carefully direct resources toward the projects and the industries where the rate of return is

highest. This improves a locative efficiency of the market and thus a given stock of invest able

funds will be better used in procuring the highest possible GDP growth for the economy.

The growth in derivatives activities yields substantial benefits to the economy and by facilitating

the access of the domestic companies to international capital market and enabling them to lower

52
their cost of funds and diversify their funding source; derivatives improve the position of domestic

firms in an expanding, competitive, global economy.

 Improve ROI for institutions

Derivatives are basically off- balance trading in that no transfer of principal sum occurs and no

posting in the balance sheet will be required. Consequently, a fund that corresponds to the

principal sum in traditional financial transactions (on balance trading) is unnecessary, thus

substantially improving the return on investment. Looking at the restriction on the ratio of net

worth, on the other hand, the risk ratio of assets that form the basis for calculating the net worth in

off balance trading is assumed to be lower than that in the traditional on balance trading. In

practice, it is provided that the credit risk equivalence calculated by multiplying the assumed

amount of principal of an off-balance trading by a risk to value ratio is to be weighted by the credit

worthiness of the other party.

 Risk sharing

The major economic function of derivatives is typically seen in risk sharing: derivatives provide a

more efficient allocation of economic risks. Examples of risk management, which have already

mentioned are illustrative, but they don’t address the question why derivatives are necessary to

attain a better social allocation of risks.

53
 Information gathering:

In a perfect market with no transaction cost, no friction and no informational asymmetries, there

would be no benefit stemming from the use of derivatives instruments. However, in the presence

of trading costs and marketing liquidity, portfolio strategies are often implemented or

supplemented with derivatives at substantial lower cost compare to cash market transactions. In

this respect, the welfare effect of derivative instrument result from a reduction in the transaction

cost. Ute.

This is only a part of the real economic benefits of the derivatives. If risk allocation is the major

function of this instrument, and because risk is also related to information, derivatives markets also

affect the information structure of the financial system

DISADVANTAGES OF DERIVATIVES:-

 Risk associated with the derivatives

Apart from the explicit risk, which arises from various market risk exposure stemming from the

pure service or position taken in a derivative instrument, other implicit risks also associated with

derivatives?

54
  A credit risk is the risk that a loss will be incurred because a counter party fails to

make payment as due. Concern has been expressed that financial institutions may have used

derivatives to take on an excessive level of credit risk that is poorly managed.

 Market risk is the risk that the value of a position in a contract, financial instrument,

asset, or portfolio will decline when market conditions change. Concern has been expressed that

derivatives expose firm to new market risk while increasing the overall level of exposure.

 Operational risks are the risk that losses will be incurred as a result of inadequate

system and control, inadequate disaster or contingency planning, human error, or management

failure.

 Legal risk is the risk of loss because a contract cannot be enforced or because the

contract term fails to achieve the intended goals of the contracting parties. This risk, of course, is

as old as contracting itself. The legal uncertainty can result in significant unexpected losses.

 Implication in global world

Global market for trade and finance has become increasingly integrated and accessible.

Derivatives have both benefited from and contributed to this development. In these circumstances,

however, some observed fear that derivatives make it possible for shocks in one part of the global

finance system to be transmitted farther and faster than before, being reinforce rather than damped.

Concern also have been expressed that derivatives activity may exacerbated market moves through

positive feedback trading.

55
 Accounting standard for derivatives

As far as derivatives are concerned, accounting standard is not homogenized across countries

and/or market player thereby suggesting that lack of precision or ambiguous cross-comparisons

may be common. Market values are not uniformly accepted in accounting rules, and thus their

absence prevents marketing-to-marketing of derivatives positions as well as their proper

collateralization. Accounting practices measure values and not risk exposure and thus remain poor

figure for risk management purpose

 Lack of knowledge

Lack of knowledge about derivatives: derivatives are complex. The payoffs and risks that buyer

and seller face, and the economic theory that is used for pricing derivatives are considerably more

difficult than that seen on the equity market. Thus at times lack of knowledge on part of traders

leads to disaster.

 Monetarily Zero sum game

It is impossible for the both the parties in the derivatives transactions to profit concurrently

regardless of the fluctuation of value of underlying assets. Thus one party has to accept the

unprofitable position.

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Myths behind derivatives :-

In less than three decades of their coming into vogue, derivatives markets have become the most

important. Today, derivatives have become part of the day-to-day life for ordinary people in most

parts of the world.

Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when

the US announced an end to the Bretons Woods System of fixed exchange rates leading to

introduction of currency derivatives followed by other innovations, including stock index futures.

There are still apprehensions about derivatives. There are also many myths though the reality is

different especially for exchange-traded derivatives which are well regulated with all the safety

mechanisms in place.

What are these myths behind derivatives?

 Derivatives increase speculation and do not serve any economic purpose.

Numerous studies have led to a broad consensus, both in the private and public sectors, that

derivatives provide substantial benefits to the users. Derivatives are a low-cost, effective method

for users to hedge and manage their exposures to interest rates, commodity prices, or exchange

rates.

The need for derivatives as hedging tool was felt first in the commodities market. Agricultural

futures and options helped farmers and processors hedge against commodity price-risk. After the

collapse of the Breton Wood agreement, the financial markets in the world started undergoing

radical changes. This period is marked by remarkable innovations in the financial markets, such as

introduction of floating rates for currencies, increased trading in a variety of derivatives

instruments, and on-line trading in the capital markets.

57
As the complexity of instruments increased, the accompanying risk factors grew. This situation led

to the development derivatives as effective risk-management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to manage

effectively their portfolios of assets and liabilities through instruments such as stock index futures

and options. An equity fund, for example, can reduce its exposure to the stock market quickly and

at a relatively low cost without selling part of its equity assets, by using stock index futures or

index options. By providing investors and issuers with a wider array of tools for managing risks

and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global

economy, lowering the cost of capital formation and stimulating economic growth. Now that world

markets for trade and finance have become more integrated, derivatives have strengthened these

important linkages among global markets, increasing market liquidity and efficiency, and

facilitating the flow of trade and finance.

 Indian market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian capital market is not

ready for derivatives trading. Here, we look into the pre-requisites needed for the introduction of

derivatives and how the Indian market fares.

Disasters can happen 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. Careful observation will

show that these disasters, such as the Barings collapse, Metallgesellschaft, Daiwa Bank scandal

(not related to derivatives) and Orange County, occurred due to the lack of internal controls and/or

outright fraud either by employees or promoters.

58
In essence, these examples suggest that scandals have occurred in the recent past, not only in

derivatives-related instruments, but also in bonds, foreign exchange trading and commodities

trading. Most failures have taken place on the `over the-counter' deals, except in the case of

Barings, where it was a case of internal fraud, as also with Daiwa Bank, which lost more than $1

billion in debt portfolio. `Over-the-counter' (OTC) deals lack transparency, sophisticated

margining system and a well-laid-out regulatory framework, which is not the case with the

exchange-traded derivatives.

Many of the failures happened because of the complex nature of transactions while the exchange-

traded derivatives are saint easy to understand. In that sense, these derivatives have been found to

be the most useful in allowing participants to transfer their risk, without the problems associated

with the OTC deals. Internal controls would be important in any case, for normal equity or debt

trading as much as in derivatives trading and the participants need to be more careful in

implementing and operating good back-office and control systems to avoid any internal control

failures.

 Derivatives are complex and exotic instruments that Indian investors will

have difficulty in understanding

Trading in standard derivatives such as forwards, futures and options is already prevalent in India

and has a long history. The Reserve Bank of India allows forward trading in rupee-dollar forward

contracts, which has become a liquid market. The RBI also allows cross currency options trading.

Derivatives in commodities markets have a long history. The first commodity futures exchange

was set up in 1875, in Mumbai, under the aegis of Bombay Cotton Traders Association. A clearing

59
house for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market

was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute

was set up in Calcutta in 1912 and the bullion futures market in Bombay in 1920.

In the equities markets also, derivatives have existed for long. In fact, official history of the Native

Share and Stock Brokers Association, which is now known as the Bombay Stock Exchange,

suggests that the concept of options existed from early as in 1898. A quote ascribed to Mr. James

P. McAllen, MP, at the time of the inauguration of BSE's new Brokers Hall in 1898, is: ``...India

being the original home of options, a native broker would give a few points to the brokers of the

other nations in the manipulations of puts and calls.'' This amply proves that the concept of options

and futures is well-ingrained in the Indian equities market and is not as alien as it is made out to

be. Even today, complex strategies of options are traded in many exchanges which are called teji-

mandi, jota-phatak, and bhav-bhav at different places. In that sense, the derivatives are not new

to India and are current in various markets including equities markets.

India has a long history of derivatives trading. In fact, in commodities markets, Indian exchanges

are inviting foreigners to participate for which the approvals have also been granted.

 Is capital market safer than derivatives?

WORLD OVER, the spot market in equities operates on a principle of rolling settlement. In this

kind of trading, if one trades on a particular day (T), one has to settle these trades on the third

working day from the date of trading (T+3).

Futures market allows you to trade for a period of, say, one or three months and net the transaction

for the settlement at the end of the period. In India, most stock exchanges allow the participants to

trade over a one-week period for settlement in the following week. The trades are netted for the

settlement for the entire one-week period. In that sense, the Indian market is already operating on

60
the futures-style settlement. In this system, additionally, many exchanges also allow the forward-

trading called badla and contango, which was prevalent in the UK. This system is prevalent in

France, in the monthly settlement market. It allows one to even further increase the time to settle

for almost three months, under the current regulations. But this way, a curious mix of futures style

settlement with the facility to carry the settlement obligations forward, creates discrepancies.

In addition, the existing system does not ask for any margins from the clients. Given the volatility

of the equities market in India, this system has become quite prone to systemic collapse.

The Indian capital market operates on a account period system which is actually a seven-day

futures market, while internationally, the cash market operates on T+3 rolling settlement basis _

one of the G-30 recommendations for an efficient clearing and settlement mechanism. In the

futures market, there is a daily mark-to-market settlement (T+1), leading to faster settlement and

risk reduction, unlike the cash market where settlement takes seven days. Client positions are not

segregated from the trading member's proprietary role and clearing members are not segregated,

affecting the system.

61
 INDIAN
DERIVATIVES
MARKET

62
 DERIVATIVES MARKET IN INDIA

Approval for Derivatives trading

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.

63
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(Sensex) 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.

64
Exchange-traded vs. OTC (Over the Counter) derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which

have accompanied the modernization of commercial and investment banking and globalization of

financial activities. The recent developments in information technology have contributed to a great

extent to these developments.

While both exchange-traded and OTC derivative contracts offer many benefits, the former have

rigid structures compared to the latter. It has been widely discussed that the highly leveraged

institutions and their OTC derivative positions were the main cause of turbulence in financial

markets in 1998.These episodes of turbulence revealed the risks posed to market stability

originating in features of OTC derivative instruments and markets. The OTC derivatives markets

have the following features compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and located within individual

institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for

safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-

regulatory organization, although they are affected indirectly by national legal systems, banking

supervision and market surveillance.

65
DERIVATIVES MARKET AT NSE:-

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this

effect in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE and

BSE, and their clearing house/corporation to commence trading and settlement in approved

derivative contracts. To begin with, SEBI approved trading in index futures contracts based on

S&P CNX Nifty Index and BSE−30 (Sensex) Index. This was followed by approval for trading in

options based on these two indices and options on individual securities. The 3 trading in index

options commenced in June 2001 and those in options on individual securities commenced in July

2001. Futures contracts on individual stock were launched in November 2001.

66
FUNCTION OF
DERIVATIVES

67
 FUNCTION OF DERIVATIVES

According to N D Vohra & B R Bagri the derivative market performs a number of useful

economic functions:

1. Price Discovery: The futures and options market serve an all important function of price

discovery. To take advantage of such information in these markets, the individuals with better

information and judgment are inclined to participate. The actions of the speculator swiftly feed

their information into the derivative markets causing changes in the prices of derivatives, when

some new information arrives, perhaps some good news about the economy. As indicated earlier,

these markets are usually the first ones to react because the cost of transaction is much lower in

these markets than in the spot markets. Therefore, these markets indicate what is likely to happen

and thus assist in better price discovery.

2. Risk Transfer: The derivative instruments do not themselves involve risk, by the very nature.

Rather, they merely distribute the risk between market participants. In this sense, the whole

derivative market may be compared to a gigantic insurance company – providing means to hedge

against adversities of unfavorable market movements in return for a premium, providing means

and opportunities to those who are prepared to take risks and make money in the process.

3. Market Completion: The existence of derivative market adds to the degree of completeness of

the market. When the number of independent securities or instruments is equal to the number of all

possible alternative future states of economy, it implies a complete market. To understand the idea,

let us recall that the derivative instruments of futures and options are instruments that provide the

investor the ability to hedge against possible odds or events in the economy. If instruments may be

68
created which can, solely or jointly, provide a cover against all the possible adverse outcomes, then

a market would be said to be complete. It is held that a complete markets can be achieved only

when , firstly , there is a consensus among all investors in the economy can land up with, secondly,

there should exist an ‘efficient fund’ on which simple options can be traded. Here an efficient fund

implies a portfolio of basic securities that exist in the market with the property of having a unique

return that exist in the market with property of having a unique return for every possible outcome,

while a simple options is one whose payoffs depends on underlying return. Evidently, since the

requiring condition identification and listing of all possible states of the economy can never be

obtained in practice, and it is also not possible to design financial contracts that are enforceable,

which can cover an endless range of contingencies, a complete market remains a theoretical

concept. Thus leads to a great degree of market completeness due to the presence of futures and

options.

Dhingra (2004) believes if one views that past stock exchanges and the effect of blue chip

companies like IBM, Coca- Cola, Microsoft or Intel on the stock index, there is a clear sign to the

rise of stocks to substantial amounts. History shows the phenomenal growth characteristic of the

above stocks is related to that of the fundamentals on which the companies have been operating

under and not related to speculators. The current market capitalization of Microsoft Corporation is

approximately $225 billion compared to the group turnover of mere $22 million, and looking back

at the BP case study (1998), the answer indicates the advantage derivatives provide against various

risk involving commodities, fixed assets or interest rate transaction and planning.

Now the question remains -Do derivatives always aid every corporation or organization to yield

profits? Industry Week (July 1998) mentions that derivatives have been plagued, which have led

to media’s criticism and subsequent users and accounting board’s cautious attitude towards

69
derivatives. In the past most derivatives problems are related to the uncontrolled speculation by

various individuals primarily in the highly susceptible futures, forwards and swaps.

Web 7 opines the difficulties with today’s worldwide derivatives are as follows:

 It is not an investment, but a “side bet”, usually very short term at that. The money is “not” put

into productive use to generate an economic profit i.e. if loss it would affect the entire world

and if profit, creates for the entire world.

 We are giving out profits not yet created to speculators who then use those profits to chase

even larger amounts of future profits. We’ve often referred to our national debts as “hocking

the futures of our children”. But that is peanuts compared to the claims that the global financial

bubble already has upon mankind’s future economy i.e. the profits given by the companies to

the speculators are not given accurately, they are then who does the gamble in the market.

 The monetary profits are not being made through construction but “destruction”. Stability in

the markets is what is needed for development. But only through instability can the speculator

make any gain i.e. Stability is derivatives’ enemy.

 And most immediately damning to our present system is the crisis the growth in derivatives

poses for the liquidity of our monetary system. In order to maintain a growing system of

“robbing Peter to pay Paul”, we have to have more available instruments of cash to

accommodate the robbers. Far from hedging against risk as they claimed to do, “derivatives

ARE the risk.”

Once this process gets too far along, you are trapped into keeping the deception growing like the

fellow who gets so far behind at the casino; he keeps upping the ante way beyond his means as his

only hope to get back to even with the house.

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Market Manipulation

The index, with a market capitalization of Rs.2.2 trillion (CF – Conversion table), is much harder

to manipulate that individual securities. Hence the dangers of market manipulation are smaller on

an index derivatives market as compared with the existing cash market i.e. the market

manipulation is much smaller on an index of market of derivatives as compared to the cash market.

Insider Trading

Individual companies are typified by sharp information of asymmetry, between external

traders/investors and company insiders. In contrast, the index is about India’s macro economy,

where there is less information of asymmetry i.e. in this sense , there is a less scope for malpractice

on a market which trades the index.

Shah 2000 continues with the India’s dollar-rupee forward market experience, the largest market

of derivatives in existence in India today- is an example of how this might proceed. When this

market first came about, it had a fairly restricted usage. Today, the use of forward market is routine

and commonplace amongst hundreds of importers and exporters. These are firms with core

competences such as importing crude oil or exporting garments; they are faced with currency risk

and do not view trading in the rupee as being a core competence. The forward market enables them

to proceed with their core competences while using the forward market to eliminate currency risk.

The dollar-rupee forward market has typical daily trading volumes of $1.5 billion, which makes it

one of the biggest financial markets in India today. Even though it is an OTC market, it is known

as a serious disaster.

Dhingra 2004 opines that over the years the market of derivatives have become multi-trillion

dollar markets .Derivatives are financial commitments indexed or linked in some capacity on the

71
value of underlying assets. The bulk of the derivatives traded internationally are linked to

currencies and interest rates. Other derivatives are linked to equity or equity indices. A very small

volume of derivatives, compared to the total is indexed to traditional commodities. Small by

comparison to other derivatives markets, these commodities-indexed derivatives markets are large

compared to the underlying physical commodities markets. It has been a gradual march to glory

for derivatives trading in India with current average daily trading volume at more than 10000

crores (CF-Conversion table). Thanks to the market’s growing fancy for stock futures, derivatives

trading have finally been able to underline its presence in the Indian capital market. From a meager

Rs. 35 crores worth of turnover in June 2000, when derivatives where introduced in phase to Rs.

572,403 crores in December 2003 and reached Rs 600,000 crore in March 2006. There has been a

phenomenal rise in the growth of futures and options market. Gradually more derivatives products

are being offered with the underlying as diverse as commodities, credit, interest rate, currency etc.

In simple words, derivatives have come along from 1970 till today, it had helped corporations to

make immense profit, and sometimes it had corporations going down the drain with all the losses

on their head. As explained earlier, derivatives have four main variants/products which are

Forwards, Options, Swaps and Options and also have three main participants which are Hedgers,

Speculators and Arbitrageurs and the scenario of the Indian derivative market. Now let us see how

derivatives revolve around equity i.e. stock market and foreign markets in India.

72
 USERS OF
DERIVATIVES

73
 USERS OF DERIVATIVES

The institutional investor in India could be meaningfully classified into:

1. Banks

2. All India Financial institution (FI’s)

3. Mutual Funds

4. Foreign Institutional Investor

5. Life & General Insurers

The intensity of derivatives usage by any institutional investor is a function of its ability and

willingness to use derivatives for one or more of the following purposes:

a) Risk containment: Using derivatives for hedging and risk containment purpose,

b) Risk Trading /Market Making: Running derivatives trading book for profits and

arbitrage, and / or

c) Covered Intermediation: On-Balance Sheet derivatives intermediation for client

transaction, without retaining any net risk on the Balance Sheet (except credit risk).

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BANKS

Types of Banks

Based on the differences in governance structure, business practices and organizational ethos, it is

meaningful to classify the Indian banking sector into the followings:

I. Public Sector Banks(PSBs)

II. Private Sector Banks(Old generation),

III. Private Sector Banks (new generation),

IV. Foreign Banks( with banking and authorized dealer license)

Credit Derivatives

The market of fifth type of derivatives namely, credit derivatives, is currently non–existent in

India, hence has been dealt with in brief here. Credit derivatives seek to transfer credit risk and

returns of an asset from one counter party to another without transferring its ownership. The

market for credit derivatives is currently non-existent in India, though it has the potential to

develop.

Equity Derivatives in Banks

Given the highly leveraged nature of banking business, and the attendant regulatory concerns of

their investment in equities, banks in India can, at best, be turned as marginal investor in equities.

Use of equity derivatives by banks ought to be inherently limited to risk containment (hedging)

and arbitrage trading between the cash market and options and futures markets. However, for the

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following reasons, banks with direct and indirect equity market exposure are yet to use exchange

traded equity derivatives (viz.., index futures, index options, security specified futures r options)

currently available on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE).

1) RBI guidelines on investment by the banks in capital market instruments do not authorize

banks to use equity derivatives for any purpose. RBI guidelines also do not authorized banks to

undertake securities lending and/ or borrowings of equities. This disables also banks possessing

arbitrage trading skills and institutionalized risk management process for running an arbitrage

trading book to capture risk free pricing miss–match spread between the equity cash and options

and futures market- an activity banks currently any way undertake in the fixed income and FX

cash and forward markets;

2) Direct and indirect equity exposure of banks is negligible and does not warrant serious

management attention and resources for hedging purpose;

3) The internal resources and processes in most bank treasuries are inadequate to mange the

risk of equity market exposure, and monitor use of equity derivatives;

4) Inadequate technological and business process readiness of their treasuries to run equity

arbitrage trading book, and mange related risks.

Fixed Income Derivatives in Bank

Scheduled Commercial banks, Primary Dealers (PDs and All India Financial Institution (FIs have

been allowed by RBI since July 0993 to write Interest Rate Swaps (IRS) and Forward Rate

Agreement (FRAs) as product for their own assets liability management (ALM) or for market

making (risk trading) purpose. The presence of Public Sector Banks major in the rupee IRS market

76
is marginal. Most PSBs are either unable or unwilling of PSB majors seemingly stem from the

following key are yet to overcome;

1) Inadequate technological and business process readiness of their treasuries to run a

derivatives trading books, and manage related risks;

2) Inadequate of willingness of bank managements to ‘risk’ being held accountable for

bonafide trading losses in the derivatives book;

3) Inadequate readiness of their Board of Directors to permit the bank to run a derivatives

trading book, partly for reasons cited above and partly due to their own ‘discomfort of the

unfamiliar’.

Commodity Derivatives in Banks

In 1997, RBI permitted seven banks to import and resell gold as canalizing agencies. It is

understood that now about 13 banks (; bullion banks’, for short) are active in this business. The

quantum of gold Imported through bullion banks is in the region of 500 tones per annum. The

commodity risk accepted by banks is limited to price risk of gold accepted by 5 bullion banks that

launched their schemes under the RBI guidelines on the Gold Deposit Scheme 1999 announced in

the union budget of 1999-2000. in brief, these bullion banks accept assayed gold as a deposit for 3

to 7 years tenures, at the end of which the deposit is repayable at the price of gold as on date of

maturity. These gold deposits carry interest ranging from 3% to 4% per annum. SBI is a market

leader in this segment with a market share of over 90%. There is no forward market for gold in

India. In fact, forward contract on gold are prohibited. And, for this purpose, a contract settled later

than T+11 days is treated as a forward contract.

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ALL INDIA FINANCIAL INSTITUTIONS (FIs)

The All India FIIs Universe

With the merger of ICICI into ICICI Bank, the universe of all India FIs comprises IDBI, IFCI,

IIBI, SIBDI, EXIM. NABARD and IDFC. In the context of use of financial derivatives, the

universe of FIs could perhaps be extended to include a few other financially significant players

such as HDFC and NHB.

Equity Derivatives in FIs

Equity risk exposure of most FIs is rather insignificantly, and often limited-to-limited to equity

developed on them under underwriting commitments they made in the era up to mid 1990s. Use of

equity derivatives by FIs could be for risk containment (hedging purpose, and for arbitrage trading

purposes between the cash market and options and futures market. For reason identical to those

outlined earlier vis-à-vis banks, FIs too are not users of equity derivatives. However, there are no

RBI guidelines disabling FIs from running equities arbitrage- trading book to capture risk free

pricing miss-match spreads between the equity cash and options and futures markets.

Fixed income Derivatives

Since July 1999, like Banks, even FIs are permitted to write RIS and FRA for their asset liability

management (ALM) as well as for market making purpose. Some FIs actively use IRS and FRA

for their ALM. Also, a few have plans to offer IRS and FRA as products to their corporate

customer (to hedge their liabilities), albeit on a fully covered back-to- back basis, to begin with.

However, none are yet to run a rupee derivatives trading book.

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Commodities Derivatives Fi’s

FIIs have no proximate exposure to commodities. There are also no credit products whose interest

rate is benchmarked to any commodity price. Therefore, the issue of they using commodity

derivatives (whether in the overseas or Indian market) does not rise.

MUTUAL FUNDS

Equity Derivatives in Mutual Funds

Mutual Funds ought to be natural players in the equity derivatives market. SEBI (Mutual Funds)

Regulations also authorize use of exchange traded equity derivatives by mutual funds for hedging

and portfolio rebalancing purpose, and, being tax exempt, there are no tax issues relating to use of

equity derivatives by them. However, most mutual funds are not yet active in use of equity

derivatives available on the NSE and BSE. The following impediments seem to hinder use of

exchange trade equity derivatives by mutual funds:

1. SEBI (Mutual Funds) Regulation restricts use of exchange traded equity derivatives to

‘hedging and portfolio rebalancing purpose’. The popular view in the mutual fund industry is that

this regulation is very open to interpretation, and the trustees of mutual funds do not wish to be

caught on the wrong foot.

2. Inadequate technological and business process readiness of several players in the mutual fund

industry to use equity derivatives and manage related risks;

79
3. The regulatory prohibition on the use of equity derivatives for portfolio optimization return

enhancement strategies, and arbitrage strategies constricts their ability to use equity derivatives;

and

4. Relatively insignificant investor interest in equity funds ever since exchange traded options

and futures were launched in June 2000(on NSE, later on BSE).

Fixed Income Derivatives in Mutual Funds

SEBI (Mutual Funds) regulations are silent about use of IRS and FRA by mutual funds. Evidently,

IRS and FRA transactions entered into by mutual funds are not construed by SEBI as derivatives

transaction covered by the restrictive provisions which limit use of derivatives by mutual funds to

exchange traded derivatives for hedging and portfolio balancing purposes. Mutual funds are

emerging as important users of IRS and FRA in the Indian fixed income derivatives market.

Foreign Currency Derivatives in Mutual Funds

In September 1999, Indian mutual funds were allowed to invest in ADRs/GDRs of Indian

companies in the overseas market within the overall limit of US $ 500 million with a sub ceiling

for individual mutual funds of 10% of net assets managed by them (at previous year end), subject

to maximum of US $ 50 million per mutual fund. Several mutual funds had obtained the requisite

approvals from SBI and RBI for making such investments. However, given that most ADRs

/GDRs of Indian companies traded in the overseas market at a premium to their prices on domestic

equity markets, this facility has remained largely unutilized.

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Commodity derivatives in Mutual Funds

Under SEBI (Mutual Funds) Regulations, mutual fund can invest only in the transferable financial

securities. In absence of any financial security linked to commodity prices, mutual funds can not

offer a fund product that entails a proximate exposure to the price of any commodity. Therefore,

the issue of they using commodity derivatives (whether in the overseas or Indian market) does not

arise.

FOREIGN INSTITUTIONAL INVESTORS (FIIs)

Equity Derivatives in FIIs

Till January 2002, applicable SEBI & RBI Guidelines permitted FIIs to trade only in index future

contracts on NSE & BSE. It is only since 4 February 2002 that RBI has permitted (as a sequel to

SEBI permission in December 2001) FIIs to trade in all exchange traded derivatives contract

within the position limits for trading of FIIs and their sub-accounts. With the enabling regulatory

framework available to FIIs from Feb 2002, their activity in the exchange traded equity derivatives

market in India should increase noticeably in the emerging future. Perhaps, the two years of

successful track record of the NSE in managing the systematic risk associated with its futures and

options segment would also pave way for greater FIIs activity in the equity derivatives market in

India in the emerging future.

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Fixed Income Derivatives in FIIs

Since May 2000, FIIs are permitted to invest in domestic sovereign or corporate debt market

under the 100% debt rout subject to an overall cap under the external commercial borrowing

(ECB) category, with individual sub ceilings allocated by SEBI to each FII or sub accounts. FIIs

are also permitted to enter into foreign exchange derivatives contract by RBI to hedge the currency

and interest rate risk to the extent of market value of their debt investment under the 100% debt

route. However, investment by FIIs in the domestic sovereign or corporate debt market has been

negligible till now.

Foreign Currency Derivatives in FIIs

Equity investing FIIs leave their foreign currency risk largely nudged since they believe that the

currency risk can be readily absorbed by the expected returns on the equity

investments, barring in periods of unforeseen volatility (such as the Far Eastern crisis). And, as

indicated above, FII investment in the domestic sovereign and corporate debt market has been

negligible. Consequently, FII in the foreign currency derivative market in India has also been

negligible till now.

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LIFE & GENERAL INSURERS

Equity Derivatives in Life & General Insurers

The Insurance Act as well as the IRDA (Investment) Regulation 2000 is silent about use of equity

(or other) derivatives by life or general insurance companies. It is the view of the IRDA that life &

general insurers are not permitted to use equity (or other financial) derivatives until IRDA frames

guideline/ regulation related to their use. And IRDA is yet to frame this guidelines/ regulation,

though it is seized of the urgent need to frame them. Life or general insurers would have to wait

for these guidelines /regulations to fall in the place before they can use equity (or other financial)

derivatives.

Fixed Income Derivatives in Life and General Insurers

As indicate earlier, it is view of the IRDA that use of rupee fixed income derivatives (including

IRS and FRA) by Life & General insurers too would have to wait for IRDA guidelines/regulations

on the use of financial derivatives.

Foreign Currency Derivatives in Life & General Insurers

Given the long term nature of life insurance contracts, insurance regulations in the many parts of

the world apply currency –matching principle for assets and liability under life insurance contracts.

Indian insurance law too prohibits investment of fund from insurance business written in India,

into overseas or foreign securities.

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REGULATORY FRAMEWORKS:-

Evolution of a Legal Framework for Derivatives Trading

Derivatives are supposed to be defined as security under Section 2(h) of SC(R) Act, 1956.

Present definition of securities includes shares, stocks, bonds, debentures, debentures stocks or

other marketable securities in or of any incorporated company or other body corporate

Government securities Rights or interest in securities, such other instrument as may be declared by

the central government to be securities. An important step towards introduction of derivatives

trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995,

which lifted the prohibition on "options in securities" (NSEIL, 2001). However, since there was no

regulatory framework to govern trading of securities, the derivatives market could not develop.

SEBI set up a committee in November 1996 under the chairmanship of Dr. L.C. Gupta to develop

appropriate regulatory framework for derivatives trading. The committee suggested that if

derivatives could be declared as "securities" under SCRA, the appropriate regulatory framework of

"securities" could also govern trading of derivatives. SEBI also set up a group under the

chairmanship of Prof. J.R. Verma in 1998 to recommend risk containment measures for

derivatives trading. The Government decided that a legislative amendment in the securities laws

was necessary to provide a legal framework for derivatives trading in India. Consequently, the

Securities Contracts (Regulation) Amendment Bill 1998 was introduced in the LokSabha on 4th

July 1998 and was referred to the Parliamentary Standing Committee on Finance for examination

and report thereon. The Bill suggested that derivatives may be included in the definition of

84
"securities" in the SCRA whereby trading in derivatives may be possible within the framework of

that Act. The said Committee submitted the report on 17th March 1999.

Securities Exchange Board of India (SEBI)

The oversight regular for the securities market appointed a Committee on derivatives under the

Chairmanship of Dr. L.C. Gupta on 18, November 1996 to develop appropriate regulatory

framework introducing of derivatives trading in India, starting with stock index futures.

Regulatory objectives

The Committee believes that regulation should be designed to achieve specific, well-defined goals.

It is inclined towards positive regulation designed to encourage healthy activity and behavior. It

has been guided by the following objectives:

A. Investor Protection: Attention needs to be given to the following four aspects:

1. Fairness and Transparency: The trading rules should ensure that trading is

conducted in a fair and transparent manner. Experience in other countries shows that in many

cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context,

sales practices adopted by dealers for derivatives would require specific regulation. In some of the

most widely reported mishaps in the derivatives market elsewhere, the underlying reason was

inadequate internal control system at the user-firm itself so that overall exposure was not

controlled and the use of derivatives was for speculation rather than for risk hedging. These

experiences provide useful lessons for us for designing regulations.

85
2. Safeguard for clients' moneys: Moneys and securities deposited by clients with the

trading members should not only be kept in a separate clients' account but should also not be

attachable for meeting the broker's own debts. It should be ensured that trading by dealers on own

account is totally segregated from that for clients.

3. Competent and honest service: The eligibility criteria for trading members should

be designed to encourage competent and qualified personnel so that investors/clients are served

well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the

sales persons appointed by them in terms of a knowledge base.

4. Market integrity: The trading system should ensure that the market's integrity is

safeguarded by minimizing the possibility of defaults. This requires

5. Framing appropriate rules about capital adequacy, margins, Clearing Corporation, etc.

B. Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity

and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and

price-discovery. This is a much broader objective than market integrity.

C. Innovation: While curbing any undesirable tendencies, the regulatory framework should not

stifle innovation which is the source of all economic progress, more so because financial

derivatives represent a new rapidly developing area, aided by advancements in information

technology.

Recommendations of Dr. L.C.Gupta Committee

The recommendations of the L.C. Gupta Committee were made with relation to Exchange

operations, membership, products, and participants, trading and clearing regulations.

86
A. The main recommendation relating to a derivatives exchange are as

follows:

 The derivatives Exchange should have online screen based trading system with online

surveillance capabilities.

 The Derivatives Exchange shall disseminate information in real –time through at least two

information vendors.

 Existing Stock exchange can carry out derivatives trading as a separate segment.

 The Derivatives Exchange should inspect every broker/member annually.

 SEBI to approve Rules, Bye-laws and Regulation of the Derivatives Exchange

before commencement of trading.

 The Derivatives Exchange should have investor grievance and redressed Mechanism

operative from all four regions of the country.

B. Main recommendations relating to membership of a derivatives

exchange are as follows:

 The Derivatives Exchange should have at least 50 trading members to start Derivatives

trading.

 Existing members cannot automatically become derivative members.

 Membership norms include certain net worth criterion passing SEBI approved

certification.

 Membership shall be trading members being a member of the Exchange and Clearing

member being of Clearing Corporation’s

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 Clearing members should have minimum net worth of Rs.300 lakhs and make a deposit

of Rs.50 lakhs with clearing corporations.

C. Recommendations relating to introduction and trading of derivatives

product are as follows

 SEBI shall approve any new derivatives product if it serves an economical function.

 The Exchange may suspend any derivatives contract due to suspension of Trading in

underlying securities, for protection of Interest of Investor and for the purpose of maintaining a fair

and orderly market.

D. Recommendation relating to participants in the derivatives markets are

as follows:

 Restriction on investment institutions on uses old derivatives should be removed.

 Corporate and mutual funds allowed trading in derivatives to the extent authorized by Board

of Directors or Trustees as the case may be.

 Margin collection will be mandatory from all clients including institutions.

Recommendations relating to trading regulations are as follows:

 Investor should read the Risk Disclosure document made available to him by the broker/

member and sign the Client Registration form.

 Contract note that must be stamped with time of order-receipt and order execution (trade).

88
E. Recommendations relating to clearing regulations are as follows:

 Exposure limit of clearing member linked to deposit maintained with Clearing Co-operation.

 Level of Initial margin will be calculated using “Value at risk” concept and will be large

enough to cover one-day loss 99% of the days.

 Clearing members may be cleared defaulter if he is unable to fulfill obligations, he fails to

pay within specified times, damages and money differences due to compulsory close-out and fails

to abide arbitration proceedings.

SEBI board has accepted the LC Gupta report’s recommendations and further prescribed that all

derivatives contract should have a minimum contract size of Rs. 1 lakh.

POLICY ISSUES FOR DEVELOPMENT OF THE MARKETS

1. Strengthening of Financial Infrastructure

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While the Indian regulatory framework for derivatives is mostly consistent with the international

practices, some elements of financial infrastructure need to be strengthened. It is suggested that the

bankruptcy and insolvency laws should 10 clearly prescribe providing due concern to rights of

securities holders on winding up or on insolvency of intermediaries and multilateral netting

procedures innovation.

2. Transparency of Derivatives Transactions and Financial Stability

The Basel Committee on Banking Supervision and IOSCO Technical Committee have

presented recommendations for public disclosure of trading and derivatives activities of banks and

securities firms which could also be used by such non-financial companies that make material use

of complex financial products.

These recommendations emphasize the importance of transparency in promoting financial

stability. It is observed that transparency based on meaningful public disclosure plays an important

role in reinforcing the efforts of supervisory authorities in encouraging the sound risk management

practices and promoting financial market stability (IOSCO 1999). This goes beyond simple

accounting treatment of derivatives in the books of the clients or participants. Enhanced

transparency would also benefit bank and securities firms themselves by enhancing their ability to

evaluate and manage their exposures to counter parties. Institutions should, therefore, provide

meaningful information, both qualitative and quantitative, on the scope and nature of trading and

derivatives activities and elaborate how these activities contribute to their earning profile.

Accounting and valuation and reporting requirements for forward rate agreements and interest

rates swaps have been prescribed in the RBI guidelines (for regulatory reporting), to all scheduled

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commercial banks, primary dealers and All India Financial Institutions by RBI in July 1999.

However, what is being suggested is that the IOSCO principles would need to be suitably

incorporated (through a statutory mandate) in the public disclosure of trading and derivatives

activities of banks and securities firms.

3. Declaring Transactions in Derivatives as Non-speculative

The derivatives markets have three categories of participants− hedgers, speculators and

arbitrageurs. Viewed from the perspective of risk management, derivatives markets are an inter

play of hedgers and speculators, i.e., those who arerisk averse need to have a counter party who are

risk takers. That is why it is absolutely essential that while taking decisions about various aspects

of derivatives trading, such as taxation, accounting etc. a balance needs to be struck between the

interests of hedgers as well as speculators (Sahoo, 2000). 3.2 There are no specific tax provisions

for derivatives transactions under the Income Tax Act, 1961. However, some provisions have

indirect relevance for derivatives transactions. Under section 73(1) of the Income Tax Act, 1961

any losses on speculative business are eligible for set off against profits and gains of speculative

business only, up to a maximum of eight years. The section 43(5) of the Income Tax Act, 1961

defines a speculative transaction where the contract for purchase or sale of any commodity,

including share, is settled otherwise than by actual delivery. There are exceptions given to

jobbing/arbitrage transactions and hedging of underlying positions. It follows that a transaction is

speculative if it is settled otherwise than by actual delivery. The hedging and arbitrage

transactions, even though not settled by actual delivery, are considered non-speculative. Thus, a

speculative transaction is one, which is

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(i) A transaction in commodities/ shares,

(ii) Settled otherwise than actual delivery,

(iii) The participant has no underlying position, and

(iv) The transaction is not for jobbing/arbitrage.

Further, a transaction is construed as speculative, if a participant enters into a hedging transaction

in shares outside his holdings. It is possible that an investor does not have all the 30 or 50 stocks

represented by the index. As a result, it is apprehended that an investor’s losses or profits out of

derivatives transactions, even though they are of hedging nature, may be treated as speculative.

This is contrary to capital asset pricing model, which states that portfolios in any economy move in

sympathy with the index although the portfolios do not necessarily contain any security in the

index.

To summaries, in view of

(i) Practical difficulties in administration of tax for different purposes of the same transaction,

(ii) Innate nature of a derivative contract requiring its settlement otherwise than by actual delivery,

(iii) Need to provide level playing field to all the parties to derivatives contracts (which includes

hedgers as well as speculators and treating the income of all parties to a derivatives contract

equitably), and

(iv). The need to promote the economic purpose of future price discovery, hedging and risk

management in the securities market, it is suggested that the exchange traded derivatives contracts

are exempted from the purview of speculative transactions. These must, however, be taxed as

normal business income or capital gains at the option of the assesses. This would be fiscally more

prudent since it would avoid arbitrary exercise of discretion and possible resultant litigation. This

suggestion would need to be flagged to the tax authorities.

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Legality of OTC Derivatives: International Experience and Lessons for India

Pursuant to the amendment made through the Securities Laws (Amendment) Act, 1999 in SCRA

regarding legally permitted "derivatives," a doubt was raised about the legality of the OTC

derivatives such as forward rate agreements and interest rate swaps permitted under RBI guidelines

issued to banks, primary dealers and All India financial institutions in July 1999. It was felt that

these OTC derivatives could be deemed as illegal in view of express exemption to only exchange

based derivatives from wagering contracts under SCRA. Efforts need to be made to examine

solution to the issue so that the legality of OTC derivatives can be ensured. In this connection, it

would be instructive to study the US experience of the recent past when the US Government was

involved in clarifying the uncertainty in the OTC derivatives markets. The US efforts are

documented in the report of the President’s Working Group on Financial Markets (Report of The

President’s Working Group on 13 Financial Markets 1999) entitled "Over the Counter Derivatives

Markets and the Commodity Exchange Act" and the Commodity Futures Modernization Act

(CFMA) of 2000.

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 ANALYSIS OF
DERIVATIVES IN
INDIAN CAPITAL
MARKET

ANALYSIS OF DERIVATIVES IN INDIAN CAPITAL MARKET

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SWOT ANALYSIS

 STRENGTH

 High leverage

 Profit in both bulls and bear markets

 Lower transactions

 Cost highly liquidity

 WEAKNESS

 Complex

 Highly speculative

 Liquidity risk

 OPPORTUNITY

 Price control opportunities

 THREAT

 Knowledge restriction

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 FINDINGS AND
CONCLUSION

FINDINGS AND CONCLUSION

 Derivatives play a very important role in the up-bringing of an organization; it plays a

major role in the equity market.

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 Today, with the help of derivatives, the Indian stock exchange market has recently

rocketed up to become Asia’s fourth largest exchange traded derivatives market.

 In terms of growth of derivative markets and a variety of derivatives users, the Indian

market has exceeded or equaled many other Indian markets.

 The variety of instruments in derivatives instruments available for trading is also

expanding.

 Corporations, private sectors institutions, state-owned and smaller companies are

gradually getting into the act.

 The business growth of NSE started from a mere Rs.1000 million and has reached to 2,

50,000 million (conversion table) during Jan- Mar 2006 quarter and is at the booming stage

at the moment possible itself. This shows that the stock market with the help of derivatives

have taken for a very good progress in the Indian economy.

 There exist large gaps in the range of derivative products that are actively traded. In

equity derivatives, NSE figures show that 90% of activity is due to index futures or stock

futures, whereas trading in options is limited to few stocks, partly they are cash settled and

not the underlying stocks. Exchange-traded derivatives on interest rates and currencies are

virtually absent.

 Although from the past experience of stock exchanges, we have seen that derivatives

have yielded losses to MNC’s like BP , Proctor & Gamble and etc but at the same time it

has also yielded profits to MNC’s like Coca-Cola, Intel etc for their organization, thus we

can see clearly that derivatives do not involve risk all the time.

 The institutional investors are major players in the derivatives market as mentioned

earlier.

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 According to NSE, retail investors (including small brokerages trading for themselves)

are the major participants in equity derivatives, accounting for 65% of turnover in August

2010.

 The success of single stock futures in India is unique, as it has failed in most other

countries. One reason for this success may be retail investors’ prior familiarity with “badla”

trades which shared some features of trading in derivatives. Another reason may be small

size of future contracts, as compared to similar contracts in other countries.

 There is a lot of risk in investment in Equity Funds and is appropriate for those individual

who can afford to take high risk, but this high risk may either leave the investor to loose all

their money with no returns as they are not safe investments or pay them high returns in the

long run. Therefore, from the point of view of the investment in such type of equity funds

would be safer and investments would be secure.

 Equity derivatives of Banks are highly leveraged nature of banking business and the

investment in the equities, banks in India are the best and termed as marginal investors in

equity.

 Equity derivatives in FIs do not run an equities arbitrage trading book, yet it appears that

there is no RBI guideline disabling FIs from running an equities arbitrage trading book to

capture risk free pricing stocks.

 Equity derivatives in Mutual Funds are ought to be natural players in the equity derivatives

market and SEBI have also authorized use of exchange traded equity derivatives for mutual

fund plc.

 The activities in the FII in the equity derivatives market in India are in the emerging future.

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 Equity derivatives in Life and General Insurers are silent about the use of equity or other

derivatives.

 The market has a very automatic borrowing and lending market which is not up to the

market.

 Put-Call issues are very good indicators of the derivative market.

The second key factor where the equity derivatives market has as yet not made substantial

progress is the large-scale utilization of IT systems in trading, arbitrage, market marking,

etc. When a few dozen underlying generate thousands of derivative securities, it is essential

to have computer systems primarily driving the actuimplementation of trading strategies

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LIMITATIONS

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 LIMITATIONS

As per the researcher following are the limitations of this study:-

1. Time Factor

As we know that nobody can hold time therefore in my study of derivatives in Indian capital

market, researcher find less time to expose his efforts and knowledge to collect thorough details of

the topic.

2. Source of data

According to researcher this study is completely based on secondary data and does not involved

any personnel interaction with any financial entities.

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 RECOMMENDATION

RECOMMENDATIONS

 Further Research in this area after a span of year’s time would be worthwhile to do

because the derivatives market and equity market are not stable.

 A research based on strategic alliances between BSE (Bombay Stock Exchange), NSE

(National Stock Exchange) and NADAQ could be seen in the upcoming years.

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 Since derivative and equity market depend on exchange rate on a large scale and they are

of a very fluctuating nature, further research on exchange rate would be prudent.

 At the same time, research on the interest rate would be sensible; because, as exchange rate

have a fluctuating nature, interest rate depends upon the exchange rate of any country for

its progress and on the whole interest rate are co-related with the derivatives and equity

market.

 In the derivative market more scripts are required in the F&O segment.

 The lots size need to be reduced from Rs.2, 00,000 to Rs.1, 00,000.

 Markets should be stock settled instead of cash settlement.

 Since the equity market depends on any individual’s disposable income, further research

should also be looked into disposable income.

 To have a consistent method of accounting for losses and gains from the derivatives

trading, a proper framework to account for derivatives needs to be developed.

 Research on the institutional investors in India i.e. FIs, Mutual Funds, Banks, Life and

general insurers would be meaningful to do on a large scale, because these are the major

players who use derivatives and invest in equity market.

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 BIBLIOGRAPHY

BIBLIOGRAPHY

I. Vohra, N.D, & Bagri.B.R. Futures & option, publisher Tata McGraw.

II. Bhalla.V.K.International Financial Management, Anmol publishing Pvt. Ltd. New Delhi

III. Gupta .L.C. Regulatory framework derivatives in India,

IV. http://www.derivativesindia.com

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 V. http://www.igidr.ac.in

VI. http://www.nseindia.com

VII. http://www.rediff/money/derivatives

VIII. https://www.sebi.gov.in

IX. http://www.bseindia.com

X. http://google.com

XI. http://www.capitalmarket.com

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