Adu Final Blackbook.docx

A STUDY ON DERIVATIVES MARKET

A Project Submitted To University Of Mumbai For Partial Completion Of The Degree Of Bachelors Of Financial Markets Semester-VI

By ADITI KHOBREKAR Roll No. 307 Under the Guidance of Ganashree Kokulla

Smt. Parmeshwaridevi Durgadutt Tibrewala Lions Juhu College Of Arts, Science & Commerce J. B. Nagar, Andheri (E), Mumbai-400 059 2018-2019

Smt. Parmeshwaridevi Durgadutt Tibrewala Lions Juhu College Of Arts, Science & Commerce J. B. Nagar, Andheri (E), Mumbai-400 059

CERTIFICATE This is to certify that Miss. Aditi Khobrekar has worked and duly completed her project work for the degree of bachelors of financial market and his project is entitled, “A STUDY ON DERIVATIVES MARKET”, under my supervision. I further certify that the entire work has been done by the learner under my guidance and that no part of it has been submitted previously for any degree or diploma of any university. It is her own work and facts reported by his personal findings and investigations.

Name and Signature of Guiding Teacher

Date of submission:

DECLARATION BY LEARNER I the undersigned Miss. Aditi Khobrekar here by, declare that the work embodied in this project work titles “A Study On Derivatives Market”, forms my own contribution to the research work carried out under the guidance of Ganashree Kokulla is a result of my own research work and has not been previously submitted to any other university for any other Degree to this or any other University. Wherever reference has been made to previous works of others, it has been clearly indicated as such and included in the webliography. I here by further declare that all information of this document has been obtained and presented in accordance with academic rules and ethical conduct.

Name and Signature of the learner

Certified by Name and signature of the Guiding Teacher

ACKNOWLEDGEMENT To list who all have helped me is difficult because they are so numerous and the depth is so enormous. I would like to acknowledge the following as being idealistic channels and fresh dimensions in the completion of this project. I take this opportunity to thank the University of Mumbai for giving me chance to do this project. I would like to thank my Principal, Trishla Mehta for providing the necessary facilities required for completion of this project. I take this opportunity to thank our Coordinator Dr. Nanda Indulkar, for her moral support and guidance. I would also like to express my sincere gratitude towards my project guide Prof Pooja Soni, Reshma Khan, & Anita Kedare whose guidance and care made the project successful. I would like to thank my College Library, for having provided various reference books and magazines related to my project. Lastly, I would like to thank each and every person who directly or indirectly helped me in the completion of the project especially my Parents and Peers who supported me throughout my project.

EXECUTIVE SUMMARY Many associate the financial market mostly with the equity market. The financial market is, of course, far broader, encompassing bonds, foreign exchange, real estate, commodities, and numerous other asset classes and financial instruments. A segment of the market has fast become its most important one: derivatives. The derivatives market has seen the highest growth of all financial market segments in recent years. It has become a central contributor to the stability of the financial system and an important factor in the functioning of the real economy. Despite the importance of the derivatives market, few outsiders have a comprehensive perspective on its size, structure, role and segments and on how it works. The derivatives market has recently attracted more attention against the backdrop of the sub prime lending crisis, financial crisis, fraud cases and the near failure of some market participants. Although the financial crisis has primarily been caused by structured credit-linked securities that are not derivatives, policy makers and regulators have started to think about strengthening regulation to increase transparency and safety both for derivatives and other financial instruments. The study is purely based on the secondary data for examining futures market in terms of relationship, modelling and forecasting volatility in India. The study period spanned from January 2003 to December 2008 with a sample of 25 stock futures contracts. For the purpose of evaluating stock futures, we used ARCH/GARCH family model to draw valid conclusion. Our findings suggest that, volatility is a part and parcel of capital market and have a major effect in derivative market fluctuations, it is due to the other key determining factors like inflow of foreign capital into the country like exchange rate, balance of payment, interest rate etc. Rise in market capitalization leads to rise in inflation rates, Industrial Production Index (IIP) and Gross Domestic Product (GDP). Overall, it is clearly desirable to preserve the environment that has contributed to the impressive development of the derivatives market and enhances the overall depth, increases market liquidity and compresses spot market volatility in the Indian economy. However, some aspects of the futures trading terminal can still be improved further.

CONTENT

SR NO.

TOPIC

1)

INTRODUCTION

1.1

Introduction of derivatives

1

1.2

Definition

3

1.3

Why do derivatives matter?

4

1.4

Evolution and growth of derivatives

4

1.5

How do derivatives work

8

1.6

Derivatives market in India

9

1.7

Features of derivatives

15

1.8

Uses of derivatives

17

1.9

Functions of derivatives

18

1.10

Dangers of derivatives

21

1.11

Types of derivatives

23

1.12

Participants of derivatives

50

2)

RESEARCH METHODOLOGY

2.1

Research methodology

56

2.2

Objectives of study

58

2.3

Questionnaire for research

59

3)

REVIEW OF LITERATURE

61

4)

DATA ANALYSIS

64

4.1

Findings

72

5)

CONCLUSION &SUGGESTION

5.1

Conclusion

73

5.2

suggestion

74

WEBLOGRAPHY

75

1. INTRODUCTION

PAGE NO.

1.1 INTRODUCTION OF DERIVATIVES A derivative is a financial security with a value that is reliant upon, or derived from, an underlying asset or group of assets. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset. The

most

common

include stocks, bonds, commodities, currencies, interest

underlying rates and market

assets indexes.

These assets are commonly purchased through a variety of brokerages. You can check out Investopedia's list of the best online brokers to see some of the top places to start investing. Derivatives can either be traded over-the-counter (OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives and are not standardized. Meanwhile, derivatives traded on exchanges are standardized and more heavily regulated. OTC derivatives generally have greater counterparty risk than standardized derivatives. Derivatives are securities that derive their value from an underlying asset or benchmark. Common derivatives include futures contracts, options and swaps. Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset. Exchange-traded derivatives like futures and stock options are standardized and eliminate or reduce many of the risks of over-the-counter derivatives like counterparty and liquidity risks. Derivatives are usually leveraged instruments, which increases the potential risks and rewards of these securities. Derivatives, such as options or futures, are financial contracts which derive their value of a spot price time-series, which is called \the underlying". For examples, wheat farmers may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market. This market is the \derivative market” and the prices on this market would be driven by the spot market price of wheat which is the \underlying". The terms \contracts" or \products" are often applied to denote the specific traded instrument. The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange and real estate.

The past decade has witnessed an explosive growth in the use of financial derivatives by a wide range of corporate and financial institutions. This growth has run in parallel with the increasing direct reliance of companies on the capital markets as the major source of long-term funding. In this respect, derivatives have a vital role to play in enhancing shareholder value by ensuring access to the cheapest source of funds. Furthermore, active use of derivative instruments allows the overall business risk profile to be modified, thereby providing the potential to improve earnings quality by offsetting undesired risks. Despite the clear benefits that the use of derivatives can offer, too often the public and shareholder perception of these instruments has been coloured by the intense media coverage of financial disasters where the use of derivatives has been blamed. The impression is usually given that these losses arose from extreme complex and difficult to understand financial strategies. The reality is quite different. When the facts behind the well-reported disasters are analyzed almost invariably it is found that the true source of losses was a basic organizational weakness or a failure to observe some simple business controls. The corollary to this observation is that derivatives can indeed be used safely and successfully provided that a sensible control and management strategy is established and executed. Certainly, a degree of quantitative pricing and risk analysis may be needed, depending on the extent and sophistication of the derivative strategies employed. However, detailed analytic capabilities are not the key issue. Rather, successful execution of a derivatives strategy and of business risk management in general relies much more heavily on having a sound appreciation of qualitative market and industry trends and on developing a solid organisation, infrastructure and controls. Within a sound control framework, the choice of a particular quantitative risk management technique is very much a secondary concern. The objective of this chapter is to examine the growth of financial derivatives in world markets and to analyse the impact of these financial derivatives on the monetary policy The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of

volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking–in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

1.2 DEFINITION The word derivative comes from the verb “derive”, which means the action of having or taking something from an underlying source. A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Derivative is easier to understand than to describe it and it is easier to describe than to define it. Derivative is a generic term used to describe a spectrum of products that derive their price or have their value linked to some other product. A derivative is a financial instrument whose value depends on the value of underlying assets (variables). These variables can be prices of currency, stock, commodity, indices, interest rates, etc. The term derivative has been defined in securities contracts (regulations) Act, as: a derivative includes a) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b) A contract which derives its value from the prices, or index of prices, of underlying securities.

1.3 WHY DO DERIVATIVES MATTER? As often is the case in trading, the more risk you undertake the more reward you stand to gain. Derivatives can be used on both sides of the equation, to either reduce risk or assume risk with the possibility of a commensurate reward. This is where derivatives

have received such notoriety as of late: in the dark art of speculating through derivatives. Speculators who enter into a derivative contract are essentially betting that the future price of the asset will be substantially different from the expected price held by the other member of the contract. They operate under the assumption that the party seeking insurance has it wrong in regard to the future market price, and look to profit from

the

error

Contrary to popular opinion, though, derivatives are not inherently bad. In fact, they are a necessity for many companies to ensure profits in volatile markets or provide mitigated risk for everyday investors looking for investment insurance.

1.4 EVOLUTION AND GROWTH OF DERIVATIVES: According to some financial scholars, future trading dates back in India to around 200 B. C. Evolution of trading methods of futures can be traced in the medieval fairs of France and England as early as the 12th century. It is difficult to trace out origin of futures trading since it is not clearly established as to where and when the first forward market came into existence. Historically, it is evident that futures markets were developed after the development of forward markets. It is believed that the forward trading was in existence during 12th century in England and France. Forward trading in rice was started in 17th century in Japan, known as Cho-at-Mai a kind (rice trade-on-book) concentrated around Dojima in Osaka, later on the trade As per the records, rice was traded for future delivery in Osaka in the 1730s. Wheat and corn futures were reportedly traded in the UK and the USA in the 19th century. The Chicago Board of Trade (CBOT), established in 1848, was an active exchange for handling commodities, especially corn and wheat. The history of derivatives has two important milestones. The first was the establishment of stock options trade in Chicago — initially OTC and subsequently on the CBOT market in equity derivatives in 1987. The CBOT was set up in 1848 as a meeting place for farmers and merchants. It standardized the quantities and qualities of the grains that were to be traded. The first future type contract was known as ‘to arrive’ contract.

The CBOT now offers futures contract on various assets like corn, soya bean meal, soya bean oil, wheat, silver, bonds, treasury notes, stock index, etc. In 1874, the Chicago Produce Exchange was established to provide a market for poultry products, butter and other perishable agricultural products. In 1898, the butter and egg dealers detached themselves from this exchange and formed Chicago Butter and Egg Board. In 1919, this was renamed as Chicago Mercantile Exchange and was reorganized for future trading. In 1972, the International Monetary Market (IMM) was constituted as a division of the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies. The first traded financial futures were foreign currency contracts which began trading on the International Commercial Exchange (ICE) in 1970. However, it did not succeed and had to go out of business. Additional foreign currency contracts commenced trading on the Chicago Mercantile Exchange in 1974. In 1975, the commodity futures trading commission (CFTC) officially designated nine currencies as contract markets on these exchanges, these included British pound, Canadian dollar, Deutschemarks, Dutch guilders, Japanese Yen, Swiss traces, Italian Lira and Mexican Pesos. Global futures market currently includes metals, grains, petroleum products financial instruments and a whole lot of other products. Other futures that trade in futures world over include the Chicago Rice and Cotton Exchange, the New York Future Exchange, the London International Finance Futures Exchange (LIFFE), the Toronto Futures Exchange (TFE) and the Singapore International Monetary Exchange (SIMEX), MATIF (France), EOE (Holland), SOFFEX (Switzerland) and DTB (Germany). In India, there is no derivative based on interest rate currently. But there is a future market on selected commodities (Castor seed, hessian, gur, potatoes, turmeric and pepper). The Forward Markets Commission (FMC) is the controlling body for these markets.

India also has a strong currency forward market. Daily volume in this market is reportedly over US $ 500 million per day. The forward cover is currently available for a maximum of 6 months. Indian users can also buy derivatives based on foreign currencies on foreign markets for hedging. Ever since the “Badla” was banned, there has been a crying need for other risk-hedging devices. The Bombay Stock Exchange has been glamorizing for the return of the “Badla” in its old form. But the National Stock Exchange has set into motion the process of introducing futures and options. The L. C. Gupta Committee on derivatives was of the view that there was need for equity-based derivatives, interest rate derivatives and currency derivatives. But it recommended introduction of equity-based derivatives in the first instance based on futures only, rather than options or futures/options on individual stocks which are considered more risky. The Committee suggested that the other complex type of derivatives should be introduced at a later stage after the market participants have acquired some degree of comfort and familiarity with the simpler types. The Securities and Exchange Board of India (SEBI) has, of late, accepted the recommendation of the Gupta Committee and allowed phased introduction of derivative trading in the country beginning with a stock index futures. Amendments to the Securities Contract Act (SCRA) are on the anvil. This will facilitate inclusion of derivative contracts based on index of prices of securities and other derivative contracts in securities trading. The SEBI also approved suggestive by-laws proposed by the Committee covering operational aspects for regulation and control on derivative contracts. The RBI introduced recently, rupee derivative trading in the country. It formally allowed banks and corporates from July 6, 1999 to hedge against interest rate risks through the use of interest rate swaps (IRS) and forward rate agreements (FRA). According to the guidelines, there would be no restriction on the tenure and size of the IRS and FRA entered into by banks.

The IRS would allow corporates to hedge their interest rate risks and also provide an opportunity to swap their old high cost loans with cheaper ones. However, the RBI has warned that while dealing with corporates, the participants should ensure that they are undertaking FRAs/IRS only for hedging their own balance sheet exposures and not for speculative purposes. Thus, commercial banks, primary dealers, and corporates can now undertake IRS and FRA as a product for their own balance sheet management and market making purposes. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity forward/futures contracts. However when derivatives trading in securities was introduced in 2001, the term ‘security’ in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the preview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Interest rate fluctuations had not only created instability in bond prices, but also in other long-term assets such as, company stocks and shares. Share prices are determined on the basis of expected present values of future dividend payments discounted at the appropriate discount rate. Discount rates are usually based on longterm interest rates in the market. So increased instability in the long-term interest rates caused enhanced fluctuations in the share prices in the stock markets.

1.5 HOW DO DERIVATIVES WORK? Derivatives are often used as an instrument to hedge risk for one party of a contract, while offering the potential for high returns for the other party. Derivatives have been created

to

mitigate

a

remarkable

number

of

risks:

fluctuations

in stock, bond, commodity, and index prices; changes in foreign exchange rates; changes in interest rates; and weather events, to name a few. One of the most commonly used derivatives is the option. Let's look at an example:

Say Company XYZ is involved in the production of pre-packaged foods. They are a large consumer of flour and other commodities, which are subject to volatile price movements. In order for the company to assure any kind of consistency with their product and meet their bottom-line objectives, they need to be able to purchase commodities at a predictable and market-friendly rate. In order to do this, company XYZ would enter into an options contract with farmers or wheat producers to buy a certain amount of their crop at a certain price during an agreed upon period of time. If the price of wheat, for whatever reason, goes above the threshold, then Company XYZ can exercise the option and purchase the asset at the strike price. Company XYZ pays a premium for this privilege, but receives protection in return for one of their most important input costs. If XYZ decides not to exercise its option, the producer is free to sell the asset at market value to any buyer. In the end, the partnership acts as a win-win for both parties: Company XYZ is guaranteed a competitive price for the commodity, while the producer is assured of a fair value for its goods. In this example, the value of the option is "derived" from an underlying asset; in this case, a certain number of bushels of wheat. Other common derivatives include futures, forwards and swaps.

1.6 DERIVATIVES MARKET IN INDIA 1.6.1 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 SCRA was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three–decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. 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 index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. 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. 1.6.2 Derivatives market at NSE The derivatives trading on the exchange 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 Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. 1.6.3 Trading mechanism The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen–based trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict price–time priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users. The Trading Members(TM) have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Good-till-Day, Goodtill-Cancelled, Good till-Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take. 1.6.4 Membership criteria NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2–tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs:



Self-Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients.



Trading Member Clearing Member: TM–CM is a CM who is also a TM. TM–CM may clear and settle his own proprietary trades and client’s trades as well as clear and settle for other TMs.



Professional Clearing Member: PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TM1.

Business growth of futures and options market: Turnover(Rs. Crore) Month Index futures Stock futures Index futures Stock options Jun-00 35 Jul-00 108 Aug-00 90 Sep-00 119 Oct-00 153 Nov-00 247 Dec-00 237 Jan-01 471 Feb-01 524 Mar-01 381 Apr-01 292 May-01 230 Jun-01 590 196 -

Total 35 108 90 119 153 247 237 471 524 381 292 230 785

Jul-01 Aug-01 Sep-01 Oct-01

1309 1305 2857 2485

-

326 284 559 559

396 1107 2012 2433

2031 2696 5281 5477

Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 2001-02

2484 2339 2660 2747 2185 21482

2811 7515 13261 13939 13989 51516

455 405 338 430 360 3766

3010 2660 5089 4499 3957 25163

8760 12919 21348 21616 20490 101925

Details of the eligibility criteria for membership on the F&O segment are provided in Tables 12.1 and 12.2(Chapter 12). The TM–CM and the PCM are required to bring in additional security deposit in respect of every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a certification programme approved by SEBI.\

1.6.5 Turnover The trading volumes on NSE’s derivatives market have seen a steady increase since the launch of the first derivatives contract, i.e. index futures in June 2000. Table 1.3 gives the value of contracts traded on the NSE from the inception of the market to March 2002. The average daily turnover at NSE now exceeds a 1000 crore. A total of 41,96,873 contracts with a total turnover of Rs.1,01,926 crore was traded during 2001-2002. 1.6.6 Clearing and settlement NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. We take a brief look at the clearing and settlement mechanism.

 Clearing The first step in clearing process is working out open positions or obligations of members. A CM’s open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TM’s open position is arrived at as the summation of his proprietary open position and clients open positions, in the contracts in which they have traded. While entering orders on the trading system, TMs are required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for each contract. Clients’ positions are arrived at by summing together net (buy-sell) positions of each individual client for each contract. A TMs open position is the sum of proprietary open position, client open long position and client open short position.

 Settlement 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. 1.6.7 Risk management system 

The salient features of risk containment measures on the F&O segment are: Anybody interested in taking membership of F&O segment is required to take membership of“CM and F&O”or “CM, WDM and F&O”. An existing member of CM segment can also take membership of F&O segment. The details of the eligibility criteria for membership of F&O segment are given in the chapter on regulations in this book.



NSCCL charges an upfront initial margin for all the open positions of a CM Upto client level. It follows the VaR based margining system through SPAN system. NSCCL computes the initial margin percentage for each Nifty index

futures contract on a daily basis and informs the CMs. The CM in turn collects the initial margin from the TMs and their respective clients. 

NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time basis. Limits are set for each CM based on his base capital and additional capital deposited with NSCCL. The on-line position monitoring system generates alerts whenever a CM reaches a position li 1.7 Derivatives market in India 17 set up by NSCCL. NSCCL monitors the CMs and TMs for mark to market value violation and for contract-wise position limit violation.



CMs are provided with a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through them. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it withdraws the trading facility provided to such TM.



A separate Settlement Guarantee Fund for this segment has been created out of the capital deposited by the members with NSCC

1.7 FEATURES OF FINANCIAL DERIVATIVES 1. It is a contract: Derivative is defined as the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short term interest rate futures and long term interest rate futures contract. 2. Derives value from underlying asset: Normally, the derivative instruments have the value which is derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of derivatives depends upon the

value of underlying instrument and which changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related. 3. Specified obligation: In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different. 4. Direct or exchange traded: The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial futures contracts. The exchange-traded derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are Dow Jon’s, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.

5. Related to notional amount: In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the payoff. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differs from the payoff that their notional amount might suggest. 6. Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no

effective limit on the quantity of claims, which can be traded in respect of underlying assets. 7. May be used as deferred delivery: Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to financial engineering. 8. Secondary market instruments: Derivatives are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are exception in this respect. 9. Exposure to risk: Although in the market, the standardized, general and exchange-traded derivatives are being increasingly evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counterparty risk and legal risk. Further, there may also be uncertainty about the regulatory status of such derivatives.

1.8 USES OF DERIVATIVES Derivatives are supposed to provide the following services: 1. Risk aversion tools: One of the most important services provided by the derivatives is to control, avoid, shift and manage efficiently different types of risks through various strategies like hedging, arbitraging, spreading, etc. Derivatives assist the holders to shift or modify suitably the risk characteristics of their portfolios. These are specifically useful in highly volatile financial market conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary chaos.

2. Prediction of future prices: Derivatives serve as barometers of the future trends in prices which result in the discovery of new prices both on the spot and futures markets. Further, they help in disseminating different information regarding the futures markets trading of various commodities and securities to the society which enable to discover or form suitable or correct or true equilibrium prices in the markets. As a result, they assist in appropriate and superior allocation of resources in the society. 3. Enhance liquidity: As we see that in derivatives trading no immediate full amount of the transaction is required since most of them are based on margin trading. As a result, large number of traders, speculators arbitrageurs operates in such markets. So, derivatives trading enhance liquidity and reduce transaction costs in the markets for underlying assets 4. Assist investors: The derivatives assist the investors, traders and managers of large pools of funds to devise such strategies so that they may make proper asset allocation increase their yields and achieve other investment goals.

1.9 FUNCTIONS OF DERIVATIVES MARKETS The following functions are performed by derivative markets: 1. Price Discovery: Price discovery is expectation of the future cash/spot prices on the basis of prices of the futures/forward contracts’. Price discovery is a mechanism by which a “fair value price” is determined by the large number of participants in the derivatives markets. The markets participants can estimate the prices of underlying at a given point in time with the help of information currently available in the derivatives

segment/market. Increasing participants of hedgers, speculators and arbitrageurs has increased the depth of the derivatives markets. The automation of derivatives exchange and electronic trading systems established by the derivatives exchanges has led to faster and smoother information dissemination amongst market participants. Due to which the price discovery mechanism has become more efficient. 2. Risk transfer: The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Linked to cash markets: Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Check on speculation: Speculation traders shift to a more controlled environment of the derivatives market. In the absence of an organised derivatives market, speculators trade in the underlying cash markets. Managing, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

5. Encourages entrepreneurship: An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. 6. Increases savings and investments:

Derivatives markets help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity. 7. Beneficial to banks and financial institutions: Banks and Financial Institutions can benefit by hedging their risks since they deal primarily in the underlying on which financial derivatives are based. They can hedge the risk even if the underlying does not meet their requirements of exact specifications. 8. Lower transaction cost: The increasing participation in the derivatives markets by variety of participants, the transaction costs are showing falling trend. 9. An option for high net worth investors: With the rapid spread of derivatives trading in commodities, the commodities route too has become an option for high net worth and savy investors to consider in their overall asset allocation.

10. High financial leverage: Leveraged investment is possible in derivatives markets. For example, trading in Infosys shares need only 4% initial margin. Thus, if one Infosys futures contract (each futures contract lot size is 100 shares) is valued at Rs. 1,04,000 when futures price is Rs. 1,040 per share, the investor is expected to deposit an initial margin of only Rs. 4,160 to be able to trade. If the price of Infosys shares goes up by even 2%, the investor would make profit of Rs. 2,080 (2% of Rs. 1,04,000) on a deposit of Rs. 4,160/- before the expiry of the contract i.e. Return of 50% on deposit on initial margin amount. This is the benefit of leveraged trading transaction.

11. Derivatives as an asset class for diversification of portfolio risk: Derivatives provide wider scope to portfolio management in bettering their investment risk-return trade off. Portfolio managers can diversify their portfolios in a better way by including derivatives in their investment basket. The risk management and leveraging function of derivatives helps portfolio managers in efficient portfolio management. Derivatives have historically an inverse correlation of daily returns as compared to equities. The skewness of daily returns favours derivatives, thereby indicating that in a given time period derivatives have a greater probability of providing positive returns as compared to equities. Another consisting of derivatives as well as equities. Even with a marginal distribution of funds in a portfolio to include derivatives, the Sharpe ratio is greatly enhanced, thereby indicating a decrease in risk for given level of returns. Thus, an investor can effectively minimize the portfolio risk arising due to price fluctuations in other asset classes by including derivatives in the portfolio.

1.10 DANGERS OF DERIVATIVES Derivatives products are primarily used as risk management tool. They are required to be used appropriately and carefully. If they are used indiscriminately they instead of risk management tool may become risk prone tools. Indiscriminate use of derivatives can lead to disasters. Following are selected pitfalls/dangers of derivatives products. 1. Speculative and volatile 2. Restrictive regulation 3. Increased bankruptcy

1.10.1. Speculative and volatile: The high leveraging capabilities offered by derivatives products attracts participants with thin capital base. The prospect of high returns induces participants in taking indiscriminate positions in derivatives markets which leads to excessive speculation. The speculative tendencies tend to become dominant. This dominance of speculative forces leads to volatility in the prices of derivatives as well as underlying assets in the spot market. Indian derivatives markets, especially commodity derivatives, have quite often experienced extreme volatilities and excessive speculation. The prices in the spot markets usually get overvalued because of these excesses. The extreme volatility and excessive speculation leads to demand-supply mismatch too. 1.10.2. Restrictive regulations: The extreme volatility and excessive speculation throws the spot market out of sync. The overvaluation in spot market and demand-supply imbalance prompts the regulatory authority to suspend trading in derivatives of those underlying whose prices have become volatile and speculative. This affects the risk management programs of hedgers who have genuine exposure to risk. Further, in order to discourage excessive speculation and volatility the regulatory authority world over have put in place controls measures. Such controls are often not favoured by some participants. They view such controls as barriers to growth of derivatives market. The participants at time may feel that derivative markets are over-regulated, thus inhibiting development of derivatives markets.

1.10.3. Increased Bankruptcy High leveraging feature of derivatives induces participants in derivatives markets to builds positions indiscriminately beyond their financial capabilities. The positions in derivatives markets are sequential thus one default creates chain reaction and ultimately leading to collapse of entire derivatives market. The recent global financial crisis is an evidence of indiscriminate trading in derivatives markets, which created chain reaction and sequentially financial markets across the globe started

failing. The crisis reached such disastrous levels that the monetary authorities of affected countries had to bail out the affected financial institutions by infusing funds into these institutions. These bail-out packages are strain on exchequer. The gravity of crisis is such that it prompted regulatory authorities across the globe to impose more stringent norms for entire financial markets.

1.11 TYPES OF DERIVATIVES Derivatives are of two types: financial and commodities.

One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a commodity derivative, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soya beans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matter. However, despite the distinction between these two from structure and functioning point of view, both are almost similar in nature. The most commonly used derivatives contracts are forwards, futures and options.

1.11.1. FINANCIAL DERIVATIVES A financial derivative is a financial instrument whose value is based on or derived from one or more underlying assets or indexes of assets. The underlying assets in case of financial derivatives are typically equities (stocks), debt (bonds, TBills, and notes), currencies and even indexes of these various financial assets such as NSE’s S&P Nifty, BSE’s Sensex, Volatility Index, etc. Financial derivatives are kind of a risk management tool widely used by investors and portfolio managers. Numerous forms of financial derivatives are available in the financial markets. The three most fundamental financial derivatives are forward, futures and options. One important feature of financial derivatives is that these are tools which is merely a contract and does not help mobilize funds in the primary markets. These are created by a contractual agreement between two parties based on the price of the underlying asset. There is usually no limit on the number of contracts that can be created, except in case of exchange traded financial derivatives wherein the exchange clearing house imposes limits on number of derivative contracts for particular underlying asset or class of asset. Initially derivative products emerged as hedging devices to guard against fluctuations in commodity prices. For a long time commodity-linked derivatives were the sole forms of derivatives products available for trading. The growing instability in the financial markets, post 1970 the financial derivatives gained importance and became very popular. Two-thirds of the total trade in derivatives products was in the form of financial derivatives. In the recent years, the market for financial derivatives has grown in terms of types of instruments available and their complexity

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

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



Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.



The contract price is generally not available in public domain.



On the expiration date, the contract has to be settled by delivery of the asset.



If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market.

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to raise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.  How it works (Example): If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if prices rise later, you will get only what your contract entitles you to. If you are Kellogg, you might want to purchase a forward contract to lock in prices and control your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat depending on the market price when you take delivery of the wheat.

 Features of Forward Contract The basic features of a forward contract are given in brief here as under: 

Bilateral: Forward contracts are bilateral contracts, and hence, they are exposed to counterparty risk.



More risky than futures: There is risk of non-performance of obligation by either of the parties, so these are riskier than futures contracts.



Customised contracts: Each contract is custom designed, and hence, is unique in terms of contract size, expiration date, the asset type, quality, etc.



Long and short positions:

In forward contract, one of the parties takes a long position by agreeing to buy the asset at a certain specified future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contract is said to have an open position. A party with a closed position is, sometimes, called a hedger.



Delivery price: The specified price in a forward contract is referred to as the delivery price. The forward price for a particular forward contract at a particular time is the delivery price that would apply if the contract were entered into at that time. It is important

to differentiate between the forward price and the delivery price. Both are equal at the time the contract is entered into. However, as time passes, the forward price is likely to change whereas the delivery price remains the same.



Synthetic assets: In the forward contract, derivative assets can often be contracted from the combination of underlying assets, such assets are oftenly known as synthetic assets in the forward market. The forward contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which may dominate and command the price it wants as being in a monopoly situation.



Pricing of arbitrage based forward prices: In the forward contract, covered parity or cost-of-carry relations are relation between the prices of forward and underlying assets. Such relations further assist in determining the arbitrage-based forward asset prices.



Popular in forex market: Forward contracts are very popular in foreign exchange market as well as interest rate bearing instruments. Most of the large and international banks quoted the forward rate through their ‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange quotes by these banks are displayed with the spot rates.

2. Futures contracts

A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Examples of futures markets are the New York Mercantile Exchange, the Kansas City Board of Trade, the Chicago Mercantile Exchange, the Chicago Board Options Exchange and the Minneapolis Grain Exchange. Originally, such trading was carried on through open yelling and hand signals in a trading pit, though in the 21st century, like most other markets, futures exchanges are mostly electronic. In order to understand fully what a futures market is, it’s important to understand the basics of futures contracts, the assets traded in these markets. Futures contracts are made in an attempt by producers and suppliers of commodities to avoid market volatility. These producers and suppliers negotiate contracts with an investor who agrees to take on both the risk and reward of a volatile market. Futures markets or futures exchanges are where these financial products are bought and sold for delivery at some agreed-upon date in the future with a price fixed at the time of the deal. Futures markets are for more than simply agricultural contracts, and now involve the buying, selling and hedging of products and future values of interest rates. Futures contracts can be made or "created" as long as open interest is increased, unlike other securities that are issued. The sizes of futures markets (which usually increase when the stock market outlook is uncertain) are larger than that of commodity markets, and are a key part of the financial system. Suppose a farmer produces rice and he expects to have an excellent yield on rice; but he is worried about the future price fall of that commodity. How can he protect himself from falling price of rice in future? He may enter into a contract on today with some party who wants to buy rice at a specified future date on a price determined today itself. In the whole process the farmer will deliver rice to the party and receive

the agreed price and the other party will take delivery of rice and pay to the farmer. In this illustration, there is no exchange of money and the contract is binding on both the parties. Hence future contracts are forward contracts traded only on organised exchanges and are in standardised contract-size. The farmer has protected himself against the risk by selling rice futures and this action is called short hedge while on the other hand, the other party also protects against-risk by buying rice futures is called long hedge.  How Do Futures Contracts Work? The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth,

and

certain

financial

instruments

are

also

part

of

today's commodity markets. There are two kinds of futures traders: hedgers and speculators. Hedgers do not usually seek a profit by trading commodities futures but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the market for the underlying physical commodity. For example, if you plan to grow 500 bushels of wheat next year, you could either grow the wheat and then sell it for whatever the price is when you harvest it, or you could lock in a price now by selling a futures contract that obligates you to sell 500 bushels of wheat after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if the season is terrible and the supply of wheat falls, prices will probably rise later -- but you will get only what your contract entitled you to. If you are a bread manufacturer, you might want to purchase wheat futures contract to lock in prices and control your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat depending on where prices actually are when you take delivery of the wheat.

• 

Features of Futures Contract

Exchange Traded: Futures contract are traded on centralized exchange floor, either physical or electronically networked.



Standardized Contracts: The contract size (i.e. lot size), Maturity period, settlement dates are fixed by derivatives exchange.



Exchange Regulated: The trading in futures contract is regulated by the derivatives exchange.



No Perfect Hedge: Since futures contract are standardized contracts entered on derivatives exchange, they do not offer perfect hedge. The buyer / seller of contract will be either over hedged or under hedged. For example, an importer has a payment obligation of US $ IS 10,570/- three months from today and if the lot size fixed by derivatives exchange for futures contract on US $ is 1,000 per contract, then the importer will have to take either 10 contracts or 11 contracts to hedge his exposure of US $ 10,570/-. If importer buys 10 futures contracts then he will be under hedged (uncovered) by US $ 570 (i.e. US $ 10,570 – US $ 10,000) and if importer buys 11 futures then he will be over hedged by US $ 430 (i.e. US$10,570-US$11,000).



Exchange as Counter Party: The futures contracts are written against the clearing house of the derivatives exchanges thus the clearing house is the counter-party to the contract. That is, for buyer and seller of futures contract the clearing house of the exchange is the counter party. In other words, the contract is between the buyer or seller and the clearing house of the exchange.



Margin: The clearing house of the exchange as a part of risk management process keeps collecting margin from the buyer/seller of the futures contract for the erosion in the value of the contract.

 Low Or Nil Counter-Party Default: Since, exchange clearing house collects margin on ongoing basis, the risk of counter-party default gets eliminated.

 Liquid: The futures contracts are traded on exchanges hence they offer liquidity to the buyer/seller of futures contract.

3. OPTION An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. Options are a financial derivative sold by an option writer to an option buyer. They are typically purchased through online or retail brokers. The contract offers the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at an agreed-upon price during a certain period of time or on a specific date. The agreed upon price is called the strike price. American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date (exercise date). Exercising means utilizing the right to buy or the sell the underlying security. Still confused? The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000. Now, consider two theoretical situations that might arise: 1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000). 2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now

consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option. •

How it works (Example):

Options are derivative instruments, meaning that their prices are derived from the price of their underlying security, which could be almost anything: stocks, bonds, currencies, indexes, commodities, etc. Many options are created in a standardized form and traded on an options exchange like the Chicago Board Options Exchange (CBOE), although it is possible for the two parties to an options contract to agree to create options with completely customized terms. There are two types of options: call options and put options. A buyer of a call option has the right to buy the underlying asset for a certain price. The buyer of a put option has the right to sell the underlying asset for a certain price. Every option represents a contract between the options writer and the options buyer. The options writer is the party that "writes," or creates, the options contract, and then sells it. •

Features of Option Contract

1. Highly flexible: On one hand, option contract are highly standardized and so they can be traded only in organized exchanges. Such option instruments cannot be made flexible according to the requirements of the writer as well as the user. On the other hand, there are also privately arranged options which can be traded ‘over the counter’. These instruments can be made according to the requirements of the writer and user. Thus, it combines the features of ‘futures’ as well as ‘forward’ contracts. 2. Down Payment: The option holder must pay a certain amount called ‘premium’ for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise his option, he has to forego this premium. Otherwise, this premium will be deducted from the total payoff in calculating the net payoff due to the option holder.

3. Settlement: No money or commodity or share is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option by the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required. 4. Non – Linearity: Unlike futures and forward, an option contract does not possess the property of linearity. It means that the option holder’s profit, when the value of the underlying asset moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profits and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration: 5. No Obligation to Buy or Sell: In all option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.

•

Distinction between futures and options

Though both futures and options are contracts or agreements between two parties, yet the relies some point of difference between the two. Futures contracts are obligatory in nature where both parties have to oblige the performance of the contracts, but in options, the parties have the right and not the obligation to perform the contract. In option one party has to pay a cash premium (option price) to the other party (seller) and this amount is not returned to the buyer whether no insists for actual performance of the contract or not. In future contract no such cash premium is transferred by either of the two parties. In futures contract the buyer of contract realizes the gains/profit if price increases and incurs losses if the price falls and the opposite in case of vice-versa. But the risk/rewards relationship in options is different. Option price (premium) is the maximum price that seller of adoption realizes. There is a process of closing out a

position causing causation of contracts but the option contract maybe any number in existence. •

Valuing an option

The value of option can be determined by taking the difference between two or if it is not exercised then the value is zero. The valuation of option contract has two components: intrinsic value and time value of options.

4. Warrants •

Introduction

Warrants are a derivative that give the right, but not the obligation, to buy or sell a security-most commonly equity—at a certain price before expiration. The price at which the underlying security can be bought or sold is referred to as the exercise price or strike price. An American warrant can be exercised at any time on or before the expiration date, while European warrants can only be exercised on the expiration date. Warrants that give the right to buy a security are known as call warrants; those that give the right to sell a security are known as put warrants. Warrants are a little bit like a living memory of a long-past era of finance. Although relatively uncommon and out of favour in the United States, warrants have remained more popular in other areas of the world, such as Hong Kong. However, they do still appear in the U.S. markets, and investors should know how to assess and value

them. Warrants can be a high-return investment tool. A warrant is like an option. It gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. It is unlike an option in that a warrant is issued by a company, whereas an option is an instrument of the stock exchange. The security represented in the warrant (usually share equity) is delivered by the issuing company instead

of

by

an

investor

holding

the

shares.

Companies will often include warrants as part of a new-issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, provided the underlying value of the security actually does increase over time. (Warrants are just one type of equity derivative. Find out about the others in 5 Equity Derivatives And How They Work.) Warrants are in many ways similar to options, but a few key differences distinguish them. Warrants are generally issued by the company itself, not a third party, and they are traded over-the-counter more often than on an exchange. Investors cannot write warrants like they can options. Unlike options, warrants are dilutive. When an investor exercises their warrant, they receive newly issued stock, rather than already-outstanding stock. Warrants tend to have much longer periods between issue and expiration than options, of years rather than months.

Warrants do not pay dividends or come with voting rights. Investors are attracted to warrants as a means of leveraging their positions in a security, hedging against downside (for example, by combining a put warrant with a long position in the underlying stock) or exploiting arbitrage opportunities. Warrants are no longer common in the United States, but are heavily traded in Hong Kong, Germany and other countries.

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CHARACTERISTICS / FEATURES OF A WARRANT

A warrant is identified by the following characteristics: ISSUANCE A warrant can either be issued by a company or a financial institution. A company can issue these instruments for its own stock while a financial institution issues them for a variety of underlying assets. EXERCISE A warrant can either be exercised at the end of expiry or can be traded independently of the debt instrument with which it was issued. LIFE

A warrant usually has a life running from 10 to 15 years. American type warrant can be exercised anytime during its life while a European type warrant can only be exercised at the end of its life. PREMIUM A warrant is an option like an instrument and hence has a premium attached to it. Premium is the price that the holder pays for the privilege of exercising the warrant at a suitable time. LEVERAGE A warrant is a derivative instrument and has a leverage attached to it. A holder with $100 worth of warrants will have more exposure to the underlying stock than a holder with $100 worth of shares.

5. SWAP •

Introduction

In the recent past, there has been integration of financial markets world-wide which have led to the emergence of some innovative financial instruments. In a complex world of variety of financial transactions being taken place every now and then, there arises a need to understand the risk factors and the mechanism to avoid the risks involved in these financial transactions. The recent trends in financial markets show increased volume and size of swaps markets. Financial swaps are an asset liability management technique which permits a borrower to access one market and then exchange the liability for another type of liability. Thus, investors can exchange one asset to another with some return and risk features in a swap market. In this lesson an attempt has been made to get the students

acquainted with the mechanism of swaps markets and the valuation of the swap instruments. •

Meaning of swaps

The dictionary meaning of ‘swap’ is to exchange something for another. Like other financial derivatives, swap is also agreement between two parties to exchange cash flows. The cash flows may arise due to change in interest Rate or currency or equity etc. In other words, swap denotes an agreement to exchange payments of two different kinds in the future. The parties that agree to exchange cash flows are called ‘counter parties’. In case of interest rate swap, the exchange may be of cash flows arising from fixed or floating interest rates, equity swaps involve the exchange of cash flows from returns of stocks index portfolio. Currency swaps have basis cash flow exchange of foreign currencies and their fluctuating prices, because of varying rates of interest, pricing of currencies and stock return among different markets of the world.

•

Features of swaps

The following are features of financial swaps: Counter parties:

Financial swaps involve the agreement between two or more parties to exchange cash flows or the parties interested in exchanging the liabilities. Facilitators:

The amount of cash flow exchange between parties are huge and also the process is complex. Therefore, to facilitate the transaction, an intermediary comes into picture which brings different parties together for big deal. These may be brokers whose objective is to initiate the counter parties to finalize the swap deal. While swap dealers are themselves counter partied who bear risk and provide portfolio management service. Cash flows:

The present values of future cash flows are estimated by the counterparties before entering into a contract. Both the parties want to get assurance of exchanging same financial liabilities before the swap deal. Less documentation

It is required in case of swap deals because the deals are based on the needs of parties, therefore, less complex and less risk consuming. Transaction costs:

Generating very less percentage is involved in swap agreement. Benefit to both parties:

The swap agreement will be attractive only when parties get benefits of these agreements. •

Types of financial swaps

The swaps agreement provides a mechanism to hedge the risk of the counterparties. The risk can be- interest rate, currency or equity etc. Interest rate swaps

It is a financial agreement to exchange interest payments or receipts for a predetermined period of time traded in the OTC market. The swap may be on the basis of fixed interest rate for floating interest rate. This is the most common swap also called ‘plain vanilla coupon swap’ which is simply in agreement between two parties in which one party payments agrees to the other on a particular date a fixed amount of money in the future till a specified termination date. This is a standard fixed-to-floating interest rate swap in which the party (fixed interest payer) make fixed payments and the other (floating rate payer) will make payments which depend on the future evolution of a specified interest rate index. The fixed payments are expressed as percentage of the notional principal according to which fixed or floating rates are calculated supposing the interest payments on a specified amount borrowed or lent. The principal is notional because the parties do not exchange this amount at any time but is used for computing the sequence of periodic payments. The rate used for computing the size of the fixed payment, which the financial institution or bank are willing to pay if they are fixed rate payers (bid) and interested to receive if they

are floating rate payers in a swap (ask) is called fixed rate. A US dollar floating to fixed 9-year swap rate will be quoted as:

Currency swaps

In these types of swaps, currencies are exchanged at specific exchange rates and at specified intervals. The two payments streams being exchanged are dominated in two different currencies. There is an exchange of principal amount at the beginning and a re-exchange at termination in a currency swap. Basic purpose of currency swaps is to lock in the rates (exchange rates). As intermediaries large banks agree to take position in currency swap agreements. In a fixed to fixed currency rate, one party raises funds in currency suppose ‘pounds’ and the other party raises the funds at fixed rate in currency suppose US dollars. The principal amount are equivalent at the spot market exchange rate. In the beginning of the swap contract, the principal amount is exchanged with the first party handing over British Pound to the second, and subsequently receives US dollars as return. The first party pays periodic dollar payment to the second and the interest is calculated on the dollar principal while it receives from the second party payment in pound again computed as interest on the pound principal. At maturity the British pound and dollar principals are re-exchanged on a fixed-to-floating currency swaps or cross-currency-coupon swaps, the following possibilities may occur: (a) One payment is calculated at a fixed interest rate while the other in floating rate. (b) Both payments on floating rates but in different currencies.

(c) There may be contracts without and with exchange and re-exchange of principals.

6. Exotic Option An exotic option is an option that differs in structure from the more common American options or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. Exotic options are generally more complex than plain vanilla call and put options. Despite their embedded complexities, exotic options have certain advantages over regular options, which include: 

Being more adaptable to specific risk-management needs of individuals or entities



Trading and management of unique risk dimensions



A greater range of investment products to meet investors' portfolio needs



In some cases, they are cheaper than regular options

Exotic options have unique underlying conditions that make them a good fit for highlevel active portfolio management and situation-specific solutions. Complex pricing of these derivatives may give rise to arbitrage, which can provide great opportunities for sophisticated quantitative investors. In many cases an exotic option can be purchased for a smaller premium than a comparable vanilla option. This is because often exotic options contain additional features that increase the chances of the option expiring worthless. This is not the case with chooser options, for example, since the "choice" actually increases the chances of the option finishing in the money. In this case, the chooser may be more expensive than a single vanilla option, but could be cheaper than buying both a vanilla call and put if a big move is expected but the trader is unsure on the direction. Exotic options may also be suitable for business that need to hedge up to or down to specific price levels in the underlying asset. In these cases, barrier options may be effective because they come into existence or go out of existence at specific/barrier price levels.

•

Exotic Option Examples

There are many types of exotic options available. Below we will run through some of them. Chooser Options Chooser options are an instrument that allows an investor to choose whether the option is a put or call at a certain point during the option's life. Because this type of option can change over the holding period, it is not found on regular exchanges. Compound Options Compound options are options that give the owner the right, but not the obligation, to purchase another option at a specific price on or by a specific date. Typically, the underlying asset of a call or put option is an equity security, but the underlying asset of a compound option is always another option. Compound options come in four types: call on call, call on put, put on put, and put on call. These types of options are commonly used in foreign exchange and fixed-income markets. Barrier Options Barrier options are similar to plain vanilla calls and puts, but only become activated or extinguished when the underlying asset hits certain price levels. In this sense, the value of barrier options jumps up or down in leaps, instead of changing in price in small increments. These options are commonly traded in the foreign exchange and equity markets. They come in four types: up-and-out, down-and-out, up-and-in, and down-and-in. As an example, a barrier option with a knock-out price of $100 and a strike price of $90 may be written on a stock that is currently trading at $80. The option will behave like normal when the underlying is below $99.99, but once the underlying stock's price hits $100, the option gets knocked-out and becomes worthless. A knock-in would be the opposite. If the underlying is below $99.99, the option doesn't exist, but once the underlying hits $100 the option comes into existence and is $10 in the money.

Binary Options A binary option, or digital option, is defined by its unique payout method. Unlike traditional call options, in which final payouts increase incrementally with each rise in the underlying asset's price above the strike, this option provides the buyer with a finite lump sum at that point and beyond. Inversely, with the buyer of a binary put option, the finite lump-sum payout is received by the buyer if the asset closes below the stated strike price. For example, if a trader buys a binary call option with a stated payout of $10 at the strike price of $50 and the underlying asset is above the strike at expiration, the holder will receive a lump-sum payout of $10 (irrespective of how deep in the money the option is). If the underlying asset is below the strike at expiration, the trader will not receive anything. Most traded binary options are based on the outcomes of events rather than equities. Things like the level of the Consumer Price Index or the value of Gross Domestic Product on a specific date are usually the underlyings of the option. As such, early exercise is impossible because the underlying conditions will not have been met. Bermuda Options Bermuda options can be exercised at the expiry date, as well as certain specified dates in between the creation and expiration of the option's life. This style of option may provide the writer with more control over when the option is exercised and provides the buyer with a slightly less expensive alternative to an American option without the restrictions of a European option (American options demand a slightly larger premium due to their "anytime" exercise feature). Quantity-Adjusting Options Quantity-adjusting options, called quanto options for short, expose the buyer to foreign assets but provide the safety of a fixed exchange rate in the buyer's home currency. This option is great for an investor looking to gain exposure in foreign markets, but who may be worried about how exchange rates will settle when it comes time to settle the option.

For example, a French investor looking at Brazil may find a favourable economic situation on the horizon and decide to put some portion of allocated capital in the BOVESPA Index, which represents Brazil's largest stock exchange. The problem is, the French investor is a little worried about how the exchange rate for the euro and Brazilian real might settle in the interim. The solution for this French investor is to buy a quantity-adjusting call option on the BOVESPA denominated in euros. This solution provides the investor with exposure to the BOVESPA and lets the payout remain denominated in euros. As a two-in-one package, this option will inherently demand an additional premium that is above and beyond what a traditional call option would require. This provides quantity-adjusting option writers with additional premium if they are willing to take on the additional risk of currency Look-Back Options Look-back options do not have a fixed exercise price at the beginning. The holder of such an option can choose the most favourable exercise price retrospectively for the time period of the option. These options eliminate the risk associated with timing market entry and are, therefore, more expensive than plain vanilla options. Let’s say an investor buys a one-month look-back call option on a stock at the beginning of month. The exercise price is decided at maturity by taking the lowest price achieved during the life of the option. If the underlying is at $106 at expiration and the lowest price achieved was $71, the payoff is $35 ($106-$71). Asian Options Asian options have a payoff based on the average price of the underlying on a few specific dates. If the average price based on those dates is less than the exercise price, the option expires out of the money. Basket Options Basket options are similar to plain vanilla options except that they are based on more than one underlying. For example, an option that pays off based on the price movement of not one but three underlying assets is a type of basket option. The

underlying assets can have equal weights in the basket or different weights, based on the characteristics of the option. Extendible Options Extendible options allow the investor to extend the expiration date of the option. There are two types: 

Holder-extendible: The buyer of the option (call or put) has the right to extend the option by a pre-specified amount of time if the option is out of the money at the original expiration date.



Writer-extendible: The writer of the option (call or put) has the right to extend the option by a pre-specified amount of time if the option is out of the money at the original expiration date.

Spread Options The underlying asset for spread options is the spread or difference between the prices of two underlying assets. Let’s say a one-month spread call option has a strike price of $3 and the price difference between stocks ABC and XYZ as the underlying. At expiry, if stocks ABC and XYZ are trading at $106 and $98, respectively, the option will pay $106 - $98 - $3 = $5. Shout Options A shout option allows the holder to lock in a certain amount in profit while retaining future upside potential on the position. If a trader buys a shout call option with a strike price of $100 on stock ABC for a onemonth period, when the stock price goes to $118, the holder of the shout option can lock in this price and have a guaranteed profit of $18. At expiry, if the underlying stock goes to $125, the option pays $25. Meanwhile, if the stock ends at $106 at expiry, the holder still receives $18 on the position.

1.11.2. COMMODITY DERIVATIVE Commodity derivatives are financial instruments whose value is based on underlying commodities, such as oil, gas, metals, agricultural products and minerals. Other assets such as emissions trading credits, freight rates and even the weather can also underlie commodity derivatives. Although the market has been around for centuries, commodity derivatives remain a vital and increasingly sophisticated product today. Airlines continue to hedge themselves against volatility in fuel prices, mining corporations against declines in metal values and power companies against rises in the price of natural gas. This accessible title explains each type of transaction, together with the documentation involved. In particular, the book analyses and guides the reader through the full suite of over-the-counter, exchange-traded and structured commodity derivative documentation, and provides a detailed guide to International Swaps and Derivatives Association and other leading documentation platforms. The book further contains detailed analysis of the regulatory and tax issues affecting commodity derivative products in the United Kingdom and United States.

1.12. PARTICIPANTS OF DERIVATIVES MARKET The participants of the derivatives markets can be classified as under: A. On the basis of motives B. On the basis of constitution of participants C. On the basis of nature of roles performed 1.12.1. On the basis of motives Depending on the motives of participation in the derivatives markets the participants can be broadly classified into following three types:

1. Hedgers: Risk is inherent in all activities that we perform in our day to day life. Risk is a basic element of any business and investment activities. All of us are concerned about the risk. Risk can be defined as a deviation of the actual outcomes from the expected results. Elimination of risk is something which each one of us are interested, however, complete elimination of risk is not possible. Alternatively, risk can be mitigated to a considerable extent. Derivative is one of the tools that can be effectively used to hedge against the risk of fluctuation in the prices of underlying assets, which either we own or intend to own at future date. Hedgers are those who enter into a derivative contract with the objectives of covering risk arising out of price fluctuation. An importer having a deferred liability (payables in foreign currency) faces uncertainty about the exchange rate at the time of payable becoming due. A forward/futures contract would eliminate the price risk (foreign exchange rate fluctuation in this case). A foreign currency forward/futures contract is entered into with objective of hedging against the risk of exchange rate fluctuation. The hedger (importer in this case) would settle the contract by taking delivery of agreed quantity of foreign currency at the pre-agreed price on future pre-decided

delivery date by paying the pre-agreed price or offset the contract by settling it in cash.

2. Speculator A trader, who trades or takes position without having exposure in the cash/spot market, with the sole intention of earning profit from price movements is a speculator. Speculators are those who may not have an interest in the ready contracts, etc. but see an opportunity of price movement favourable to them. They are prepared to assume the risks, which the hedgers are trying to cover in the futures market. They provide depth and liquidity to the market. It would not be wrong to say that in absence of speculators the market will not be liquid and may at time collapse. Although one can argue that all investment is speculation, an acknowledged speculator will buy or sell a security solely to reap a typically short-term profit from the price movement of that security. This motivation differs significantly from those of more traditional investors or hedgers. For example, consider the purchase of corn futures. A hedger may purchase these securities in order to offset any negative movements in the price of corn and thus stabilize his or her portfolio (these people might be corn growers or cereal companies, for instance). A speculator, however, may buy the very same security simply because he or she has reason to believe the position will increase in value. He or she simply bets on which way the market is going to go. Speculation can sometimes drive securities prices away from their intrinsic value, either becoming overpriced during a buying frenzy or becoming underpriced during a huge sell-off. Although speculators sometimes get a bad rap in the press for this reason, they are a crucial lubricant to the markets, particularly the commodities markets. Although they don't want to physically possess any of the commodities they're trading (that is, they don't really want a truckload of rice delivered to their door), their trading activity brings liquidity to the market, which in turn provides stability and efficiency to those markets.

It is important to note, however, that speculators are generally bigger risk takers than other investors. They are more likely than other investors to use leverage, and as such can suffer huge losses alongside huge gains.

3. Arbitrageurs The process of simultaneously buying of securities or derivatives in one market/segment at lower price and sale thereof inn another market/segment at higher prices is known as arbitrage. The markets for derivatives and underlying are separate. The spot market or cash segment, on Indian exchanges, is a market where securities (underlying) are sold for cash and delivered as per the settlement period i.e. on T+2 day basis. While, derivatives products for those underlying (securities) are traded on futures & options segment. It is possible that there may be price mismatches and earn riskless profits. For example on maturity if the Infosys futures contract is priced at Rs. 1,040 per share and the spot price is Rs. 950 per share, then the arbitrageur will buy Infosys @ Rs. 950 in the spot segment and short sell futures in F & 0 segment @ Rs. 1040, thereby making riskless profit of Rs. 90 per share. Thus, riskless profit making is the prime goal of arbitrageurs. The hedgers attempt to eliminate risk and speculator assumes the risk of hedgers, whereas arbitrageurs take riskless position and yet make profits. Arbitrageurs constantly monitor the prices of different assets on these two segments/markets and capture the mispricing of the products to earn arbitrage profits. Such arbitrage gain arises due to imperfections in the markets/segments. However, it may be noted that market imperfections do not last long. In the selling market/segment the prices fall because of increased supply and in the buying market prices rise due increasing demand. This results in the convergence of prices in two different segments/markets and they operate in tandem. Thus, the price equilibrium is achieved through demandsupply forces. The arbitrageurs encashes on these short-lived market imperfections. In fact, arbitrageurs restore the balance and consistency in different segment through the arbitrage process. Arbitrageurs arrests the overbidding or underbidding of prices by speculators in F&O segment as compared to cash segment.

1.12.2. On the basis of constitution of participants 1. Mutual funds 2. Corporate treasury 3. Banks/financial institution 4. High net worth individuals

1. Mutual funds house Mutual fund can be defined as a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested by the fund manager on behalf of the investors in different types of securities. As already discussed the securities are in general subject to price risk fluctuation. The fluctuation in the prices of securities held by mutual funds may erode the asset value of the fund. Thus, the fund managers make use of derivatives products to manage/hedge the price risk of the securities held under various schemes. Fund managers may also take speculative view based on its understanding of market wide factors. Fund managers are specialists, who track the prices of securities continuously, thus making it possible for them to identifying arbitrage opportunities and make riskless gains. It may therefore be noted that mutual fund houses may participate in the derivatives markets as hedger or speculator or even as an arbitrageur.

7. Corporate treasury The companies into regular exports or imports of goods or services are exposed to risk of fluctuation in foreign exchange rates. Such exchange rates fluctuation in foreign exchange rates. Such exchange rates fluctuations may affect the viability of imports or exports. These companies usually have separate treasury and risk management department (or a manager), who employ risk management tools to hedge the risk

arising out of foreign exchange rate fluctuations. Foreign Currency forwards and futures and options are popular risk management products sought after by these treasury managers. Similarly, companies having borrowing in foreign currency are also exposed to risk of fluctuation in foreign exchange rates, since the debt servicing i.e. interest and principal repayments obligations are in foreign currency. The treasury manager or department of such companies may participate in the derivatives markets as hedger, to guard against the probable losses due to foreign exchange rate fluctuation. A manufacturing company is also exposed to risk of fluctuation in the prices of commodities which are its principal raw material/input. For example, Finolex cables, manufacturer of electrical wires and cables is exposed to risk of fluctuation in the prices of copper, since copper is its principal input. Such companies may participate in the commodities futures and options markets to guard itself against the risk of fluctuation in the prices of its input.

8. Banks and financial institutions Banks and financial institutions have exposures in the form of lending to its customers. They face the risk of credit default as well as changes in interest rates. Bank and financial institutions use derivatives products such as credit default swaps and interest rates futures to hedge the risk of credit default and interest rates changes. Banks may also have exposures in foreign exchange towards its customers involved in import and export trade. These merchant transactions make bank vulnerable to losses due to fluctuation in foreign exchange rates. Banks covers its exposure arising out of such merchant transactions with the help of suitable derivatives products by patriating in derivatives market.

9. High net worth individuals High net worth individuals are those who have large scale investments in various classes of investment assets. The investment assets such as stocks, bonds, etc. are prone to risk of price fluctuations. The high net worth investors participate in the derivatives markets to manage the price risk element of their portfolio of investments.

The high net-worth individuals usually have high risk appetite, so they also tend to speculate in the derivatives markets. High net-worth investors may also participate as arbitrageur in the derivatives market.

1.12.3. On the basis of nature of roles performed: The participants of derivatives market perform various roles SEBI taking into account the nature of roles performed has categorized derivatives market participants as under:

1. Trading member: A trading member is a registered member of a SEBI recognized financial derivatives exchange. A trading member executes trade on behalf of its clients and on its own behalf. They cannot clear and settle the trades executed by them. Clearing and settlement of trade is done by clearing member.

10.Trading cum clearing member: Trading cum clearing member besides trading on its own behalf and on behalf of its clients, also clear and settle the trades executed by them (own and its client) as well as trades of other trading members.

11.Self-clearing member: Self-clearing members clear and settle trades executed by them only. They do not clear and settle trades of other trading members. Professional clearing member Professional clearing members performs only clearing function. They clear and settle the trades executed by trading members. They do not execute trade either on their own behalf or for any clients.

2) RESEARCH METHODOLOGY 2.1 Introduction Research methodology is a way to solve the research problem systematically. It involves the various steps to find out the solution of an identified problem. It also clarifies the logic behind the study of the problem. When we talk about research methodology we not only talk of the research method but also consider the logic behind the method we use in the context of our research study and explain why we are using a particular method or techniques and why we are not using other so the result are capable of being evaluated.

1. Research design: A descriptive study tries to discover answers to the questions who, what, when, where, and sometimes, how. The researcher attempts to describe or define a subject, often by creating a profile of a group of problems, people or events. Such studies may involve the collection of data and the creation of a distribution of the number of times the researcher observes a single event or characteristic (the research variable), or they may involve relating the interaction of two or more variables. Organizations that maintain databases of their employees, customers and suppliers already have significant data to conduct descriptive studies using internal information. Yet many firms that have such data files do not mine them regularly for the decision-making insight they might provide. This descriptive study is popular in business research of

its versatility across disciplines. In for-profit, not-for-profit and government organizations, descriptive investigations have broad appeal to the administrator and policy analyst for planning, monitoring and evaluating. In this context, how questions address issues such as quantity cost, efficiency, effectiveness and adequacy. Descriptive studies may or may not have the potential for drawing powerful inferences.

12.Sample method Convenience sampling method is used for the survey of this project. It is a nonprobability sample. This Is the least reliable design but normally the cheapest and easiest to conduct. In this method researcher have the freedom to choose whomever they find, thus the name convenience. Example includes informal pools of friends and neighbour or people responding to a newspaper’s invitation for readers to state their position on some public issue.

13.Sample size Sample size denotes the number of elements selected for the study. For the present study, 50 respondents were selected at random.

14.Sampling method A sample is a representative part of the population. In sampling technique, information is collected only from a representative part of the universe and the conclusions are drawn on that basis for the entire universe.

15.Types of data Every decision poses unique needs for information, and relevant strategies can be developed based on the information gathered through research. Research is the systematic objective and exhaustive search for and study of facts relevant to the problem. Research design means the framework of study that leads to the collection and analysis of data. It is a conceptual structure with in which research as effective as possible.

Primary data:

Primary data are those collected by the investigator himself for the first time and thus they are original in character, they are collected for a particular purpose. A wellstructured questionnaire was personally administered to the selected sample to collect the primary data. Secondary data:

Secondary data are those, which have already been collected by some other persons for their purpose and published. Secondary data are usually in the shape of finished products.

2.2 Objectives of study 1) To analyze the perception of investors towards investment in derivative instrument and market 2) To know different types of financial derivatives. 3) To study the awareness about derivative market.

2.3 QUESTIONNAIRE FOR RESEARCH Instructor

Name

Results

Age Gender Annual income

1. Are you trading in derivative market? Yes No 2. If No is the reply in the Q1 question, reasons for not investing in derivative market? Lack of knowledge Lack of awareness Very risky / counter party risk Huge amount of investment Other

3. Which of the following derivative instruments do you deal in? Stock Future Stock Index Futures Stock Options Stock Index Options Swaps Currency 4. How much percentage of your income you trade in Derivative market? Don’t trade Less than 5% 5%-10% 11%-15% 16%-20% More than 20% 5. You participate in Derivative market as? Hedger

Speculator Arbitrageur Others

6. For what purpose do you invest in derivative market ? Regular income Meet future obligations Capital appreciation Others 7. What is the rate of return expected by you from derivative market? Do not trade Less than 5% 5%-10% 14%-17% 18%-23% More than 23% 8. Are you satisfied with the current performance of the derivative market? Do not trade Strongly disagree Disagree

Neutral Agree Strongly agree

3) REVIEW OF LITERATURE Abdulla Yameen (2001) delivered massage, investors will need to be alert to any new development in capital market and take advantage of the Investor Education and Awareness Campaign program which to be undertaken by the Capital Market Section to acquaint of the risks and rewards of investing on the Capital market. Speech was also focused on to create a new breed of financial intermediaries, which will deal on the market for their clients. These intermediaries have to be professionals with quite advanced knowledge on stock exchange operations, techniques, law and companies valuation. Investors depend to a large extent on their professional advice when investing on the market. Furthermore, these intermediaries must be men of integrity and honesty as they would deal with clients‟ money Confidence of investors in these professionals is a key to the success of the capital market. Warren Buffet (2002) argued that derivatives as time bombs, both for the parties that deal in them and the economic system. He also argued that those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by markto-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on largescale mischief. In extreme cases, mark-to-model degenerates into mark-to-myth. Many people argue that derivatives reduce systemic problems, in that participant who can’t bear certain risks are able to transfer them to stronger hands. He said that the derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.

G.N.Bajpai (2006) showed that continuously monitors performance through movements of share prices in the market and the threats of takeover improves efficiency of resource utilisation and thereby significantly increases returns on investment. As a result, savers and investors are not constrained by their individual abilities, but fascinated by the economy’s capability to invest and save, which inevitably enhances savings and investment in the economy. Thus, the capital market converts a given stock of investible resources into a larger flow of goods and services and augments economic growth. The study concluded the investors and issuers can take comfort and undertake transactions with confidence if the intermediaries as well as their employees (i.) follow a code of conduct and deal with probity and (ii) are capable of providing professional services. K. Ravichandran (2007) argued the younger generation investors are willing to invest in capital market instruments and that too very highly in Derivatives segment. Even though the knowledge to the investors in the Derivative segment is not adequate, they tend to take decisions with the help of the brokers or through their friends and were trying to invest in this market. He also argued majority the investors want to invest in short-term funds instead of long-term funds that prefer wealth maximization instruments followed by steady growth instruments. Empirical study also shows that market risk and credit risk are the two major risks perceived by the investors, and for minimizing that risk they take the help of newspaper and financial experts. Derivatives acts as a major tool for reducing the risk involved in investing in stock markets for getting the best results out of it. The investors should be aware of the various hedging and speculation strategies, which can be used for reducing their risk. Awareness about the various uses of derivatives can help investors to reduce risk and increase profits. Though the stock market is subjected to high risk, by using derivatives the loss can be minimized to an extent. Rajiv Gupta (2010) argued in Capital Market 2009-10 IPO-QIP Report there have been several noticeable trends over the past five years. First, the size of offerings by Indian issuers has been growing and there are more and larger size global offerings reflecting the maturing and increasing depth of the Indian capital markets. Second, India has become a destination and region in its own right for 13

raising capital - previously companies could not raise more than a few hundred million, but now have capital issues like Reliance Power, in excess of Rs. 13,200 crore ($ 3 billion). While the ADR/GDR markets remain attractive, fewer companies are using that route as Indian markets have become strong and have the appetite for large transactions. Third, Indian capital markets now attract companies across sectors, rather than in any single sector.

4) DATA ANALYSIS

1. Are you trading in derivative market? ANSWER

PERCENTAGE

Yes

38%

No

62%

70 60 50 40 30 20 10 0 Yes

No

Interpretation: From the above graph out of 50 investor, only 38% investors means 19 respondent are trading in derivative market and 62% means 31 respondents are not trading in derivative market.

16.If No is the reply in the Q1 question, reasons for not investing in derivative market? REASONS

PERCENTAGE

Lack Of Knowledge

20%

Lack Of Awareness

15%

High Risky

49%

Huge Amount Of Investment

13%

Other

3%

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

l

ac

f ko

ge ed l ow kn l

ac

f ko

ss ne e ar aw

gh hi

ri s

ky

ge hu

f to n ou am

t en m t s ve in

r he ot

Interpretation From the above graphical representation you can see that 20% of the investors don’t have knowledge about derivatives. 15% of investors are not aware of derivative market. 49% investors think that the derivatives are high risky whereas 3% investors don’t have specify their reasons for not trading in derivative market.

17.Which of the following derivative instruments do you deal in? PREFERNCES

SALES

Stock Futures

26%

Stock Index Futures

10%

Stock Options

20%

Stock Index Options

25%

SWAPS

19%

Sales 19

26

stock futures stock index futures stock options stock index options 10 swaps

25 20

Interpretation

From the above graph you can see that 26% of investors invest in stock futures, 10% in stock index futures, 20% in stock options, 25% in stock index options and 19% of investors invest in SWAPS.

18.How much percentage of your income you trade in Derivative market? PREFERNCES

PERCENTAGE

Don't Trade

62%

Less Than 5%

4%

5%-10%

14%

11%-15%

13%

16%20%

6%

More Than 20%

1%

70% 62% 60% 50% 40% 30% 20% 14%

10% 0% don't trade

13%

4% less than 5%

6% 5%-10%

11%-15%

1% 16%20%

more than 20%

Interpretation: From the above graph we can see that 62% investors don’t invest in derivatives market. 4% of investors invest less than 5% of their income. 14% investors invest 5%-10%of their income. 13% of investors invest 11%-15% of their income. 6% of investors invest 16%-20% of their income. 1% of investors invest more than 20% of their income.

19.You participate in Derivative market as? PARTICPANTS

PERCENTAGE

Arbitrageurs

16%

Speculator

47%

Hedger

27%

Others

10%

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% arbitrageurs

speculator

hedger

others

Interpretation: From the above graph

we can see that 16% of

investors are in the form of

arbitrageurs and 47% of investors are in the form of speculators while 27% of investors are in the form of hedger and others are of only 10%.

20.For what purpose do you invest in derivative market? PURPOSE OF INVESTMENT

PERCENTAGE

Regular Income

43%

Meet Future Obligations

54%

Capital Appreciation

2%

Others

1%

60% 50% 40% 30% 20% 10% 0% regular income meet future obligations capital appreciation others

Interpretation From the above graph we can see that 43% investors invest their money in derivatives to earn their regular income. 54% of investors invest for the purpose to meet future obligations. 2% of investors invest for capital appreciation while 1% of investors invest for other purpose.

21.What is the rate of return expected by you from derivative market? EXPECTATION RATE Do Not Trade 5%-9% 10%-13% 14%-17% 18%-23%

PERCENTAGE 62% 10% 12% 11% 5%

5000% 4500% 4000% 3500% 3000% 2500% 2000% 1500% 1000% 500% 0% do not trade

5%-9%

10%-13%

14%-17%

18%-23%

Interpretation From the above graph we can see that 62% do not trade in derivatives so they don’t expect anything from derivative market but remaining 38% investor expect some range of returns from derivative market i.e. 10% expect 5%-9% returns, 12% expect 10%-13%returns, 11% investor expect 14%-17% and 5% investors expect 18%-23% of returns.

22.Are you satisfied with the current performance of the derivative market? PREFERENCES Do Not Trade Strongly Disagree Disagree Neutral Agree Strongly Agree

PERCENTAGE 62% 4% 8% 10% 12% 4%

4.00% 12.00%

10.00%

8.00%

62.00%

do not trade strongly disagree disagree neutral agree strongly agree

4.00%

Interpretation From the above graph we can see that 62% of investors don’t trade in derivative market. 4% are strongly disagree with current performance of the derivative market but at the same time 4% of investors are strongly agree with the current performance. 8% are disagreeing but 12% are agreeing with the performance and remaining 10% has no answer they are neither satisfied nor dissatisfied.

3.1 Findings 1. Here we found that out of 50 investors only 38% investors means 19 respondent are trading in derivative market and 62% means 31 respondents are not trading in derivative market. 2. Reasons for not investing in derivative market is because lack of awareness and knowledge, high risky, need huge amount of investment. 3. The main objective of trading in derivative market of the investors is getting high return. 4. 14% of respondents save 11%-15% of their income for investments and only 1% of respondents save more than 25% of their income for investments. 5. 54% of respondents investing to meet future obligations and 43% respondents are looking for regular income. 6. 62% of respondents are not willing to invest in derivatives, 49% of respondents are felt that derivatives are highly risky. 15% of respondents not aware of derivatives, so derivatives are highly risky and expected profit or loss is also high 7. 47% of investors are speculators in derivatives market, 27% of investors are hedging for their investments, followed by 16% of investors are arbitrageurs. 8. 25% of investors are more often invest in index options. And 10% are more often invest in index futures.

5) CONCLUSION & SUGGESTIONS 5.1 Conclusion Now a days the investors know about the derivative market, so they are aware as derivative market offers more return, with the hedging of interest rate risk and exchange rate risk with maximum profits and minimum loss. Indian derivative markets have had a very good performance till date, to continue with this same growth individual investors have to be encouraged to enter into trades more often so that they help to drive the economy. In the study, it was found that derivatives are used as risk Hedging tool and the trend of the spot market affects the trading of Derivatives. It has been noticed that there has been awareness about derivatives trading amongst the derivatives in India since last few years. SEBI and government should take responsibility to create awareness among investors and need to educate individual investors through different seminars or training programs regarding the advantages and risk factors associated with derivative instruments. Respondents perceived that Market Risk and Credit risk are the two major risk observed in capital markets. Exchange traded derivatives market helps investors in many different ways in planning the finances, hedging/mitigating various risks, appropriate price discovery, arbitrage opportunities, ease of speculations etc. There are various strategic applications, uses and benefits of the equity derivatives market in the Indian Markets in today’s economic scenario such as providing efficiency to capital markets, helping investors in mitigating risks, providing equitable price discovery, comforting foreign investors, creating jobs and developing human capital, preserving value of assets during stressed market scenario and many more ways. Equity derivatives turnover has surpassed its underlying turnover in the financial year 2003-04 and today stands far taller than its underlying turnover. The equity derivatives turnover was 12.66% of its underlying equity market turnover in the year 2001-02. Today, in 2011-12, the equity derivatives turnover is 924.51% of its underlying equity market turnover.

5.2 Suggestions There is a need to introduce more equity derivatives products in India and has long strides to take in terms of providing larger liquidity and depth to the bigger market players. Many respondents felt that it is right time to introduce the other complex products like exotic derivatives. In this study Derivatives market is risk and return game that‘s why the investor get risk. Due to absence of delivery based settlement, many investors may not be participating in the derivatives market. Also, this could bring one more type of product in the basket to be offered to the market at large. Hence, NSE may look at starting the physical delivery derivatives contracts to give further fillip to volume on its exchange in particular and the Indian equity derivatives market at large. Investors are more often invest in index options because of derivatives are highly risky. The study suggests that Government should look forward to setting up a super regulator who can take care of these various regulatory arbitrage/risk issues or there should be joint committee of all the regulatory bodies to look into such concerns of the market from overall perspective. This study can be used by the regulating authorities and broker houses to increase awareness among the investors about derivatives. Only 38% investors are trading whereas 62% are not trading so attract them for trading. The investors who are not aware of derivatives make them aware that will increase the customers. Some investors don’t have knowledge about derivatives so provide them knowledge for trading in derivatives market. Those who are not satisfied with the derivative by knowing their behaviour of investment make them satisfied because negative word mouth of the customers fall down the business and good word of mouth builds the business.

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