Derivatives Market In India.docx

DERIVATIVES MARKET IN INDIA A Project Submitted To University of Mumbai for partial completion of the degree of Bachelor in Commerce (Financial Markets) Under the Faculty of Commerce By Sagar Alva Under the Guidance of Prof. Payal Mane Ghanshyamdas Saraf College of Arts & Commerce. RSET Campus, SV Road, Sunder Nagar, Malad West.

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RSET’s Ghanshyamdas Saraf College of Arts & Commerce Affiliated to University Of Mumbai Reaccredited by NAAC with ‘A’ Grade S.V. Road, Malad (West) Mumbai-400064

CERTIFICATE

This is to certify that Mr. _______________________________ has worked and duly completed his Project Work for the Degree of Bachelor in Commerce (Financial Markets) under the faculty of Commerce in the subject of Project work in Financial Markets and his project is entitled “_______________________________________________________________ _________________________________________” 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 his own work and facts reported by his personal findings and investigations. __________________ __________________ Name & Signature of Guiding Teacher

COLLEGE SEAL

Signature of External Examiner:

Signature of the Principal:

Date of Submission:

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DECLARATION BY LEARNER I the undersigned Mr. SAGAR SANKAPPA ALVA hereby, declare that the work embodied in this Project work titled “DERIVATIVES MARKET IN INDIA” forms my own contribution to the research work carried out under the guidance of Prof. PAYAL MANE is a result of my own Research Work and has not been previously submitted to any other University for any other Degree / Diploma 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 Bibliography. I, hereby further declare that all information of this document has been obtained and presented in accordance with rules and ethical conduct. ________________________ ________________________ Name and Signature of Learner Certified by Name and Signature of Guiding Teacher Prof

___________________ ___________________

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ACKNOWLEDGEMENT To list who 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, Dr. Jayant Apte for providing the necessary facilities required for completion of this project. I take this opportunity to thank our Chief Coordinator Dr. Lipi Mukherjee, for her support. I take this opportunity to thank our Coordinator Prof. Prasanna Choudhari, for her moral support and guidance. I would also like to express my sincere gratitude towards my project Guide Prof. Payal Mane 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 and directly helped me in the completion of the project especially my Parents and Peers who supported me throughout my project.

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Executive Summary Derivatives are an important class of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies. The introduction of financial derivatives and specially the equity derivatives on the exchange traded platform have revolutionized the landscape of financial industry across the globe. The Equity derivatives have gained extremely significant place among all the financial products. Derivatives are risk management tools that help in effective management of risk by various stakeholders. Derivatives are used to transfer risk, from the risk averse to the one who is willing to accept it at a cost. The growth of derivatives market in India has been phenomenal in a short span of just over a decade. Derivatives are now widely used as a risk management tool that helps in effective management of risk by various classes of investors.

This project is for the detailed study on Indian derivatives market. First segment of this project helps us to study various functions and characteristics, types, participants in derivative market. This project helps us to understand various derivative models that provides you information about how options are calculated. This project helps us to gain knowledge about origin of Indian derivative market and benefits of derivatives in India. Payoffs of options contract helps to understand the use of call and put options. This projects provides you information about evolution of futures contract. This project helps to gain knowledge about option and future terminology. Last segment of this project provides information about clearing and settlement system for financial derivatives. The derivatives market is predominantly a professional wholesale market with banks, investment firms, insurance companies and corporate as its main participants. By and large, the derivatives market is safe and efficient. Risks are particularly well controlled in the exchange segment, where central counterparties (CCPs) operate very efficiently and mitigate the risks for all market participants.

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INDEX

SR.NO

PARTICULARS

1.

Objectives

1

Research Methodology

1

INTRODUCTION TO DERIVATIVES

2. 2.1

Introduction and definition

2.2

Functions and characteristics

2.3

Underlying Assets

2.4

Types of derivative contract

2.5

Participants in derivative contract

2.6

Uses of derivatives INDIAN DERIVATIVES MARKET

3. 3.1

Origin of derivative market

3.2

Emergence of derivative market in India

3.3

Equity Derivatives in India

3.4

L.C. Gupta & J.R. Varma committee

3.5

Benefits of derivatives in India FORWARDS CONTRACT

4. 4.1

Salient features

4.2

Advantages and disadvantages

4.3

Forward prices versus futures prices FUTURES CONTRACT

5. 5.1

Evolution of futures market in India

5.2

Salient features

5.3

Futures terminology

5.4

Distinguish between forward and future contract OPTIONS CONTRACT

6.

PAGE.NO

6.1

Options terminology

6.2

Options payoffs

6.3

Distinguish between future and option contract 6

CLEARING AND SETTLEMENT SYSTEM

7.

FOR FINANCIAL DERIVATIVE 7.1

NSCCL

7.2

Risk management

7.3

Role of RBI in payment and settlement system

7.4

Settlement mechanism DERIVATIVE MODELS

8. 8.1

Black Scholes model

8.2

Binomial model

8.3

Cost of carry model

8.4

Whaley’s Quadratic model

9.

CASE STUDY

10.

CONCLUSION

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OBJECTIVES



To get proper idea about the derivative markets in India



To know about the functions and characteristics of derivative market.



To know in detail benefits of derivatives in India.



To study forward, future and option contracts.



To get knowledge about the participants in derivative contract.



To know in detail about the origin of Indian derivatives market.



To study various derivative models.



To know in detail about clearing and settlement system for financial derivatives.

RESEARCH METHODOLOGY Research in common phase refers to a search for knowledge. One can also define research as a scientific and systematic search for pertinent information on a specific topic. In fact, research is an art of scientific investigation. This project is for the detailed study on Indian Derivatives Markets. For the study purpose only secondary data is used. In secondary data information is collected from various books, through webs, newspaper, blogs, articles etc. The data in this project is collected from library, international websites, annual reports, published research papers etc. Various case study is also taken related to Indian derivatives market.

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INTRODUCTION TO DERIVATIVES 2.1 INTRODUCTION & DEFINITION OF DERIVATIVES. In the era of globalisation the financial markets worldwide have witnessed excessive volatility. The companies are continuously getting exposed to risk due to fluctuation in the price of commodities, interest rates, foreign exchange rates, etc. the portfolio of investment held by financial institutions are exposed to the risk of erosion in the value of portfolio due to fluctuation the price of the assets (securities) included in the portfolio. Banks runs the risk changes in interest rates. This price fluctuations makes it difficult for the organisations to estimate their cost and revenues. Sharp and unexpected movements in the prices, has made it imperative for the organisations to develop and adopt innovative price risk management tools. Derivative products are valuable tool that can be effectively used by management to control the price volatility. The impact of fluctuation in asset prices on the profitability and cash flow position of the companies and financial institutions can be minimised by locking-in asset prices with the help of derivatives products. Derivatives are one of the most complex instruments. The word derivative comes from the word ‘to derive’. It indicates that it has no independent value. A derivative is a contract whose value is derived from the value of another asset, known as the underlying asset, which could be a share, a stock market index, an interest rate, a commodity, or a currency. The underlying is the identification tag for a derivative contract. When the price of the underlying changes, the value of the derivative also changes. Without an underlying asset, derivatives do not have any meaning. For example, the value of a gold futures contract derives from the value of the underlying asset i.e., gold. The prices in the derivatives market are driven by the spot or cash market price of the underlying asset, which is gold in this example. Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft and so on. Derivatives on the other hand, take care of market risks - volatility in interest rates, currency rates, commodity prices, and share prices. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. They offer a range of mechanisms to improve redistribution of risk, which can be extended to every product existing, from coffee to cotton and live cattle to debt instruments.

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Definition Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.

According to Securities Contracts (Regulation) Act, 1956, as: A derivatives includes: 

A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security.



A contract which derives its value from the prices, or index of prices, of underlying securities.

Derivatives are securities under the Securities Contract (Regulation) Act and hence the trading of derivatives is governed by the regulatory framework under the Securities Contract (Regulation) Act.

Elements of Derivative Contracts: Derivative are contracts which are legally binding on the parties to the contract. The contracting parties agree to exchange underlying assets at a future date at a predetermined future price today. Thus, the common elements of derivatives are as follows: 

It is a legally binding contract.



There are two parties to the contract i.e. buyer and the seller.



There is an underlying asset.



Future date; and



Future price

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2.2 FUNCTIONS AND CHARACTERISTICS OF DERIVATIVE

Functions of Derivatives Trading in derivative provides two important functions-price discovery and price risk management, with reference to given underlying asset. It is therefore useful to all the segments of economy and particularly to all the constituents of the financial market system. The economic function of derivatives are discussed as under. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The

prices

of

derivatives

converge

with

the

prices

of

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

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

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the

introduction

of

derivatives,

the

underlying

market

witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

4. Speculative

trades

shift

market.

the

absence

In

to of

a

more an

controlled

organized

environment

derivatives

of

derivatives

market,

speculators

trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

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Characteristics of Derivatives Derivative can be defined as a contract or an agreement for exchange of payments, whose value is derived from the value of an underlying asset. In simple words the price of derivative depends on the price of other assets. Here are some of the characteristics of derivative markets –

1. Derivative are of three kinds future or forward contract, options and swaps and underlying assets can be foreign exchange, equity, commodities markets or financial bearing assets. 2. As all transactions in derivatives takes place in future specific dates as it is easier to short sell then doing the same in cash markets because an individual can take of markets and take the position accordingly because one has more time in derivatives. 3. Since derivatives have standardized terms due to which it has low counterparty risk, also transactions costs are low in derivative market and hence they tend to be more liquid and one can take large positions in derivative markets quite easily. 4. The value of derivatives depends on the movement in the prices of their underlying. 5. Future and options contract are transacted on recognized stock exchange and settled through clearing house of the exchange. 6. They are leveraged instruments, since buying derivatives products does not require upfront full payment. Leverage is a financial term that refers to the multiplication that happens when a small amount of money is used to control an item of much larger value. 7. In case of Forwards and Futures contracts the parties to the contract are obliged to deliver the underlying asset or offset them. And in case of options contracts options buyer has right, but not obligation.

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2.3 UNDERLYING ASSETS In case of derivatives an underlying asset is “the security, property or other asset that gives value to the derivative product”. An underlying asset may be many things, such as a physical commodity, a security, a piece of land, or part of a business. The underlying asset of a stock option is that stock for which the bond can be exchanged. For example, in an option giving one the right to buy the shares of Infosys, the underlying asset is the shares of Infosys. In case of USD futures contract the underlying asset is the US Dollar.

CATEGORY

EXAMPLES OF UNDERLYING

Financial: Equity Based: Individual stocks



Infosys, Tata Motors, etc.

Indices



Sensex, Nifty, NSE Volatility Index, etc.

Interest Rates



LIBOR, T-Bill Rates, etc.

Credit



Bonds (cash Flows), Loan Receivables, etc.

Currency



US Dollar, GBP, Euro, etc.

Weather



Temperature, Rainfall Index, etc.

Emissions



Carbon Credits



Cereals and Pulses, Fruits, Vegetables, etc.

Metals



Gold, Silver, Copper, Zinc, etc.

Dairy Products



Butter, Margarine, etc.

Animal Products



Egg, Lamb, etc.

Energy Products



Crude Oil, Gases (Methane, Butane, etc.)

Debt Based:

Others:

Physical/ NonFinancial: Agricultural: Non-Agricultural:

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2.4 TYPES OF DERIVATIVE CONTRACTS 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. Four most common examples of derivative instruments are as follows 1. Forward Contracts 2. Future Contracts 3. Option Contracts 4. Swaps

1. Forward Contracts Forward contracts are the simplest form of derivatives that are available today. Also, they are the oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present. However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk. Also, before the internet age, finding an interested counterparty was a difficult proposition. Another point that needs to be noticed is that if these contracts have to be reversed before their expiration, the terms may not be favourable since each party has one and only option i.e. to deal with the other party. The details of the forward contracts are privileged information for both the parties involved and they do not have any compulsion to release this information in the public domain.

2. Futures Contracts A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present. However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided expirations. Also, since these contracts are traded on the exchange they have 7

to follow a daily settlement procedure meaning that any gains or losses realized on this contract on a given day have to be settled on that very day. This is done to negate the counterparty credit risk.

3. Option Contracts The options contract, on the other hand is asymmetrical. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the party that makes a choice has to pay a premium for the privilege. There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price. Any individual therefore has 4 options when they buy an options contract. They can be on the long side or the short side of either the put or call option. Like futures, options are also traded on the exchange.

4. Swaps Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well. Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are usually not traded on the exchange. These are private contracts which are negotiated between two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a large amount of exchange rate risks. So, these are the 4 basic types of derivatives. Modern derivative contracts include countless combinations of these 4 basic types and result in the creation of extremely complex contracts.

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2.5 PARTICIPANTS IN DERIVATIVE MARKET The participants in the derivative markets can be broadly classified in three depending upon their motives. These are: 1. Hedgers 2. Speculators 3. Arbitrageurs

1. Hedgers Hedgers are those who enter into a derivative contract with the objective of covering risk. Farmer growing wheat faces uncertainty about the price of his produce at the time of the harvest. Similarly, a flour mill needing wheat also faces uncertainty of price of input. Both the farmer and the flour mill can enter into a forward contract, where the farmer agrees to sell his produce when harvested at predetermined price to the flour mill. The farmer apprehends price fall while the flour mill fears price rise. Both the parties face price risk. A forward contract would eliminate price risk for both the parties. A forward contract is entered into with the objective of hedging against the price risk being faced by the farmer as well as the flour mill. Such participants in the derivatives markets are called hedgers.

2. Speculators Speculators are those who enter into a derivative contract to make profit by r assuming risk. They have an independent view of future price behaviour of the underlying asset and take appropriate position in derivatives with the intention of making profit later. For example, the forward price in US dollar for a contract maturing in three months is ` 48.00. If one believes that three months later the price of US dollar would be ` 50, one would buy forward today and sell later. On the contrary, if one believes US dollar would depreciate to ` 46.00 in 1 month one would sell now and buy later. Speculators perform an extremely important function. They render liquidity to the market. Without speculators in the market not only would it be difficult for hedgers to find matching parties but the hedge is likely to be far from being efficient. Presence of speculators makes the markets competitive, reduces transaction costs, and expands the market size. More importantly, they are the ones who assume risk and serve the needs of hedgers who avoid risk. With speculators around, hedgers find counterparties conveniently. 9

3. Arbitrageurs The third category of participants, i.e. arbitrageurs, performs the function of making the prices in different markets converge and be in tandem with each other. While hedgers and speculators want to eliminate and assume risk respectively, the arbitrageurs take riskless position and yet earn profit. They are constantly monitoring the prices of different assets in different markets and identify opportunities to make profit that emanate from mispricing of products. For example, if the share price of Hindustan Unilever is ` 175 in National Stock Exchange (NSE) and ` 177 in Bombay Stock Exchange (BSE), the arbitrageur will buy at NSE and sell at BSE simultaneously and pocket the difference of ` 2 per share. Arbitrageurs are the ones who prohibit speculators to overbid or underbid the prices in the derivatives as compared to the physical markets.

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2.6 USES OF DERIVATIVES Derivatives are supposed to provide the following services: 1. 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.

2. 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 numbers of traders, speculators arbitrageurs operate in such markets. So, derivatives trading enhance liquidity and reduce transaction costs in the markets for underlying assets.

3. 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.

4. It has been observed from the derivatives trading in the market that the derivatives have smoothen out price fluctuations, squeeze the price spread, integrate price structure at different points of time and remove gluts and shortages in the markets.

5. The derivatives trading encourage the competitive trading in the markets, different risk taking preference of the market operators like speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in trading volume in the country. They also attract young investors, professionals and other experts who will act as catalysts to the growth of financial markets.

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CHAPTER 3 DERIVATIVES MARKET IN INDIA 3.1 History Of Derivative Market The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700’s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of ‘credit risk’ and to provide centralised location to negotiate forward contracts. From ‘forward’ trading in commodities emerged the commodity ‘futures’. The first type of futures contract was called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In1865, CBOT listed the first ‘exchange traded’ derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of ‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge were the currency in1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.

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The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers more than 50 futures and option contracts (with the annual volume at more than 454 million in 2003).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

3.2

Emergence Of Derivative Market In India

The concept of derivatives is not new in India. Commodity derivatives market has been in existence in India for a long time. India has had a long history of trading in commodities. Indian traders started trading in commodities around the last quarter of the nineteenth century much before many other countries started commodity trading. In India there has been long history of commodity futures of more than 125 years. The Indian experience, however, is much older as references to such markets in India appear in Kautilya’s Arthashastra. Wide speculation in the commodity futures market and the negative sentiments prompted the government to ban commodity futures trading in mid-seventies. After long hibernation of the forwards market in commodities, the Khusro committee in 1980 suggested reintroducing the future trading in commodities primarily in agricultural produce. With the ushering in of liberalization and financial market reforms from 1991 onwards steps to open up the futures trading in commodities has been accelerated. With the implementation of policies of economic liberalization and the signing of GATT agreement by India in the early 90’s, the futures market in commodities gained momentum. The recommendation of Kabra committee in 1994 and the National Agricultural Policy in 2000 directed the development of commodity derivatives markets in India. With this background, the government gave notifications for the futures trading in commodities in India in 2003 In 1992 the government permitted unrestricted booking and cancellation of foreign currency forward contracts for all genuine exposures, whether trade related or not. This led to spurt in the volume of rupee forward post 1992. The Foreign Exchange Management Act, 2000 (FEMA) furthered fostered the development of foreign currency derivatives market. Fresh set of guidelines were issued for hedging in foreign currency forward contracts. In July 2004, 13

government made amendments in the conditions under which FII could enter into foreign currency forward contract to hedge its exposure in India. Under the amended guidelines only registered FIIs could enter into forward contract that to only if, the value of hedge does not exceed the market value of underlying debt or equity instruments. Guidelines further stated that, the forward contract once booked shall be allowed to continue to the original maturity even if the value of underlying portfolio shrinks.

Trading stock derivatives contracts in organized market were legal before Morarji’s Desai’s government, which banned forward contracts in 1977. In unorganized markets, derivatives on stock were traded in the form of Teji and Mandi. The first steps towards introduction of exchange based derivatives trading in India was the promulgation of securities law (amendment) ordinance, 1995. However the regulation framework for governing exchange traded derivatives was not in place. Thus, the market for exchange traded derivatives did not come up.

3.3

Equity Derivatives in India

In the decade of 1900’s revolutionary changes took place in the institutional infrastructure in India’s equity market. It has led to wholly new ideas in market design that has come to dominate the market. These new institutional arrangements, coupled with the widespread knowledge and orientation towards equity investment and speculation, have combined to provide an environment where the equity derivatives is now India’s most sophisticated financial market. One aspect of the sophistication of the equity market is seen in the levels of market liquidity that are now visible. The market impact cost of doing program trades of Rs 5 million at the NIFTY index is around 0.2 %. This state of liquidity on the equity spot and derivative markets does well for the market efficiency. Stock trading is widely prevalent in India, hence it seems easy to think that derivatives based on individual securities could be very important. The index is the counter piece of portfolio analysis in modern financial economies. Index fluctuations affect all portfolios. The index is much harder to manipulate. This is particularly important given the weaknesses of Law Enforcement in India, which havemade numerous manipulative episodes possible. The market capitalisation of the NSE-50 index is Rs.2.6 trillion. This is six times larger than the market capitalisation of the largest stock and 500 times larger than stocks such as Sterlite, BPL and Videocon. If market manipulation is used to artificially obtain 10% move in the price of a 14

stock with a 10% weight in the NIFTY, this yields a 1% in the NIFTY. Cash settlements, which is universally used with index derivatives, also helps in terms of reducing the vulnerability to market manipulation, in so far as the ‘short-squeeze’ is not a problem. Thus, index derivatives are inherently less vulnerable to market manipulation. .

3.4 L.C. GUPTA & J.R VARMA COMMITTEE: Pre Requisites for a Successful Derivatives Markets L.C. Gupta Committee Report SEBI appointed the L.C. Gupta Committee on 18th November 1996 to develop appropriate regulatory framework for derivatives trading and to recommend suggestive bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts. The Committee was also to focus on financial derivatives and in particular, equity derivatives. The Committee submitted its report in March 1998. The Board of SEBI in its meeting held on May 11, 1998 accepted the recommendations of the L.C. Gupta Committee and approved the phased introduction of derivatives trading in India beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-laws" recommended by the committee for Regulation and Control of Trading and Settlement of Derivatives Contracts. SEBI circulated the contents of the Report in June 98.

The L.C. Gupta Committee had conducted a wide market survey contacting several entities relevant to derivatives trading like brokers, mutual funds, banks/FIs, FIIs and merchant banks. The Committee observed that there was a widespread recognition of the need for derivatives products including Equity, Interest Rate and Currency derivatives products. However Stock Index Futures was the most preferred product followed by stock index options. Options on individual stocks was the third in the order of preference. The participants interviewed mostly stated that their objective in derivative trading would be hedging. But there were also a few interested in derivatives dealing for speculation/dealing. Other market preferences indicated are, 3 month Futures as the most preferred product and in terms of the category of Options American Options were preferred over European Option

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Major Recommendations of Dr. L.C. Gupta Committee. 1. There is need for equity derivatives, interest rate derivatives and currency derivatives.

2. Futures trading through derivatives should be introduced in phased manner starting with stock index futures, which will be followed by options on index and later options on stocks. It will enhance the efficiency and liquidity of cash markets in equities through arbitrage process.

3. There should be two-level regulation (regulatory framework for derivatives trading), i.e., exchange level and SEBI level. Further, there must be considerable emphasis on selfregulatory competence of derivative exchanges under the overall supervision and guidance of SEBI.

4. The derivative trading should be initiated on a separate segment of existing stock exchanges having an independent governing council. The number of the trading members will be limited to 40 percent of the total number. The Chairman of the governing council will not be permitted to trade on any of the stock exchanges.

5. The settlement of derivatives will be through an independent clearing Corporation/ Clearing house, which will become counter-party for all trades or alternatively guarantees the settlement of all trades. The clearing corporation will have adequate risk containment measures and will collect margins through EFT. 6. The derivatives exchange will have on-line-trading and adequate surveillance systems. It will disseminate trade and price information on real time basis through two information vending networks. It should inspect 100 percent of members every year. 7. There will be complete segregation of client money at the level of trading/clearing member and even at the level of clearing corporation.

8. The trading and clearing member will have stringent eligibility conditions. At least two persons should have passed the certification programme approved by the SEBI.

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9. The clearing members should deposit minimum ` 50 lakh with clearing corporation and should have a net worth of 3 crore.

10. Removal of the regulatory prohibition on the use of derivatives by mutual funds while making the trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio balancing and not for specification. 11. The operations of the cash market on which the derivatives market will be based, needed improvement in many respects.

12. Creation of a Derivation Cell, a Derivative Advisory Committee, and Economic Research Wing by SEBI.

J.R. Varma Committee Report SEBI appointed a committee under a chairmanship of Dr .L.C. Gupta in November 1996 to develop appropriate regulatory framework for derivatives trading in India. In June 1998 the SEBI board mandated a setting up of a group to recommend measures for risk contentment in the derivative market under prof .J.R. Varma. The group began by listing the risk contentment issue that assumes importance in the Indian context while setting up the index future market.

1. Estimation Of Volatility Several issues arise in the estimation of volatility: 1. Volatility in Indian market is quite high as compared to developed markets.

2. The volatility in Indian market is not constant and is varying over time. 3. The statistics on the volatility of the index futures markets do not exist (as these markets are yet to be introduced) and therefore, in the initial period, reliance has to be made on the volatility in the underlying securities market. 4. The LCGC has prescribed that no cross margining would be permitted and separate margins would be charged on the position in the futures market and the underlying securities market.

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In the absence of cross margining, index arbitrage would be costly and therefore possibly inefficient.

2. Calendar Spreads In developed markets, calendar spreads are essentially a play on interest rates with negligible stock market exposure. As such margins for calendar spreads are very low. However, in India, the calendar basis risk could be high because of the absence of efficient index arbitrage and the lack of channels for the flow of funds from the organized money market into the index futures market.

3. Trader Net Worth Even an accurate 99% “value at risk” model would give rise to end of day mark to market losses exceeding the margin approximately once every six months. Trader net worth provides an additional level of safety to the market and works as a deterrent to the incidence of defaults. A member with high net worth would try harder to avoid defaults as his own net worth would be at stake. The definition of net worth needs to be made precise having regard to prevailing accounting practices and laws.

4. Margin Collection And Enforcement Apart from the correct calculation of margin, the actual collection of margin is also of equal importance. Since initial margins can be deposited in the form of bank guarantee and securities, the risk containment issues in regard to these need to be tackled.

5. Clearing Corporation The clearing corporation provides novation and becomes the counter party for each trade. In the circumstances, the credibility of the clearing corporation assumes importance and issues of governance and transparency need to be addressed.

18

6. Position Limit Position Limits it may be necessary to prescribe position limits for the market as a whole and for the individual clearing member / trading member / client.

7. Legal issues Some members expressed the concern that certain legal opinions seem to be suggesting that mere declaration of cash settled futures as securities under SCRA would not put them on a sound legal footing unless the provisions of the Contract Act were either amended or explicitly overridden. Some court judgements in foreign countries were said to be extremely worrying in this regard.

3.5 BENEFITS OF DERIVATIVES IN INDIA During December, 1995, the NSE applied to the SEBI for permission to undertake trading in stock index futures. Later SEBI appointed the Dr. L.C. Gupta Committee, which conducted a survey amongst market participants and observed an overwhelming interest in stock index futures, followed by other derivatives products. The LCGC recommended derivatives trading in the stock exchanges in a phased manner. It is in this context SEBI permitted both NSE and BSE in the year 2000 to commence trading in stock index futures. The question, therefore, becomes relevant—what are the benefits of trading in Derivatives for the country and in particular for choosing stock index futures as the first preferred product?

19

Following are some benefits of derivatives in India: 1. India’s financial market system will strongly benefit from smoothly functioning index derivatives markets.

2.

Internationally, the launch of derivatives has been associated with substantial improvements in market quality on the underlying equity market. Liquidity and market efficiency on India’s equity market will improve once the derivatives commence trading.

3. Foreign investors coming into India would be more comfortable if the hedging vehicles routinely used by them worldwide are available to them.

4. Many risks in the financial markets can be eliminated by diversification. Index derivatives are special in so far as they can be used by the investors to protect themselves from the one risk in the equity market that cannot be diversified away, i.e., a fall in the market index. Once the investors use index derivatives, they will stiffer less when fluctuations in the market index take place. 5. The launch of derivatives is a logical next step in the development of human capital in India. Skills in the financial sector have grown tremendously in the last few years. Thanks to the structural changes in the market, the economy is now ripe for derivatives as the next area for addition of skills.

20

CHAPTER 4 FORWARD CONTRACTS A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly for hedging. A forward contract settlement can occur on a cash or delivery basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments.

4.1 SALIENT FEATURES OF FORWARDS CONTRACT:

Highly customized - Counterparties can determine and define the terms and features to fit their specific needs, including when delivery will take place and the exact identity of the underlying asset.



All parties are exposed to counterparty default risk - This is the risk that the other party may not make the required delivery or payment.



Transactions take place in large, private and largely unregulated markets consisting of banks, investment banks, government and corporations.



Underlying assets can be a stocks, bonds, foreign currencies, commodities or some combination thereof. The underlying asset could even be interest rates.



They tend to be held to maturity and have little or no market liquidity.

 Commitment between two parties to trade an asset in the future is a forward contract.

21

4.2 ADVANTAGES AND DISADVANTAGES OF FORWARDS CONTRACT Forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified time at an agreed price.

The advantages of forward contracts are as follows: 1) They can be matched against the time period of exposure as well as for the cash size of the exposure.

2) Forwards are tailor made and can be written for any amount and term.

3) It offers a complete hedge.

4) Forwards are over-the-counter products.

5) The use of forwards provide price protection.

6) They are easy to understand.

The disadvantages of forward contracts are: 1) It requires tying up capital. There are no intermediate cash flows before settlement.

2) It is subject to default risk.

3) Contracts may be difficult to cancel.

4) There may be difficult to find a counter-party.

22

4.3 FORWARD PRICES VERSUS FUTURES PRICES

1. Whether the forward prices are equal to futures prices, this is very important and debatable issue. It is argued that if risk free interest rate is constant and the same for all maturities, in such market situations, lie forward price will be same as the futures price for the contract.

2. However, in actual practice, the interest rates do not remain constant and usually vary unpredictably, then forward prices and futures prices no longer remain the same. We can get sense of the nature of the relationship by considering the situation where the price of the underlying asset is strongly positively correlated with interest rates.

3. Since in futures contracts, there is daily settlement, so if current price(s) increases, an investor who holds a long future position, makes an immediate profit, which will be reinvested at a higher than average rate of interest.

4. Similarly when current price(s) decreases, the investor will incur immediate loss, and this loss will be financed at a lower than average rate of interest. However, this position does not arise in the forward contract because there is no daily settlement and interest rate movements will not have any affect till maturity.

5. It is further observed that though there may be theoretical difference between forward prices and futures prices due to various factors like taxes, transaction costs, treatment of margin and default risk, but this difference is very small which may be ignored.

23

CHAPTER 5 FUTURES CONTRACT 5.1 EVOLUTION OF FUTURES MARKET IN INDIA 

Organized futures market evolved in India by the setting up of “Bombay Cotton Trade Association Ltd.” in 1875. In 1883, a separate association called “The Bombay Cotton Exchange Ltd.” was constituted.



Futures trading in oilseeds were started with the setting up of Gujarati Vyapari Mandali in 1900. A second exchange, the Seeds Traders’ Association Ltd., trading oilseeds such as castor and groundnuts, was setup in 1926 in Mumbai. Then, many other exchanges trading in jute, pepper, turmeric, potatoes, sugar, and silver, followed.



Futures market in bullion began at Mumbai, in 1920.



In 1940s, trading in forwards and futures was made difficult through price controls till 1952 when the government passed the Forward Contract Regulation Act, which controls all transferable forward contracts and futures.



During the 1960s and 70s, the Central Government suspended trading in several commodities like cotton, jute, edible oilseeds, etc. as it felt that these markets helped increase prices for commodities



Two committees that were appointed—Datwala Committee in 1966, and Khusro Committee in 1980, recommended the reintroduction of futures trading in major commodities, but without much result. One more committee on Forwards market, the Kabra Committee was appointed in

1993,

which recommended futures trading in wide range of commodities and also up 210 gradation of futures market. Accepting partially the recommendations, Government permitted futures trading in many of the commodities.

24

5.2 SALIENT FEATURES OF FUTURES CONTRACT A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts are standardized to facilitate trading on a futures exchange and, depending on the underlying asset being traded, detail the quality and quantity of the commodity. 

Standardization: The future contracts are standardized in terms of quantity and quality and future delivery date.



Margining: The other characteristics of a futures contract is the margining process. The margin differs from exchange to exchange and may change as the exchange’s perception of risk changes. This is known as the initial margin. In addition to this there is also daily variation margin and this process is known as marking to market.



Participants: The majority of users are large corporations and financial institutions either as traders or hedgers.



Futures are exchange traded: In futures market there is availability of clearing house for settlement of transactions.



Liquidity: The future contracts are traded on exchange hence they offer liquidity to the buyer/seller of futures contract.



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



Exchange as counter party: The futures contracts are written against clearing house of the derivative exchanges thus the clearing house is the counter party to the contract.

25

5.3 FUTURE TERMINOLOGY Futures are derivatives and they differ from cash instruments such as stocks in many ways. These are some terms you need to be familiar with in order to understand and trade futures. 

TRANSACTION / CONTRACT DATE:Contract date is the date on which buyer/seller agree to enter into transaction to exchange underlying asset.



SETTLEMENT DATE / VALUE DATE:The day on which transaction is settled either by offsetting it in cash or by giving the delivery of the underlying asset at the price agreed on transaction / contract date.



READY CONTRACT:In case of ready contract, the contract date and the value date is the same.



SPOT TRANSACTION:In this case the value date is two days after the contract date i.e. T+2



SPOT PRICE:The price of an underlying asset that is quoted for immediate delivery of the underlying asset is known as spot price. It is also referred to as cash price. Spot prices are quoted on the cash/spot segment of exchange.



STRIKE PRICE / FUTURES PRICE:The price mutually agreed between the parties to the contract at the time of entering into the contract for the delivery of the underlying asset at a future specific date is referred to as futures price.



BASIS:Basis is the difference between spot price of the underlying and the futures price of that underlying.

26



COST OF CARRY:It is the cost of holding the asset over a period of time. It includes interest on invested funds, storage cost and other incidental cost. It is also referred to as carrying charges.



INITIAL MARGIN:The initial margin is determined by the exchange and tells you exactly how much cash you need to put up as collateral for each contract of a certain future. If the position goes against you however, you need to put up more margin so you better not sail too close to the wind here. Your broker will shut down your position if you fail to maintain enough collateral in your account.



MAINTENANCE MARGIN:The amount of money needed on your account to hold on to a contract. If your account drops below this amount you are required to either close the position or replenish funds in your account.

5.4 Distinguish Between Forward Contracts and Future Contracts

Basis of

Forwards contract

comparison

27

Futures contract

Definition

A forward contract is an

A futures contract is a

agreement between two

standardized contract,

parties to buy or sell an asset

traded on a futures

(which can be of any kind) at

exchange, to buy or sell a

a pre-agreed future point in

certain underlying

time at a specified price.

instrument at a certain date in the future, at a specified price.

Over the counter, i.e. there is

Organized stock

no secondary market.

exchange.

Settlement

On maturity date

On a daily basis

Risk

High

Low

Size Of Contract

Depends on the contract

Fixed

Traded On

terms.

Regulation

Self-regulated

By stock exchange

Liquidity

Low

High

CHAPTER 6 OPTIONS CONTRACT 6.1 OPTIONS TERMINOLOGY

28

An options contract is an agreement between a buyer and seller that gives the purchaser of the option the right to buy or sell a particular asset at a later date at an agreed upon price. Options contracts are often used in securities, commodities, and real estate transactions. These are some terms you need to be familiar with in order to understand and trade options. CALL OPTION:It gives the holder the right but not the obligation to buy an asset by a certain date for a certain price PUT OPTION:It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. HOLDER OF AN OPTION:The buyer of an option is the one who by paying the option Premium buys the right but not the obligation to exercise his option on the seller/ writer. WRITER OF AN OPTION:The writer of a call/put option is the one who receives the option Premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. OPTION PRICE/PREMIUM:It is the price which the option buyer pays to the option seller. It is also referred to as the option premium. EXPIRATION DATE:The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

STRIKE PRICE:The price specified in the options contract is known as the strike price or the exercise price. IN-THE-MONEY OPTION:-

29

An in-the-money (ITM) option would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in the-Money when the current index stands at a level higher than the strike price (i.e. spot Price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. AT-THE-MONEY OPTION:An at-the-money (ATM) option would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). OUT-OF-THE-MONEY OPTION:An out-of-the-money (OTM) option would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money

6.2 OPTION PAYOFFS The option has non-linear payoffs. The loss of the option buyer is limited to the extent of premium paid and the profit potential is unlimited. For the option writer the payoffs are exactly opposite i.e. profit is limited to the extent of premium received and loss potential is unlimited. The call option payoffs of, option buyer and writer are presented here under.

 LONG CALL This is one of the basic strategies as it involves entering into one position i.e. buying the Call Option only. Any investor who buys the Call Option will be bullish in nature and would be expecting the market to give decent returns in the near future. Risk: The risk of the buyer is the amount paid by him to buy the Call Option i.e. the premium value. Reward: The reward will be unlimited as the underlying asset value can rise up to any value until the expiry. Break-Even Point: The break-even point for the Call Option Holder will be ‘Strike Price + Premium.’ 30

Example: - Currently NIFTY is trading around 5300 levels, and Mr. X is bullish on NIFTY and buys one 5200 Call Option (ITM) for Rs. 200 premium. Lot size is 50. The investment amount will be Rs. 10000. (200*50) Case 1: NIFTY closes at 5500 levels; Mr. X will make a profit of Rs. 5000. [(300-200)*50] Case 2: NIFTY dips to 5100 levels; Mr. X will incur a loss of Rs. 10000 (200*50) which is the premium he paid for buying one lot of 5200 Call Option.



SHORT CALL

A trader shorts or writes a Call Option when he feels that underlying stock price is likely to go down. Selling Call Option is a strategy preferred for experienced traders. However this strategy is very risky in nature. If the stock rallies on the upside, your risk becomes potentially unquantifiable and unlimited. If the strategy works out in your favor then you will pocket the premium amount as your reward. Risk: Unlimited Reward: Limited Example:- If the NIFTY is trading around 5300 levels, Mr. X feels that Nifty is likely to fall in the near future then he will sell one 5400 Call Option for a premium of Rs. 120. Mr. X will get a credit of Rs 6000 (120*50) in his account for selling or writing the call option. Case 1: NIFTY closes at 5200 levels, Mr. X will bag the premium amount i.e. Rs. 6000. (120*50) Case 2: NIFTY closes at 5600 levels; Mr. X will incur a loss of Rs. 4000. [(Strike Price - Expiry Price) + Premium Price * 50] [(5400-5600) + 120)*50] 31

 LONG PUT This strategy is implemented by buying 1 Put Option i.e. a single position, when the person is bearish on the market and expects the market to move downwards in the near future. Risk: The maximum loss will be the premium amount paid. Reward: The profits will be limited by the maximum fall in the underlying asset price i.e. potentially null value (i.e. zero ‘0’). Example: - Mr. X is bearish on NIFTY and expects the market to move downwards in the near future. NIFTY is currently trading around Rs. 5200 level. Lot size of NIFTY is 50. Mr. X buys 1 5300 Put Option of NIFTY for a premium of Rs. 115. His initial investment will be Rs. 5750. (115*50) Case 1: If the market moves as per Mr. X’s expectations and dips down to Rs. 5100 level, then the net profit will be Rs. 4250. [(200-115)*50] Case 2: If the market moves upwards against his expectations then the maximum loss/risk will be the premium amount paid i.e. Rs. 5750. (115*50)

32

 SHORT PUT A trader will short put if he is bullish in nature and expects the underlying asset not to fall below a certain level. Risk: Losses will be potentially unlimited if the stock skyrockets above the strike price of put. Reward: His profits will be capped by the premium amount received. Example: - Suppose NIFTY is trading at 5200 level and Mr. X is bullish on the market. He expects NIFTY to stay near 5200-5300 levels or even rise further until expiry. He will sell one NIFTY 5200 Put Option for a premium of Rs. 70. The lot size of NIFTY is 50. Mr. X’s account will be credited by Rs. 3500 (70*50) which is the premium received on sale of Put option. Case 1: If the NIFTY closes at 5400, then Mr. X will receive the maximum profit of Rs. 3500. Case 2: If the NIFTY closes at 5000, then Mr. X will face a loss of Rs. 6500. [(200-70)*50]

6.3 Distinguish between futures contract and options contract

33

Basis for comparison Meaning

Futures contract

Options contract

Futures contract is a

Options are the contract

binding agreement, for

in which the investor gets

buying and selling of a

the right to buy or sell the

financial instrument at a

financial instrument at a

predetermined price at a

set price, on or before a

future specified date.

certain date, however the investor is not obligated to do so.

Obligation of buyer

Execution of

Yes, to execute the contract.

No, there is no obligation.

On the agreed date.

Any time before the expiry of the agreed date.

contract Risk

Advance payment

High

Limited

No advance payment

Paid in the form of premiums.

Degree of profit/loss

Unlimited

Unlimited profit and limited loss.

CHAPTER 7 CLEARING AND SETTLEMENT SYSTEM FOR FINANCIAL DERIVATIVES 34

7.1 NSCCL (NATIONAL SECURITIES CLEARING CORPORATION LIMITED) National Securities Clearing Corporation Limited, NSCCL, a wholly owned subsidiary of NSE is responsible for clearing and settlement of all trades executed on NSE and deposit and collateral management and risk management functions. NSCCL was the first clearing corporation to be established in India and we introduced settlement guarantee before it became a regulatory requirement. NSCCL has maintained a credit rating of "AAA" from CRISIL since 2008.

NSCCL Vision To provide robust and well-governed multi-asset class Central Counterparty (CCP) infrastructure with global presence for safe and efficient value added services through robust strong risk management systems and processes, setting global benchmarks.

Objectives 

To bring and sustain confidence in clearing and settlement of securities;



To promote and maintain, short and consistent settlement cycles;



To provide counter-party risk guarantee, and



To operate a tight risk containment system.

NSCCL commenced clearing operations in April 1996.

7.2 RISK MANAGEMENT A sound risk management system is integral to an efficient clearing and settlement system. NSE introduced for the first time in India, risk containment measures that were common internationally but were absent from the Indian securities markets. 35

Risk containment measures include capital adequacy requirements of members, monitoring of member performance and track record, stringent margin requirements, position limits based on capital, online monitoring of member positions and automatic disablement from trading when limits are breached, etc. Risk Management for Derivative products is managed with Standard Portfolio Analysis of Risk (SPAN)®is a highly sophisticated, value-at-risk methodology that calculates performance bond/margin requirements by analyzing the "what-if's" of virtually any market scenario. SPAN ® is a registered trademark of the Chicago Mercantile Exchange, used herein under License. The Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person or entity.

Some of the risk management initiatives of exchanges are briefly discussed hereunder: 

Liquid Assets

Clearing members are required to provide liquid assets which adequately cover various margins and liquid net worth requirements. A clearing member may deposit liquid assets in the form of cash, bank guarantees, fixed deposit receipts, approved securities and any other form of collateral as may be prescribed from time to time. The total liquid assets comprise of the cash component and the non-cash component wherein the cash component shall be at least 50% of liquid assets.  Margins NSCCL has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NSCCL is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN® (Standard Portfolio Analysis of Risk) system for the purpose of margining, which is a portfolio based system.

A. Initial Margin 

Span Margin

36

NSCCL collects initial margin up-front for all the open positions of a CM based on the margins computed by NSCCL-SPAN®. A CM is in turn required to collect the initial margin from the TMs and his respective clients. Similarly, a TM should collect upfront margins from his clients. 

Premium Margin

In addition to Span Margin, Premium Margin is charged to members. The premium margin is the client wise premium amount payable by the buyer of the option and is levied till the completion of pay-in towards the premium settlement. 

Assignment Margin

Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margin. It is levied on assigned positions of CMs towards interim and final exercise settlement obligations for option contracts on index and individual securities till the pay-in towards exercise settlement is complete. The Assignment Margin is the net exercise settlement value payable by a Clearing Member towards interim and final exercise settlement and is deducted from the effective deposits of the Clearing Member available towards margins.

B. Exposure Margin The exposure margins for options and futures contracts on index are as follows: For Index options and Index futures contracts: 3% of the notional value of a futures contract. In case of options it is charged only on short positions and is 3% of the notional value of open positions. For

option

contracts

and

Futures

Contract

on

individual

Securities:

The higher of 5% or 1.5 standard deviation of the notional value of gross open position in futures on individual securities and gross short open positions in options on individual securities in a particular underlying. The standard deviation of daily logarithmic returns of prices in the underlying stock in the cash market in the last six months is computed on a rolling and monthly basis at the end of each month.

For this purpose notional value means:

37

For a futures contract - the contract value at last traded price/ closing price. For an options contract - the value of an equivalent number of shares as conveyed by the options contract, in the underlying market, based on the last available closing price.

7.3 ROLE OF RBI IN PAYMENT AND SETTLEMET SYSTEM The central bank of any country is usually the driving force in the development of national payment systems. The Reserve Bank of India as the central bank of India has been playing this developmental role and has taken several initiatives for Safe, Secure, Sound, Efficient, Accessible and Authorized payment systems in the country. The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a subcommittee of the Central Board of the Reserve Bank of India is the highest policy making body on payment systems in the country. The BPSS is empowered for authorizing, prescribing policies and setting standards for regulating and supervising all the payment and settlement systems in the country. The Department of Payment and Settlement Systems of the Reserve Bank of India serves as the Secretariat to the Board and executes its directions. In India, the payment and settlement systems are regulated by the Payment and Settlement Systems Act, 2007 (PSS Act) which was legislated in December 2007. The PSS Act as well as the Payment and Settlement System Regulations, 2008 framed thereunder came into effect from August 12, 2008. In terms of Section 4 of the PSS Act, no person other than the Reserve Bank of India (RBI) can commence or operate a payment system in India unless authorized by RBI. Reserve Bank has since authorized payment system operators of pre-paid payment instruments, card schemes, cross-border in-bound money transfers, Automated Teller Machine (ATM) networks and centralized clearing arrangements.

Payment systems The Reserve Bank has taken many initiatives towards introducing and upgrading safe and efficient modes of payment systems in the country to meet the requirements of the public at large. The dominant features of large geographic spread of the country and the vast network of branches of the Indian banking system require the logistics of collection and delivery of paper instruments. These aspects of the banking structure in the country have always been kept in mind while developing the payment systems. 38

7.4 SETTLEMENT MECHANISM Settlement of futures contracts on index and individual securities 

Daily mark to market settlement:

The positions in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day.

The profits/ losses are computed as the difference between the trade price or the previous day's settlement price, as the case may be, and the current day's settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily mark-tomarket settlement. 

Final settlement:

On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash.

The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day's settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day). Open positions in futures contracts cease to exist after their expiration day.

Settlement of options contracts on index and individual securities

39



Daily premium settlement:

Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each CM at the client level to determine the net premium payable or receivable amount, at the end of each day. The CMs who have a premium payable position are required to pay the premium amount to NSCCL which is in turn passed on to the members who have a premium receivable position. This is known as daily premium settlement. CMs are responsible to collect and settle for the premium amounts from the TMs and their clients clearing and settling through them. The pay-in and pay-out of the premium settlement is on T+1 day (T = Trade day). The premium payable amount and premium receivable amount are directly debited or credited to the CMs clearing bank account. 

Final exercise settlement:

Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at inthe money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. For index options contracts and options contracts on individual securities, exercise style is European style. Final Exercise is Automatic on expiry of the option contracts. Option contracts, which have been exercised, shall be assigned and allocated to Clearing Members at the client level. Exercise settlement is cash settled by debiting/ crediting of the clearing account of the relevant Clearing Members with the respective Clearing Bank. Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Open positions, in option contracts, cease to exist after their expiration day.

CHAPTER 8 40

DERIVATIVE MODELS 8.1

Black Scholes Model

The Black Scholes model, also known as the Black-Scholes-Merton model, is a model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. The model assumes the price of heavily traded assets follows a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price Variation of the stock, the time value of the money, the options strike price and time to the option’s expiry The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used in. It is regarded as one of the best ways of determining fair prices of options. The Black Scholes model requires five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate and the volatility. Additionally, the model assumes stock prices follow a lognormal distribution because asset prices cannot be negative. Moreover, the model assumes there are no transaction costs or taxes; the risk-free interest rate is constant for all maturities; short selling of securities with use of proceeds is permitted; and there are no riskless arbitrage opportunities.

Black Scholes Formula

In order to understand the model itself, we divide it into two parts. The first part, SN (d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N (d1)]. The second part of the model,

41

Ke (-rt) N (d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.

Assumptions of the Black Scholes Model 1) Constant Volatility: The most significant assumption is that volatility, a measure of how much a stock can be expected to move in the near-term, is a constant over time. While volatility can be relatively constant in very short term, it is never constant in longer term. Some advanced option valuation models substitute Black-Scholes constant volatility with stochastic-process generated estimate 2) Efficient Markets: This assumption of the Black-Scholes model suggests that people cannot consistently predict the direction of the market or an individual stock. The BlackScholes model assumes stocks move in a manner referred to as a random walk. Random walk means that at any given moment in time, the price of the underlying stock can go up or down with the same probability. The price of a stock in time t+1 is independent from the price in time t.

3) No Dividends: Another assumption is that the underlying stock does not pay dividends during the option's life. In the real world, most companies pay dividends to their shareholders. The basic Black-Scholes model was later adjusted for dividends, so there is a workaround for this. This assumption relates to the basic Black-Scholes formula. A common way of adjusting the Black-Scholes model for dividends is to subtract the discounted value of a future dividend from the stock price.

4) Interest Rates Constant and Known: The same like with the volatility, interest rates are also assumed to be constant in the Black-Scholes model. The Black-Scholes model uses the risk-free rate to represent this constant and known rate. In the real world, there is no such thing as a risk-free rate, but it is possible to use the U.S. Government Treasury Bills 30-day rate since the U. S. government is deemed to be credible enough. However, these treasury rates can change in times of increased volatility.

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5) Log normally Distributed Returns: The Black-Scholes model assumes that returns on the underlying stock are normally distributed. This assumption is reasonable in the real world.

6) European-style options: The Black-Scholes model assumes European-style options which can only be exercised on the expiration date. American-style options can be exercised at any time during the life of the option, making American options more valuable due to their greater flexibility.

7) No Commissions and Transaction Costs: The Black-Scholes model assumes that there are no fees for buying and selling options and stocks and no barriers to trading.

8) Liquidity: The Black-Scholes model assumes that markets are perfectly liquid and it is possible to purchase or sell any amount of stock or options or their fractions at any given time.

Limitations of Black Scholes Model 

The model does not allow for early exercise

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Not suitable for valuing American options that can be exercise any time during their life.

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The stepwise binomial method is superior for valuing American options, particularly American puts and American calls on stocks that pay dividends.

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Not suitable for valuing warrants as warrants are long term options and it is quite likely that the underlying stock will pay dividends during the life of warrant.

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Also, when exercise warrants increase the total number of shares which adds another level of complication in valuing warrants using Black and Scholes formula.

8.2

Binomial Model

The binomial option pricing model is an options valuation method developed in 1979. The binomial option pricing model uses an iterative procedure, allowing for the specification of nodes, or points in time, during the time span between the valuation date and the

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option's expiration date. The model reduces possibilities of price changes, and removes the possibility for arbitrage. The binomial model of stock price movements is a discrete time model, i.e., time is divided into discrete bits and only at these time points are stock prices modelled. The binomial approach assumes that the security price obeys a binomial generating process, i.e., at every point of time there are exactly two possible states - stock can move up or down. The model lowers the possibilities of price changes and is based on the concept of no arbitrage, it assumes a perfectly efficient market, and shortens the duration of the option. Under these simplifications, it is able to provide a mathematical valuation of the option at each node specified.

Binomial Model Formula 

S0: The stock price today.

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p: The probability of a price rise.

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u: The factor by which the price rises (assuming it rises).

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d: The factor by which the price falls (assuming it falls).

Assumptions of Binomial Model The assumptions in binomial option pricing models are as follows 

There are only two possible prices for the underlying asset on the next day. From this assumption, this model has got its name as Binomial option pricing model (Bi means two).

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The two possible prices are the up-price and down-price.

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The underlying asset does not pay any dividends.

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The rate of interest (r) is constant throughout the life of the option.

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Markets are frictionless i.e. there are no taxes and no transaction cost.

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Investors are risk neutral i.e. investors are indifferent towards risk. 44

Advantages of Binomial Option Pricing Model 1. Binomial option pricing models are mathematically simple to use. 2. Binomial option pricing model is useful for valuing American options in which the option owner has the right to exercise the option any time up till expiration. 3. Binomial option model is also useful for pricing Bermudan options which can be exercised at various points during the life of the option.

Limitations of Binomial Option Pricing Model One major limitation of binomial option pricing model is its slow speed. Computation complexity increases in multi period binomial option pricing model.

8.3 Cost Of Carry Model Cost of carry can be defined simply as the net cost of holding a position. The most widely used model for pricing futures contracts, the term is used in capital markets to define the difference between the cost of a particular asset and the returns generated on it over a particular period. It can also be defined as the difference between the interests generated on a cash asset and the cost of funds to finance that instrument.

Theoretically, the price of a futures contract is the sum of the prevailing spot price and the cost of carry. But the actual price of futures contract also depends on the demand and supply of the underlying stock.

Future price= spot price + cost of carry Or cost of carry = futures price – spot price

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Cost to carry may not be an extremely high financial cost if it is effectively managed. For example, the longer a position is made on margin, the more interest payments will need to be made on the account. When making an informed investment decision, consideration must be given to all of the potential costs associated with taking that position. In capital markets, the cost of carry is the difference between the yield generated from the security and the cost of entering and maintaining the position. In the commodities markets, the cost of carry includes the cost of necessary insurances and the expense of storing the physical commodity over a period of time. The cost of carry refers to cost incurred as a result of an investment position. These cost can include financial costs, such as interest cost on bonds, interest expenses on margin accounts and interest on loans used to purchase security. They can also include economic cost, such as the opportunity cost associated with taking initial position.

Formula: There is a financial model that is used in the forwards market to determine the cost of carry (if the forward price is known), or the forward price (if the cost of carry is known). While this works for forwards, it provides a good approximation for futures prices as well. The formula is expressed as follows: F = Se ^ ((r + s - c) x t) Where: F = the forward price of the commodity S = the spot price of the commodity e = the base of natural logs, approximated as 2.718 r = the risk-free interest rate s = the storage cost, expressed as a percentage of the spot price c = the convenience yield, which is an adjustment to the cost of carry t = time to delivery of the contract, expressed as a faction of one year 46

Example Suppose the spot price of script X is rs1600 and the prevailing interest rate is 7 percent per annum. Future price of one month contract would therefore be 1600+1600*0.07*30/365 = rs1600 + rs11.51= 1611.51. Here 11.51 is the cost of carry. When making an informed investment decision, consideration must be given to all potential costs associated with taking the position. A longer position on margin attracts higher interest payment. Buying of more futures as opposed to cash generally raises the cost of carry, as it is an annualized premium of the futures to cash. The higher the absolute price difference between futures and cash, higher is the cost of carry. Meanwhile, the term is used to interpret market sentiment for a stock or index, as higher values of cost of carry along with the build-up of open interest indicates that traders are bullish and willing to pay more for holding futures. The opposite is true for falling cost of carry. Sometimes, futures trade at a discount to the price of the underlying, which makes the cost of carry negative. This usually happens when the stock is expected to pay a dividend, or when traders execute a reverse-arbitrage strategy that involves buying in spot market and selling futures. This reflects bearish sentiment.

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8.4

Whaley’s Quadratic Model

The Quadratic Approximation Method developed by G.Barone-Adesi, R.E. Whaley and L.W. MacMillian is an alternative to numerical methods for pricing American options. The quadratic approximation method is accurate and less computer intensive than Binomial pricing methods. It can be used to value American call and put options on currencies, futures contracts, stocks, and stock indices. The technique involves estimating the difference between an American option and European option.

In American option holder has right to exercise option early. Thus value of American option = European Option Value + Early Exercise Option Value

Quadratic Approximation Method calculates value of this early exercise option and adds it to the value arrived at using Modified Black-Scholes European Model. The method of determining the value of early exercise option is an iterative approach. Therefore this model is computationally more intensive than Black-Scholes model. Quadratic Approximation Method follows the same assumptions that apply to the Modified Black-Scholes model. The quadratic approximation model can be used on American options that have a continuous dividend, a constant dividend yield, and discrete dividends.

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CASE STUDIES  CEAT India The trade was executed by a 27 year old trader. Apparently this was his first options trade ever. Here is his logic for the trade: CEAT Ltd was trading around Rs.1260/- per share. Clearly the stock has been in a good up trend. However he believed the rally would not continue as there was some sort of exhaustion in the rally. He was encouraged to believe so by looking at the last few candles, clearly the last three day’s trading range was diminishing. To put thoughts into action, he bought the 1220 (OTM) Put options by paying a premium of Rs.45.75/- per lot. The trade was executed on 28th September and expiry for the contract was on October 29th. As on Sep 28, 2015

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So after he bought CEAT PE, this is what happened the very next day As on Sep 29, 2015

Stock price declined to 1244, and the premium appreciated to 52/-. He was right when he said “since there is ample time to expiry, a small dip in the stock price will lead to a good increase in option premium”. He was happy with 7/- in profits (per lot) and hence he decided to close the trade.

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Tata Motors Ltd Tata Motors Ltd is a market leader in auto industry. Tata Motors is available for option trading both in NSE with lot size of 500 units. Exponential Moving average price of the Tata Motors has been calculated based on 10 days moving period.

It is evident from the chart that the EMAP of Tata Motors has not intersected with close price during the period under reference. If we assume that prior to 2nd January 2012, both EMAP and close price have intersected and thereafter EMAP of Tata Motors is started moving in upward direction as it is visible from the chart then it is possible to predict about future movement of price. The EMPA curve is moving in upward direction therefore the price of Tata Motors is expected to move in upward direction.

Selection of Option strategy: - As price of Tata motors is expected to go up moderately in the near term, it is suggested for investor to design Bull Put Spread strategy as it will helps them to book profit/hedge risk. On 10th February 2012, the stock option price and strike price quoted for Tata Motors Ltd (lot size: 500) in NSE option segment are given: Underlying asset: Tata Motors Ltd Expiration Date: 23rd March 2012 Option Type: Put

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Bull Put Spread Strategy Buy 120, 1 Put on Tata Motors at Rs. 4.00 Sell 150, 1 Put on Tata Motors at 48.50.

This chart exhibits that the bull put spread strategy will ensure a maximum profit of Rs. 89000 if the spot price of Tata Motors moves in upward direction as per the forecast.

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Maruti Udyog Ltd. Maruti Udyog Ltd is one of the leading players in the auto industry. Maruti Udyog is available for option trading both in NSE with lot size of 250 units. Exponential Moving average price of the Maruti Udyog has been calculated based on 10 days moving period

It is evident from the chart that the EMAP of Maruti Udyog has not intersected with close price during the period under reference. If we assume that prior to 2nd January 2012, both EMAP and close price have intersected and thereafter EMAP of Maruti Udyog is started moving in upward direction as it is visible from the chart then it is possible to predict about future movement of price. The EMPA curve is moving in upward direction therefore the price of stock will move in upward direction. Selection of Option strategy :- Price of Maruti Suzuki India Ltd expected to go up moderately in

the near term; therefore investor have an opportunity to use long call option strategy to book profit / hedge risk On 10th February 2012, the stock option price and strike price quoted for Maruti Suzuki India ltd in NSE option segment are given below: Underlying asset: Maruti Suzuki India Ltd Expiration Date: 23rd March 2012

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Long Call – Buy 1000, call on Maruti Suzuki India Ltd at Rs 172

It is evident from the chart that the long call strategy helps investor to book profit if the price of Maruti Suzuki India Ltd moves to Rs.1180 and above in the cash market. The total payoff from this strategy is Rs7000 if the spot price of underlying asset reaches to Rs.1200 and Rs.32000 if the spot price reaches to Rs.1300.

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Mahindra and Mahindra Mahindra and Mahindra is also one of the major players in the auto industry. Mahindra and Mahindra is available for option trading both in NSE with lot size of 500 units. Exponential Moving average price of the Mahindra and Mahindra has been calculated based on 10 days moving period.

It is evident from the chart that the EMAP of Mahindra and Mahindra has intersected with close price on 10th February 2012 and started moving downward direction signalling that price of stock will move in downward direction in the near future. Selection of Option strategy Price of Mahindra and Mahindra expected to move in downward direction; therefore investor has an opportunity to use naked call option strategy to book profit / hedge risk

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Payoff from Naked call option:Strike Price: 640 Call Option Price: 47.50

The analysis of charts reveals that it is advantageous for investors to sell call option with strike price of 680 at Rs. 25.65 rather than selling call option with strike price of 660 and 640. The short position on call option with strike price of 660 will fetch the investors Rs.19500 if the spot price moves as per the technical analysis.

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Subprime crisis and its impact on Indian economy The global Financial Crisis of 2008 is the most severe financial crisis that the world has ever faced since the Great Depression of the 1930s. The ‘Financial Crisis of 2008’ also called the US Meltdown, has its origin in the United States housing sector back in 200102, but gradually extended over a period of time and eventually brought the entire world under its grip. The financial crisis is characterized by contracted liquidity in the global credit and housing market, triggered by the failure of mortgage companies, investment banks, and government institutions which had heavily invested in subprime loans. Though the crisis started in 2005-06, but has become more visible during 2007-08, when many of the renowned Wall Street firms collapsed. According to IMF officials, the losses due to real estate crisis is amounted to $945 billion in USA alone, but may run into trillions of dollars, the losses of all the countries considered together. The impact of this crisis was so severe that it led to the collapse of top investment firm’s viz. Lehman Brothers, Bears Sterns. Merrill Lynch and others such as Citi Group, JP Morgan were rescued by the government and AIG (American Investment Group). The impact of this crisis was so severe that the United States Government had to intervene in the free market economy and had to come with $700 billion bailout package to revive the investment banks/firms and reinstate the investor’s faith in the stock market.

Impacts of the US Financial Crisis on India Though in the beginning Indian official denied the impact of US meltdown affecting the Indian economy but later the government had to acknowledge the fact that US financial crisis will have some impact on the Indian economy. The US meltdown which shook the world had little impact on India, because of India’s strong fundamental and less exposure of Indian financial sector with the global financial market. Perhaps this has saved Indian economy from being swayed over instantly. Unlike in US where capitalism rules, in India, market is closely regulated by the government.

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1. Impact on stock market The immediate impact of the US financial crisis has been felt when India’s stock market started falling. On 10 October, Rs. 250,000 crores was wiped out on a single day bourses of the India’s share market. The Sensex lost 1000 points on that day before regaining 200 points, an intraday loss of 200 points. This huge withdrawal from the India’s stock market was mainly by Foreign Institutional Investors (FIIs), and participatory-notes. 2. Impact on India’s trade The trade deficit is reaching at alarming proportions. Because of worker’s remittances, NRI deposits, FII investment and so on, the current deficit is at around $10 billion. . Further, the foreign exchange reserves of the country has depleted by around $57 billion to $253 billion for the week ended October 31. 3. Impact on India’s export With the US and several European countries slipping under the full blown recession, Indian exports have run into difficult times, since October. Manufacturing sectors like leather, textile, gems and jewellery have been hit hard because of the slump in the demand in the US and Europe.

4. Exchange rate depreciation With the outflow of FIIs, India’s rupee depreciated approximately by 20 per cent against US dollar and stood at Rs. 49 per dollar at some point, creating panic among the importers.

5. FII and FDI The contagious financial meltdown eroded a large chunk of money from the Indian stock market, which will definitely impact the Indian corporate sector. However, the money eroded will hardly influence the performance real sector in India. Due to global recession,

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Lehman Brothers bankruptcy & its effect on India On Sept. 14, 2008, the investment bank Lehman Brothers announced that it would file for liquidation after huge losses in the mortgage market and a loss of investor confidence crippled it and it was unable to find a buyer. Denoted as “The biggest financial pandemic since the Great Depression “Lehman Brothers bankruptcy is going to hit world economy big time. Lehman, the 158-year-old investment bank, has filed for bankruptcy. It would be the largest collapse of an investment firm in 18 years. Lehman attempted to find a buyer over the weekend but it met with no success. The last remaining bidder, Barclays PLC bank pulled out Sunday afternoon. Barclays, a United Kingdom-based bank, had become the sole bidder after a consortium led by Bank of America pulled out early Sunday morning citing that it would need government support before considering a bid. The support would consist of backing bad debts owed by Lehman. Barclays cited a similar reason for withdrawing its bid. As of Monday morning, no buyer has come through to take control of the firm. As a result, the firm filed for bankruptcy protection.

Effect on India While the collapse of the US-based Lehman Brothers may not have a direct impact on Indian banks, some of them may face marginal losses due to their exposures to the US investment bank. ICICI Bank, the biggest private player in the country, arguably has the largest exposure. The government is closely monitoring the balance sheets of the Indian arms of the troubled US entities-Lehman Brothers and Merrill Lynch-to avert direct impact on the country’s economy. The government said that there will not be any possible hike in the interest rates in short-term, despite the temporary drop in inflation .The expected GDP growth is between 7.5 to 8 per cent. However Lehman currently employs about 2,500 people in India. The mood in their office at Ceejay House and back office at Hiranandani Gardens in Powai is very grim. Employees have been asked to wait for 72 hours before a decision from the headquarters is communicated. But most have already made up their minds. Most of them qualify for firms such as PricewaterhouseCoopers, JP Morgan and Deloitte The development has already lead to a loss of nearly Rs 2,000 crore for Indian companies in which Lehman had made equity investments. Even some reality developers feels the heat. ICICI Bank will lose around Rs.375 Crore as ICICI Bank UK Plc. holds 57 million euro of senior bonds of Lehman Brothers Inc. 59

The Indian markets experienced the ripple effects of the Lehman collapse, the mood is so bad that there are simply no genuine buyers in the markets. On 15th Sept The Bombay Stock Exchange (BSE) benchmark Sensex fell by 772.62 points and the Nifty of the National Stock Exchange also dipped below 4,000-mark by falling 242.40 points. The ray of hope: As of 18th September 2008 there is news that Barclays has agreed to acquire Lehman Brothers’ North American investment banking, and fixed income and equities sales, trading and research operations, including approximately 10,000 employees.

The Eurozone Debt Crisis and Its Impact on India The European sovereign debt crisis started in 2008, with the collapse of Iceland's banking system, and spread primarily to Greece, Ireland and Portugal during 2009. The debt crisis led to a crisis of confidence for European businesses and economies. The European sovereign debt crisis began at the end of 2009, when the peripheral Eurozone member states of Greece, Spain, Ireland, Portugal and Cyprus were unable to repay or refinance their government debt, or bail out their beleaguered banks without the assistance of third-party financial institutions such as the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Financial Stability Facility (EFSF). Seventeen Eurozone countries voted to create the EFSF in 2010 specifically to address and assist the European sovereign debt crisis. The Eurozone crisis resulted from a combination of complex factors, including the globalization of finance; easy credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices; the financial crisis of 2007–08; international trade imbalances; real estate bubbles that have since burst; the Great Recession of 2008–2012; fiscal policy choices related to government revenues and expenses; and approaches used by states to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

Impact on India European debt crisis and fragile US recovery have contributed to the growth slowdown of the Indian economy by hurting our exports and affecting capital inflows into India. The capital outflows have resulted in crash in our stock markets that have affected investment sentiments of the corporate world.

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The rupee’s depreciation, while aggravated by domestic speculative activity, is primarily traceable to the ongoing sovereign debt crisis in Europe. The value of rupee which was around 44.50 rupees to a US dollar in August 2011 fell to as low as 54 rupees to a dollar on December 15, 2011 and was around Rs. 54.8 to a US dollar in the first week of April 2013. As observed during the crisis of 2008, the present crisis has again led to a large withdrawal of FII money from the Indian stock market, eroding its value. This large withdrawal of portfolio investments from India also led to the depreciation of the rupee. The slowdown in GDP growth to 6.2 per cent in 2011-12 and 5 per cent in 2012-13 was partly due to Eurozone crisis. Eurozone debt crisis put a damper on India’s exports to Europe, the biggest destination for Indian exports as well as capital inflows into the Indian equity and debt markets. The government blamed European crisis as important reason for India’s slowdown in economic growth in recent years.

1991 Indian Economic Crisis and Its Causes The 1991 Indian economic crisis had its roots in 1985 when India began having balance of payments problems as imports swelled, leaving the country in a twin deficit: the Indian trade balance was in deficit at a time when the government was running a large fiscal deficit. By the end of 1990 in the run-up to the Gulf War, the situation became so serious that the Indian foreign exchange reserves could barely finance three weeks’ worth of imports while the government came close to defaulting on its financial obligations. By July that year, the low reserves had led to a sharp devaluation of the rupee, which in turn exacerbated the twin deficit problem. This led the government to airlift national gold reserves as a pledge to the International Monetary Fund (IMF) in exchange for a loan to cover balance of payment debts.

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Causes and Consequences The crisis was caused by currency devaluation the current account deficit, and investor confidence played significant role in the sharp exchange rate depreciation The economic crisis was primarily due to the large and growing fiscal imbalances over the 1980s. During the mid-eighties, India started having balance of payments problems. Precipitated by the Gulf War, India’s oil import bill swelled, exports slumped, credit dried up, and investors took their money out. Large fiscal deficits, over time, had a spillover effect on the trade deficit culminating in an external payments crisis. By the end of 1980, India was in serious economic trouble. The gross fiscal deficit of the government (center and states) rose from 9.0 percent of GDP in 1980-81 to 10.4 percent in 1985-86 and to 12.7 percent in 1990-91. For the Centre alone, the gross fiscal deficit rose from 6.1 percent of GDP in 1980-81 to 8.3 percent in 1985-86 and to 8.4 percent in 1990-91. Since these deficits had to be met by borrowings, the internal debt of the government accumulated rapidly, rising from 35 percent of GDP at the end of 1980-81 to 53 percent of GDP at the end of 1990-91. The foreign exchange reserves had dried up to the point that India could barely finance three week worth of imports. In mid-1991, India's exchange rate was subjected to a severe adjustment. This event began with a slide in the value of the Indian rupee leading up to mid-1991. The authorities at the Reserve Bank of India took partial action, defending the currency by expending international reserves and slowing the decline in value. However, in mid-1991, with foreign reserves nearly depleted, the Indian government permitted a sharp devaluation that took place in two steps within three days (1 July and 3 July 1991) against major currencies.

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Conclusion The derivatives market is very dynamic and has quickly developed into the most important segment of the financial market. Competing for business, both derivatives exchanges and OTC providers, which by far account for the largest part of the market, have fuelled growth by constant product and technology innovation. Derivatives are very complex and options are priced by using a combination of stocks and bonds in such a way as to reach prices that are free of arbitrage advantages. They should be used with caution. The derivatives market functions very well and is constantly improving. It effectively fulfils its economic functions of price efficiency and risk allocation. The imperatives for a well-functioning market are clearly fulfilled 

The exchange segment, in particular, has put in place very effective risk mitigation mechanisms – mostly through the use of automation and CCPs.



For its users, the derivatives market is highly efficient. Transaction costs for exchangetraded derivatives are particularly low.

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Innovation has been the market’s strongest growth driver and has been supported by a beneficial regulatory framework.

In comparison with the equity segment, currency derivatives and interest rate derivatives, the turnover of equity derivatives clearly shows that equity derivatives have become very prominent in the recent years. Equity derivatives market in India has grown in leaps and bounds and is poised to grow further. The progress of the derivatives market in India has been quite satisfactory and it grew at very fast pace. The equity derivatives volume has grown at an average annual growth rate of 107% year on year since 2001-02 till 2011-12.

Derivatives market growth has continued irrespective of equity cash market turnover growth. Equity market turnover has grown by 4.24 times during the period from 2001-02 to 2011-12, whereas during the same period the equity derivatives market turnover has grown by 310 times. The equity market turnover has shown intermittent declines in the turnover recorded on the equity exchanges whereas during the same period the equity derivatives turnover has continuously been steadily rising.

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