CHAPTER NO.1INTRODUCTION TO FINANCIAL DERIVATIVES Market

DERIVATIVE FINANCIAL MARKET

INTRODUCTION TO DERIVATIVES

1

MEANING:

• Derivative is a product whose value is derived from the value of one or more basic

variables, called bases (underlying asset, index, or reference rate), in a contractual

manner.

• The underlying asset can be equity, forex, commodity or any other asset.

• For example, wheat farmers may wish to sell their harvest at a future date to

eliminate the risk of a change in prices by that date.

• Such a transaction is an example of a derivative. The price of this derivative is

driven by the spot price of wheat which is the "underlying".

DEFINITION:

The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-

Derivative includes: -

(i) 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;

 (ii)  a contract which derives its value from the prices, or index of prices, of

underlying securities;

“Derivatives are instruments which make payments calculated using price

of interest rates derived from on balance sheets or cash instruments, but do not

actually employ those cash instruments to fund payments”

Derivatives are bilateral contracts or payments exchange system whose value is

derived from the value of underlying asset.

It is an innovative tradable financial instrument derived from an underlying asset

2

TYPES OF DERIVATIVES

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed Price.

Futures: A futures contract is an agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price. Futures contracts are special

types of forward contracts in the sense that the former are standardized exchange-

traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but

not the obligation to buy a given quantity of the underlying asset, at a given price on

or before a given future date. Puts give the buyer the right, but not the obligation to

sell a given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in

the future according to a prearranged formula. They can be regarded as portfolios of

forward contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash

flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between

the parties, with the cash flows in one direction being in a different currency

than those in the opposite direction.

3

Warrants: Options generally have lives of up to one year, the majority of options

traded on options exchanges having a maximum maturity of nine months. Longer-

dated options are called warrants and are generally traded over-the-counter.

Leaps: The acronym LEAPS means Long-Term Equity Anticipation Securities. These

are options having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average or a basket of assets. Equity index options are a

form of basket option

Swap options: Swap options are options to buy or sell a swap that will become

operative at the expiry of the options. Thus a swap options is an option on a forward

swap. Rather than have calls and puts, the swap options market has receiver swap

options and payer swap options. A receiver swap options is an option to receive fixed

and pay floating. A payer swap options is an option to pay fixed and receive floating.

TYPES OF UNDERLYINGS

4

CHAPTER NO.2:KINDS OF DERIVATIVES CONTRACT

5

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

BASIC FEATURES OF FORWARD CONTRACT

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

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

• The contract price is generally not available in public domain.

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

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

However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.

2.2: FUTURE CONTRACT In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the

6

futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

I. These are traded on an organized exchange like NSE, BSE, etc.

II. These involve standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc.

III. These are associated with a clearing house to ensure smooth functioning of the market.

IV. There are margin requirements and daily settlement to act as further safeguard.

V. These provide for supervision and monitoring of contract by a regulatory authority.

VI. Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset.

Futures contracts being traded on organized exchanges impart liquidity to the transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honoring of the contract and ensuring very low level of default. Following are the important types of financial futures contract:

I. Stock Future or equity futures,

II. Stock Index futures,

III. Currency futures, and

IV. Interest Rate bearing securities like Bonds, T- Bill Futures.

To give an example of a futures contract, suppose on November 2007 Rajesh holds 1000 shares of ABC Ltd. Current (spot) price of ABC Ltd shares is Rs115 at National Stock Exchange (NSE). Rajesh entertains the fear that the share price of ABC Ltd may fall in next two months resulting in a substantial loss to him. Rajesh decides to enter into futures market to protect his position at Rs 115 per share for delivery in January 2008. Each contract in futures market is of 100 Shares. This is an example of equity future in which Rajesh takes short position on ABC Ltd. Shares by selling 1000 shares at Rs 115 and locks into future price.

2.3: OPTION CONTRACT

7

In case of futures contact, both parties are under obligation to perform their respective obligations out of a contract. But an options contract, as the name suggests, is in some sense, an optional contract. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A “call option” gives one the right to buy; a “put option” gives one the right to sell. Options are the standardized financial contract that allows the buyer (holder) of the option, i.e. the right at the cost of option premium, not the obligation, to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

Options contracts are of two types:

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Call option’. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Put option’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Apart from this, options can also be classified as OTC (Over the Counter) options and exchange traded options. In case of exchange traded options contract, contracts are standardized and traded on recognized exchanges, whereas OTC options are customized contracts traded privately between the parties.

A call options gives the holder (buyer/one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Suppose an investor buys One European call options on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. Apparently, if the market price of Infosys on the day of expiry is more than Rs. 3500, the options will be exercised. In contrast, a put options gives the holder (buyer/ one who is long put), the right to sell specified quantity of the underlying asset at the strike price

on or before an expiry date. The seller of the put options (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer

8

decides to exercise his option to sell. Right to sell is called a Put Options. Suppose X has 100 shares of Bajaj Auto Limited. Current price (March) of Bajaj auto shares is Rs 700 per share. X needs money to finance its requirements after two months which he will realize after selling 100 shares after two months. But he is of the fear that by next two months price of share will decline. He decides to enter into option market by buying Put Option (Right to Sell) with an expiration date in May at a strike price of Rs 685 per share and a premium of Rs 15 per shares.

2.4 :-SWAPS

Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.

FINANCIAL SWAPS:

Financial swaps constitute a funding technique which permits a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

2.5:- OTHER KINDS OF DERIVATIVES

9

The other kind of derivatives, which are not, much popular are as follows:

BASKETS:

Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.

LEAPS:

Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.

WARRANTS:

Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

SWAP OPTIONS:

Swap options are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swap option is an option on a forward swap. Rather than have calls and puts, the swap options market has receiver swap options and payer swap options. A receiver swap option is an option to receive fixed and pay floating. A payer swap option is an option to pay fixed and receive floating.

10

CHAPTER NO.3:

HISTORY, NEED & IMPORTANCE OF DERIVATIVES

3.1 ORIGIN AND HISTORY OF DERIVATIVES

In financial markets, the term derivative is used to refer to a group of

instruments that derive their value from some underlying commodity or market.  

Forwards, futures, swaps and options are all types of derivative instruments and are

widely used for hedging or speculative purposes. While trading in derivative products

has grown tremendously in recent times, early evidence of these types of instruments

can be traced back to ancient Greece.

ORIGIN OF OPTION

Aristotle related a story about how the Greek philosopher Talus profited

handsomely from an option-type agreement around the 6th century B.C.

According to the story, one-year ahead, Thales forecast the next olive harvest would

be an exceptionally good one.   As a poor philosopher, he did not have many financial

resources at hand. But he used what he had to place a deposit on the local olive

11

presses.   As nobody knew for certain whether the harvest would be good or bad,

Thales secured the rights to the presses at a relatively low rate. When the harvest

proved to be bountiful, and so demand for the presses was high, Thales charged a high

price for their use and reaped a considerable profit

 A critical attribute of Thales arrangement was the fact that its merit did not depend on

his forecast for a good harvest being accurate.   The deposit gave him the right but not

the obligation to hire the presses.   If the harvest had failed, his losses were limited to

the initial deposit he paid.   Thales had purchased an option.

 

ORIGIN OF FORWARD CONTRACT

There is evidence that the use of a type of forward contract was prevalent among

merchants in medieval European trade fairs. When trade began to flourish in the

12th century merchants created a forward contract called a letter de faire (letter of the

fair).   These letters allowed merchants to trade on the basis of a sample of their

goods, thus relieving them of the need to transport large quantities of merchandise

along dangerous routes with no guarantee of a buyer at the journeys end.   The letter

acted as evidence that the full consignment of the specified commodity was being held

at a warehouse for future delivery.   Eventually, the contracts themselves were traded

among the merchants.  

ORIGIN OF FUTURES CONTRACT

The first record of organized trading in futures comes from 17th century Japan.  

Feudal Japanese landlords would ship surplus rice to storage warehouses in the cities

and then issue tickets promising future delivery of the rice.   The tickets represented

the right to take delivery of a certain quantity of rice at a future date at a specified

price.  These rice tickets were traded on the Dojima rice market near Osaka and in

1730.  Trading in rice tickets allowed landlords and merchants to lock the prices at

which rice was bought and sold, reducing the risk they faced. The tickets also

provided flexibility.  Someone holding a rice ticket but not a holder of a rice ticket but

not wanting to take delivery could sell it in the market. The rules governing the

trading on the Dojima market were similar to those of modern-day futures markets.

12

3.2 NEED & IMPORTANCE OF DERIVATIVES

Managing risk

There are several risks inherent in financial transactions. Derivatives allow you

to manage these risks more efficiently by unbundling the risks and allowing either

hedging or taking only one risk at a time. Once investor is long on share investor can

hedge the systematic risk by going short on share Futures. On the other hand, if

investors do not want to take unsystematic risk on anyone share, but wish to take only

systematic risk - investor can go long on Index Futures, without buying any individual

shares.

Speculation

Derivatives offer an opportunity to make unlimited money by way of

speculation. Speculators are of two types. One type is of optimistic variety, and sees a

rise in prices in future. He is known as 'bull'. The other type is a pessimist, and he sees

a fall in prices, in future. He is known as 'bear'. They undertake 'futures' transactions

with the intention of making gains through difference in contracted prices and future

cash market price prices. If, in future, their expectations turn out to be true, they gain

and if not they lose. Of course, they may limit their losses through options.

High leverage

Leverage opportunities are often expensive and complicated to implement for

many investors in the cash market, or are simply not feasible. However, options and

futures represent (highly) levered investments in the underlying cash instruments.

They require only a small fraction of the investment in the underlying securities. The

13

case is most obvious for futures, where there is essentially no initial investment except

margin payments

Arbitrage

Arbitrageurs profit from price differential existing in two markets by

simultaneously operating in two different markets. Arbitrage can be done between two

instruments when they are related to each other, but they are temporarily mispriced.

For example, the futures price and spot price are related by the interest rate, time to

maturity and corporate benefit, if any, in the interregnum.

They can also be important for,

1. Efficient Allocation of Risk

2. Lower Cost of Hedging

3. Liquidity

4. Risk Management

14

NEED FOR DERIVATIVES IN INDIA TODAY

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

become the most important markets in the world. Today, derivatives have become part

and parcel of the day-to-day life for ordinary people in major part of the world. Until

the advent of NSE, the Indian capital market had no access to the latest trading

methods and was using traditional out-dated methods of trading. There was a huge gap

between the investors’ aspirations of the markets and the available means of trading.

The opening of Indian economy has precipitated the process of integration of India’s

financial markets with the international financial markets. Introduction of risk

management instruments in India has gained momentum in last few years thanks to

Reserve Bank of India’s efforts in allowing forward contracts, cross currency options

etc. which have developed into a very large market.

The following point shows the need for the derivative market:

1. To help in transferring risks from risk averse people to risk oriented people

2. To help in the discovery of future as well as current prices

3. To catalyze entrepreneurial activity

4. To increase the volume traded in markets because of participation of risk

adverse people in greater numbers.

5. To increase savings and investment in the long run

3.3 THE PARTICIPANTS IN A DERIVATIVES MARKET

15

Hedgers use futures or options markets to reduce or eliminate the risk

associated with price of an asset.

Speculators use futures and options contracts to get extra leverage in betting

on future movements in the price of an asset. They can increase both the potential

gains and potential losses by usage of derivatives in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between

prices in two different markets. If, for example, they see the futures price of an asset

getting out of line with the cash price, they will take offsetting positions in the two

markets to lock in a profit.

3.4:- Participants in a Derivative Market

The derivatives market is similar to any other financial market and has following three broad categories of participants:

16

• Hedgers: These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios.

• Speculators: These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset.

• Arbitrageurs: They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit.

3.5:- Economic Function of the Derivative Market

The derivatives market performs a number of economic functions. In this section, we discuss some of them.

• Prices in an organized derivatives market reflect the perception of the 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.

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

• 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. This is because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

• Speculative trades shift to a more controlled environment in derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

• An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity

17

CHAPTER NO. 4:-

TRADING IN DERIVATIVES MARKETS

The NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time

18

and quantity. All quantity fields are in units and price in rupees. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.

4.1:-Futures and Options Trading System

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Index futures & options and Stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment.

The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options.

4.2:-Entities in the trading system

Following are the four entities in the trading system:

• Trading members: Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants.

The exchange assigns a trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned an unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm’s User IDs.

• Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

• Professional clearing members: A professional clearing member is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members.

19

• Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.

4.3:-Order types and conditions

The system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories:

• Time conditions

• Price conditions

• Other conditions

• Time conditions

- Day order : A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day.

- Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

• Price condition

- Stop-loss :-This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stop-loss buy order, the trigger is 1027.00, the limit price is 1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 1030.00. For the stop-loss sell order, the trigger price has to be greater than the limit price.

• Other conditions

- Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price.

- Trigger price: Price at which an order gets triggered from the stop-loss book.

- Limit price: Price of the orders after triggering from stop-loss book.

20

- Pro: Pro means that the orders are entered on the trading member’s own account.

- Cli:-Cli means that the trading member enters the orders on behalf of a client.

4.5:- Futures and Options Market Instruments

The F&O segment of NSE provides trading facilities for the following derivative instruments:

a) Index based futures

b) Index based options

c) Individual stock options

d) Individual stock futures

4.5.1:- Contract specifications for index futures

On NSE’s platform one can trade in Nifty, CNX IT, BANK Nifty, Mini Nifty etc. futures contracts having one-month, two-month and three-month expiry cycles. All contracts expire on the last Thursday of every month. Thus, a January expiration contract would expire on the last Thursday of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry would be introduced for trading. Three contracts would be available for trading with the first contract expiring on the last Thursday of that month. On the recommendations given by the SEBI, Derivatives Market Review Committee, NSE also introduced the ‘Long Term Options Contracts’ on CNX Nifty for trading in the F&O segment.

There would be 3 quarterly expiries, (March, June, September and December) and after these, 5 following semi-annual months of the cycle June/December would be available. Now option contracts with 3 year tenure are also available. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts. The Instrument type refers to “Futures contract on index” and Contract symbol - NIFTY denotes a “Futures contract on Nifty index” and

The expiry date represents the last date on which the contract will be available for trading. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (similar to the existing capital market trading system). The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas the best sell order will be the order to sell the index at the lowest index level.

21

Example: If trading is for a minimum lot size of 50 units and the index level is around 5000, then the appropriate value of a single index futures contract would be Rs.250, 000. The minimum tick size for an index future contract is 0.05 units. Thus a single move in the index value would imply a resultant gain or loss of Rs.2.50 (i.e. 0.05*50 units) on an open position of 50 units.

Contract cycle:

Jan Feb. March April

Jan 30 contract Time

Feb 27 contract

March 27 contract

April 24 contract

May 29 contract

June 26 contract

This figure shows the contract cycle for futures contracts on NSE’s derivatives market. As can be seen, at any given point of time, three contracts are available for trading - a near-month, a middle-month and a far-month. As the January contract expires on the last Thursday of the month a new three-month contract starts trading from the following day, once more making available three index futures contracts for trading.

4.5.2:-Contract specification for index options

On NSE’s index options market; there are one-month, two-month and three-month expiry contracts with minimum nine different strikes available for trading. Hence, if there are three serial month contracts available and the scheme of strikes is 6-1-6, then there are minimum 3 x 13 x 2 (call and put options) i.e. 78 options contracts available on an index. Option contracts are specified as follows: DATE-EXPIRYMONTH-YEAR-CALL/PUT-AMERICAN/ EUROPEAN-STRIKE. For example the European style call option contract on the Nifty index with a strike price of 5000 expiring on the 26th November 2009 is specified as ’26NOV2009 5000 CE’. Just as in the case of futures contracts, each option product (for instance, the 26 NOV 2009 5000 CE) has its own order book and its own prices. All index options contracts are cash settled and expire on the last Thursday of the month. The clearing corporation does the novation. The minimum tick for an index options contract is 0.05 paisa. Table 5.2 gives the contract specifications for index options trading on the NSE.

22

Contract specification of CNX Nifty Futures

Underlying index CNX Nifty

Exchange of trading National Stock Exchange of India Limited

Security descriptor FUTIDX

Contract size Permitted lot size shall be 50 (minimum value Rs.2 lakh)

Price steps Re. 0.05

Price bands Operating range of 10% of the base price

23

Trading cycle The futures contracts will have a maximum of three month trading cycle - the near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of near month contract.

Expiry day The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.

Settlement basis Mark to market and final settlement will be cash settled on T+1 basis.

Settlement price Daily settlement price will be the closing price of the futures contracts for the trading day and the final settlement price shall be the closing value of the underlying index on the last trading day of such futures contract.

Contract specification of CNX Nifty Options

Underlying index CNX Nifty

Exchange of trading National Stock Exchange of India Limited

Security descriptor OPTIDX

Contract size Permitted lot size shall be 50 (minimum value Rs. 2 lakh)

Price steps Re. 0.05

24

Price bands A contract specific price range based on its delta value and is computed and updated on a daily basis.

Trading cycle The options contracts will have a maximum of three month trading cycle - the near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of near month contract. Also, long term options have 3 quarterly and 5 half yearly

Expiry day The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.

Settlement basis Cash settlement on T+1 basis.Style of option EuropeanStrike price interval Depending on the index levelDaily settlement price Not applicable

Final settlement price Closing value of the index on the last trading day.

Other Products in the F&O Segment

The year 2008 witnessed the launch of new products in the F&O Segment of NSE. The Mini derivative (Futures and Options) contracts on CNX Nifty were introduced for trading on January 1, 2008. The mini contract have smaller contract size than the normal Nifty contract and extend greater affordability to individual investors and helps the individual investor to hedge risks of a smaller portfolio. The Long Term Options Contracts on CNX Nifty were launched on March 3, 2008. The long term options have a life cycle of maximum 5 years duration and offer long term investors to take a view on prolonged price changes over a longer duration, without needing to use a combination of shorter term option contracts.

25

4.6:- Option pricing model and option Greeks

Factors impacting option prices

The supply and demand of options and hence their prices are influenced by the following factors:

◙The underlying price,

◙The strike price,

◙The time to expiration,

◙The underlying asset’s volatility, and

◙ Risk free rate

◙ Dividend

26

The underlying price:

Call and Put options react differently to the movement in the underlying price. As the underlying price increases, intrinsic value of a call increases and intrinsic value of a put decreases.

The strike price:

The strike price is specified in the option contract and does not change overtime.

The higher the strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value of a put option.

Time to expiration:

Time to expiration is the time remaining for the option to expire.

Obviously, the time remaining in an option’s life moves constantly towards zero.

Even if the underlying price is constant, the option price will still change since time reduces constantly and the time for which the risk is remaining is reducing.

Volatility:

Volatility is an important factor in the price of an option. Volatility is defined as the uncertainty of returns.

The more volatile the underlying higher is the price of the option on the underlying. Whether we are discussing a call or a put, this relationship remains the same.

Risk free rate:

27

Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero risk). Government securities are considered to be risk free since their return is assured by the Government.

Risk free rate is the amount of return which an investor is guaranteed to get over the life time of an option without taking any risk. As we increase the risk free rate the price of the call option increases marginally whereas the price of the put option decreases marginally.

It may however be noted that option prices do not change much with changes in the risk free rate.

Dividends

Regular cash dividends influence option premiums through their impact on the underlying stock price. On a stock's "ex-dividend date" the price of the stock paying the dividend will be lowered by the dividend amount when shares begin trading.

All other pricing factors remaining constant, in general:

As an underlying stock's dividend increases, call prices decrease and put prices increase.

As an underlying stock's dividend decreases, call prices increase and put prices decrease

This is logical because of the fact that a decrease in underlying stock price will generally result in lower call prices and higher put prices. And all other factors remaining the same, the larger the dividend the greater its impact

OPTION GREEKS

♦ Greeks help us to measure the risk associated with derivative positions.

♦ Greeks also come in handy when we do local valuation of instruments.

♦This is useful when we calculate value at risk.

28

Delta

The delta of an option is defined as the rate of change of option price with respect to the price of underlying equity/asset. As example, delta of reliance call option (Rs.860 Strike) is 0.35 which means if the stock price goes up by Rs.10 then option price will tend to go up by Rs.3.5. If you have one lot (250 options) of the reliance options, then delta of your position is 250x0.35 = 87.5.

You can use delta to do hedging which is also called as delta-hedging. Suppose you have sold one lot of above mentioned reliance options. Then delta of your position is -87.5. Now you lose money if stock goes up. Delta of a stock is 1. So if you buy 87.5 (~88) stocks of reliance. Then delta of your overall position becomes zero and position is delta neutral. Now your option position is hedged.

It is important to realize that as delta changes, your position remains delta hedged for only a relatively short period of time. The hedge has to be adjusted periodically. This is known as rebalancing. This is also known as dynamic hedging. If you don't rebalance then it’s called as static hedging or hedge-and-forget.

Delta decreases as strike price of option increases and it increases with increasing time to expiry. Delta of a long call option is positive and delta of a long put option is negative.

Theta

The theta of an option is the rate of change of value of option with respect to passage of time with all else remaining same. It is also referred as the time decay of an option. In the example above, theta is -1.85 which means that with each trading day, value of the option decreases by Rs1.85 if all else remained same.

Theta is usually negative for an option. This is because, as time passes with all else remaining the same, the option tends to become less valuable.

Gamma

The gamma of an option is the rate of change of option delta with respect to the price of the underlying asset. It is the second partial derivative of option price with respect to asset price.

When you are doing dynamic hedging then rebalancing to keep the portfolio delta neutral need to be made infrequently.

In the example above, gamma is 0.0092 which means when stock price changes by Rs.1 then delta of option changes by 0.0092.

Vega

29

The Vega of an option is defined as the rate of change of value of option with respect to volatility of underlying asset.

In the example above, Vega is 40.1 which means a 1% increase in volatility of reliance stock price will result in 0.01x40.1= Rs.0.4 increase in option price and vice-versa.

If you wish to make your portfolio to be not dependent on volatility then you make it Vega neutral by taking appropriate option positions.

Rho :

The rho of an option is defined as the rate of change of value of option with respect to the interest rate.

In the example above, Vega is 4.71 which means a 1% increase in interest rate will result in 0.01x4.71= Rs.0.04 increase in option price and vice-versa.

Rho of a long call option is positive and rho of long put option is negative.

Relationship between Option Greeks and Option Price

Position Delta Gamma Vega Theta Rho

Long Call Positive Positive Positive Negative Positive

Short Call Negative Negative Negative Positive Negative

Long Put Negative Positive Positive Negative Negative

30

Short Put Positive Negative Negative Positive Positive

CHAPTER NO. 5:

CLEARING AND SETTELMENT

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement of all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal counterparty to all trades on the F&O segment and guarantees their financial settlement. This chapter gives a detailed account of clearing mechanism, settlement procedure and risk management systems at the NSE for trading of derivatives contracts.

5.1:- Clearing Entities

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

Clearing Members

In the F&O segment, some members, called self clearing members, clear and settle their trades executed by them only either on their own account or on account of their clients. Some others called trading member-cum-clearing member, clear and settle their own trades as well as trades of other trading members (TMs). Besides, there is a special category of members, called professional clearing members (PCM) who clear and settle trades executed by TMs. The members clearing their own trades and trades of others, and the PCMs are required to bring in additional security deposits in respect of every TM whose trades they undertake to clear and settle.

31

Clearing Banks

Funds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with NSCCL designated clearing bank for F&O segment. The Clearing and Settlement process comprises of the following three main activities:

1) Clearing 2) Settlement 3) Risk Management

5.2:- Settlement Procedure

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market.

However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/ clients, with respect to their obligations on MTM, premium and exercise settlement.

Settlement of Futures Contracts

Futures contracts have two types of settlements, the Mark-to-Market (MTM) settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract.

MTM settlement

All futures contracts for each member are marked-to-market (MTM) to the daily settlement price of the relevant futures contract at the end of each day. The profits/losses are computed as the difference between:

1. The trade price and the day’s settlement price for contracts executed during the day but not squared up.

2. The previous day’s settlement price and the current day’s settlement price for brought forward contracts.

3. The buy price and the sell price for contracts executed during the day and squared up.

32

Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant CM’s clearing bank account on the day following expiry day of the contract.

Settlement prices for futures

Daily settlement price on a trading day is the closing price of the respective futures contracts on such day. The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract in the F&O Segment of NSE. Final settlement price is the closing price of the relevant underlying index/security in the capital market segment of NSE, on the last trading day of the contract.

Settlement of options contracts

Options contracts have two types of settlements, daily premium settlement and final exercise settlement.

Daily premium settlement

Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the option sold by him. The premium payable amount and the premium receivable amount are netted to compute the net premium payable or receivable amount for each client for each option contract.

Final exercise settlement

Final exercise settlement is effected for all open long in-the-money strike price options existing at the close of trading hours, on the expiration day of an option contract. All such long positions are exercised and automatically assigned to short positions in option contracts with the same series, on a random basis. The investor who has long in-the-money options on the expiry date will receive the

exercise settlement value per unit of the option from the investor who is short on the option.

5.3:- Risk Management

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. 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. The salient features of risk containment mechanism on the F&O segment are:

33

There are stringent requirements for members in terms of capital adequacy measured in terms of net worth and security deposits.

1.) NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirements for each futures/options contract on a daily basis. The CM in turn collects the initial margin from the TMs and their respective clients.

2.) Client margins: NSCCL intimates all members of the margin liability of each of their client. Additionally members are also required to report details of margins collected from clients to NSCCL, which holds in trust client margin monies to the extent reported by the member as having been collected form their respective clients.

3.) The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis.

4.) NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time for all TMs and/ or custodial participants clearing and settling through the CM.

5.) CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it stops that particular TM from further trading. Further trading members are monitored based on positions limits. Trading facility is withdrawn when the open positions of the trading member exceeds the position limit.

6.) A member is alerted of his position to enable him to adjust his exposure or bring in additional capital..

7.) A separate settlement guarantee fund for this segment has been created out of the capital of members. The most critical component of risk containment mechanism for F&O segment is the margining system and on-line position monitoring. The actual position monitoring and margining is carried out on-line through Parallel Risk Management System (PRISM). PRISM uses SPAN(r) (Standard Portfolio Analysis of Risk) system for the purpose of computation of on-line margins, based on the parameters defined by SEBI.

34

NSCCL-SPAN

The objective of NSCCL-SPAN is to identify overall risk in a portfolio of all futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios, like extremely deep out-of-the-money short positions and inter-month risk. Its over-riding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day based on 99% VaR methodology.

5.4:- Types of margins

The margining system for F&O segment is explained below:

• Initial margin: Margin in the F&O segment is computed by NSCCL up to client level for open positions of CMs/TMs. These are required to be paid up-front on gross basis at individual client level for client positions and on net basis for proprietary positions. NSCCL collects initial margin for all the open positions of a CM based on the margins computed by NSE-SPAN. A CM is required to ensure collection of adequate initial margin from his TMs and his respective clients. The TM is required to collect adequate initial margins up-front from his clients.

• Premium margin: In addition to initial margin, premium margin is charged at client level. This margin is required to be paid by a buyer of an option till the premium settlement is complete.

• Assignment margin: Assignment margin is levied in addition to initial margin and premium margin. It is required to be paid on assigned positions of CMs towards exercise settlement obligations for option contracts, till such obligations are fulfilled. The margin is charged on the net exercise settlement value payable by a CM.

35

CHAPTER NO. 6: -

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI Act, the rules and regulations framed under that and the rules and bye–laws of the stock exchanges. This Chapter takes a look at the legal and regulatory framework for derivatives trading in India. It also, discusses in detail the recommendation of the LC Gupta Committee for trading of derivatives in India.

6.1:- Securities Contracts (Regulation) Act, 1956

SC(R)A regulates transactions in securities markets along with derivatives markets. The original act was introduced in 1956. It was subsequently amended in 1996, 1999, 2004, 2007 and 2010. It now governs the trading of securities in India. The term “securities” has been defined in the amended SC(R)A under the Section 2(h) to include:

• Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate.

• Derivative.

• Units or any other instrument issued by any collective investment scheme to the investors in such schemes.

• Security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002

• Units or any other such instrument issued to the investor under any mutual fund scheme 1.

• Any certificate or instrument (by whatever name called), issued to an investor by an issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt as the case may be.

• Government securities

• Such other instruments as may be declared by the Central Government to be securities.

• Rights or interests in securities. “Derivative” is defined to include:

36

• 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.

Section 18A of the SC(R)A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are:

• Traded on a recognized stock exchange

• Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye–laws of such stock exchanges

6.2:- Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India (SEBI) with statutory powers for

(a) protecting the interests of investors in securities (b) promoting the development of the securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over corporate in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market.

SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for:

• regulating the business in stock exchanges and any other securities markets.

• registering and regulating the working of stock brokers, sub–brokers etc.

• promoting and regulating self-regulatory organizations.

• prohibiting fraudulent and unfair trade practices relating to securities markets.

• calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds and other persons associated with the securities market and other intermediaries and self–regulatory organizations in the securities market.

• performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.

37

6.3:- Regulation for Derivatives Trading

SEBI set up a 24-member committee under the Chairmanship of Dr. L. C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. On May 11, 1998 SEBI accepted the recommendations of the

committee and approved the phased introduction of derivatives trading in India beginning with stock index futures.

According to this framework:

• Any Exchange fulfilling the eligibility criteria can apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange would have to regulate the sales practices of its members and would have to obtain prior approval of SEBI before start of trading in any derivative contract.

• The Exchange should have minimum 50 members.

The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members seeking admission in the derivative segment of the exchange would need to fulfill the eligibility conditions.

• The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for approval.

• Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges.

The minimum net worth for clearing members of the derivatives clearing corporation/ house shall be Rs.300 Lakh. The net worth of the member shall be computed as follows:

• Capital + Free reserves

• Less non-allowable assets viz.,

(a) Fixed assets

(b) Pledged securities

(c) Member’s card

(d) Non-allowable securities (unlisted securities)

38

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities

• The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit details of the futures contract they propose to introduce.

• The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time.

• There will be strict enforcement of “Know your customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client.

39

CHAPTER NO. 7:-

ANALYSIS OF THE RESULTS

ANALYSIS OF THE RESULTS

1. Gender of the respondents

40

Table 1: What is your Gender?Frequency Percent Valid

PercentCumulative

PercentMale 84 84.0 84.0 84.0Female 16 16.0 16.0 100.0Total 100 100.0 100.0

Interpretation: From the questionnaire it is observed that 84% of the

respondents are Male and 16% of them are Female.

2. Age of the respondents

Table 2: What is your Age?Frequency Percent Valid

PercentCumulative

Percent Between 18 - 24 23 23.0 23.0 23.0Between 25 - 34 22 22.0 22.0 45.0Between 35 - 44 46 46.0 46.0 91.0Between 45 -54 9 9.0 9.0 100.0Total 100 100.0 100.0

41

Interpretation: 46% of the respondents fall under the age category of 35 – 44

years, 23% of them fall under 18 -24 years were as 22% of the respondents are

between the age category of 25 -34 years and 9% of the respondents are Between the

age group of 45 – 54 years.

3. Occupation of the respondents

Table 3: Which of the following best describes your current Occupation?

Frequency Percent Valid Percent

Cumulative Percent

Employee 37 37.0 37.0 37.0 Businessman 34 34.0 34.0 71.0Student 10 10.0 10.0 81.0Professional 19 19.0 19.0 100.0Total 100 100.0 100.0

42

Interpretation: From the above chart it is clear that majority of the respondents are

employee with a weight age of 37% , Next are Businessman with a total of 34% and

Professionals being 19% and Students 10%.

4. Educational Qualification of the respondents

Table 4: What is your Educational Qualification?Frequency Percent Valid

PercentCumulative

PercentUndergraduate 33 33.0 33.0 33.0Graduate 35 35.0 35.0 68.0Post Graduate 21 21.0 21.0 89.0Professional Degree

11 11.0 11.0 100.0

Total 100 100.0 100.0

43

Interpretation: Majority of the respondents are Graduate being 35% were are

Undergraduate are closely followed with 33%, Post graduates consist of 21% and

Professional Degree Holders are 11%.

5. Income per Annum of the respondents

Table 5: What is your approximate Income per Annum?Frequency Percent Valid

PercentCumulative Percent

Below 1,50,000/- 15 15.0 15.0 15.0Between 1,50,001 - 3,00,000/-

39 39.0 39.0 54.0

Between 3,00,001 - 4,50,000

14 14.0 14.0 68.0

4,50,000/- and Above 32 32.0 32.0 100.0Total 100 100.0 100.0

44

Interpretation: 39% of the respondents have annual income between 1,50,001 –

3,00,000/- were as respondents having income above 4,50,000/- are 32%, between

3,00,001/- - 4,50,000/- are 14% and below 1,50,000/- are 15%.

6. Percentage of monthly income available for investment in Derivatives

Table 6: What percentage of your monthly household income would you invest in Derivatives?Frequenc

yPercent Valid Percent Cumulativ

e PercentBetween 5 - 10% 27 27.0 27.0 27.0Between 11 - 15%

41 41.0 41.0 68.0

Between 16 - 20%

32 32.0 32.0 100.0

Total 100 100.0 100.0

45

Interpretation: 41% of the respondents invest between 11 – 15% of the

monthly household income in Derivatives, were as 32% of the respondents would

invest between 16-20% and 27% of the respondents invest between 5 – 10% in

Derivatives Market.

7. Kind of risk perceive while investing in Derivatives

Table 7: What kind of risk do you perceive while investing?

Frequency

Percent

Valid Percent

Cumulative Percent

Uncertainty of Returns

43 43.0 43.0 43.0

Slump in Market 34 34.0 34.0 77.0Fear of Company Windup

9 9.0 9.0 86.0

Others 14 14.0 14.0 100.0

46

Total 100 100.0 100.0

Interpretation: 43% of the respondents feel that Uncertainty of Returns is the

major risk they perceive while investing in Derivative Market, were as 34% of the

respondents feel Slump in Market and 9% of the respondents feel that fear of company

windup is the risk they perceive while investing in Derivatives.

8. Purpose of Investing in Derivatives Market

Table 8: What is the purpose of investing in Derivative Market?Frequenc

yPercent Valid

PercentCumulative

PercentTo Hedge Funds

33 33.0 33.0 33.0

Risk Control 29 29.0 29.0 62.0

47

Stable Income 21 21.0 21.0 83.0Direct Investment

17 17.0 17.0 100.0

Total 100 100.0 100.0

Interpretation: 33% of the respondents invest in Derivatives to hedge funds,

29% of them invest for risk control, 21% of the respondents for stable income and

17% invest as a direct investment.

9. Participation in different type of Derivative instrument

Table 9: In which of the following would you like to participate?Frequenc

yPercen

tValid

PercentCumulative Percent

Index Futures 16 16.0 16.0 16.0Index Options 29 29.0 29.0 45.0Stock Futures 19 19.0 19.0 64.0

48

Stock Options 24 24.0 24.0 88.0Currency Futures/Options

12 12.0 12.0 100.0

Total 100 100.0 100.0

Interpretation: From the above chart we find that 29% of the respondent would

like to participate in Index Options were as 24% of the respondents’ would like to

invest in Stock Options, Stock Futures and Index Futures attract 19 and 16%

respectively and respondents liking to invest in Currency Futures and Options are 12%

10. Interest of investment in terms of time frame

Table 10: Which contract maturity period would interest you for trading in?

Frequency Percent Valid Percent

Cumulative Percent

1 Month 34 34.0 34.0 34.02 Months

9 9.0 9.0 43.0

3 Months

27 27.0 27.0 70.0

49

6 Months

22 22.0 22.0 92.0

1 Year 8 8.0 8.0 100.0Total 100 100.0 100.0

Interpretation: 34% of the respondents would like to invest their money for 1

Month, 27% of them for 3 months, 22% of the respondents for 6 months, 9% of the

respondents for 2 months and 8% of the respondents for 1 Year.

11. Investment in Derivatives market

Table 11: How often do you invest in Derivative Market?Frequenc

yPercen

tValid

PercentCumulative Percent

Between 1 - 10 times

62 62.0 62.0 62.0

Between 11 - 25 times

14 14.0 14.0 76.0

26 - 50 times 15 15.0 15.0 91.0

50

Regularly 9 9.0 9.0 100.0Total 100 100.0 100.0

Interpretation: Majority of the respondents 60% of them invest between 1 – 10

times a year in Derivatives, were as respondents investing between 11 – 25 times, 26 –

50 times and regularly are 14%, 15% and 9% respectively.

12. Result of InvestmentTable 12: What was the result of your Investment?

Frequency Percent Valid Percent

Cumulative Percent

Great Results 17 17.0 17.0 17.0Moderate but acceptable

50 50.0 50.0 67.0

Disappointed 33 33.0 33.0 100.0Total 100 100.0 100.0

51

Interpretation: 50% of the respondents are moderate about their results in

investing in Derivatives market, 17% of the respondents have great results and 33% of

the respondents are disappointed with their investment in Derivatives Market.

52

H0: Income and investment in different type of derivative instruments are not

relate

H1: Income and investment in different type of derivative instruments are

related.

What is your approximate Income per Annum? * In which of the following would you like to participate?

Cross Tab

CountIn which of the following would you like to

participate?Tota

lIndexFuture

s

Index Option

s

StockFutures

Stock Option

s

Currency Futures/Optio

nsWhat is your approximat

Below 1,50,000/-

3 4 2 0 6 15

53

e Income per Annum?

Between 1,50,001 - 3,00,000/-

3 14 11 11 0 39

Between 3,00,001 - 4,50,000

3 3 0 5 3 14

4,50,000/- and Above

7 8 6 8 3 32

Total 16 29 19 24 12 100

Value df Asymp. Sig. (2-sided)

Pearson Chi-Square 28.958a 12 .004

Likelihood Ratio 35.930 12 .000

Linear-by-Linear Association .315 1 .575

N of Valid Cases 100

a. 12 cells (60.0%) have expected count less than 5. The minimum expected count is

1.68.

The value of chi-squared statistic is 28.958. The chi-squared statistic has 12

degree of freedom. The p value (.004) is less than 0.05. Hence there is significant

relationship between income and investment in different type of derivative

instruments.

54

H0: Age and purpose of Investing in Derivative market are not related.

H1: Age and purpose of Investing in Derivative market are related.

What is your Age? * What is the purpose of investing in Derivative market?

Cross Tab

CountWhat is the purpose of investing in

Derivative market?TotalTo Hedge

FundsRisk

ControlStable Income

Direct Investment

What is your Age?

Between 18 – 24

10 0 8 5 23

Between 25 – 34

3 14 2 3 22

Between 35 – 44

17 12 8 9 46

Between 45 -54

3 3 3 0 9

Total 33 29 21 17 100

55

Chi-Square Tests

Value df Asymp. Sig. (2-sided)Pearson Chi-Square 26.109a 9 .002Likelihood Ratio 32.568 9 .000Linear-by-Linear Association .616 1 .432N of Valid Cases 100a. 8 cells (50.0%) have expected count less than 5. The minimum expected count is 1.53.

The value of chi-squared statistic is 26.109. The chi-squared statistic has 9 degree of

freedom. The p value (.002) is less than 0.05. Hence there is significant relationship

between age and purpose of Investing in Derivative market.

H0: Income per annum and monthly income available for investment are related

H1: Income per annum and monthly income available for investment are related

What is your approximate Income per Annum? * What percentage of your monthly household income would you invest in Derivatives?

Cross Tab

CountWhat percentage of your

monthly household income would you invest in

Derivatives?Total

Between

5 - 10%

Between 11 - 15%

Between 16 - 20%

What is your approximate Income per Annum?

Below 1,50,000/- 3 3 9 15

Between 1,50,001 - 3,00,000/- 5 17 17 39

Between 3,00,001 - 4,50,000 2 6 6 14

4,50,000/- and Above 17 15 0 32

56

Total 27 41 32 100

Chi-Square Tests

Value df Asymp. Sig. (2-sided)

Pearson Chi-Square 30.130a 6 .000Likelihood Ratio 38.871 6 .000Linear-by-Linear Association 22.017 1 .000N of Valid Cases 100a. 4 cells (33.3%) have expected count less than 5. The minimum expected count is 3.78.

The value of chi-squared statistic is 30.130. The chi-squared statistic has 6

degree of freedom. The p value (.000) is less than 0.05. Hence there is significant

relationship between income per annum and monthly income available for investment.

H0: Maturity period of investment and results of investment are no

related. H1: Maturity period of investment and results of investment are related.

What contract maturity period would interest you for trading in? * What was the result of your investment?

Cross Tab

CountWhat was the result of your

investment?Total

Great Results

Moderate but

acceptable

Disappointed

What contract maturity period would interest you for trading in?

1 Month 9 16 9 342 Months

0 3 6 9

3 Months

0 19 8 27

6 Months

5 9 8 22

1 Year 3 3 2 8Total 17 50 33 100

57

Chi-Square Tests

Value df Asymp. Sig. (2-sided)

Pearson Chi-Square 17.583a 8 .025Likelihood Ratio 22.085 8 .005Linear-by-Linear Association .010 1 .921N of Valid Cases 100a. 8 cells (53.3%) have expected count less than 5. The minimum expected count is 1.36.

The value of chi-squared statistic is 17.583. The chi-squared statistic has 8 degree of freedom. The p value (.025) is more than 0.05. Hence there is no significant relationship between maturity period of investment and results of investment.

Derivatives Turnover in BSE & NSE  BSE NSE

Year No of Contracts Turnover (Cr) No of Contracts

Turnover (Cr)

2001-02 105527 1926 4196873 1019252002-03 138037 2478 16767852 4398652003-04 382258 12074 57008110 21304682004-05 531719 16112 77017185 25470532005-06 203 9 157619271 48242512006-07 1781220 59006 216883573 73562702007-08 7453371 242308 425013200 130904772008-09 496502 11775 657390497 110104822009-10 9026 234 677293922 176636552010-11 5623 154 1034212062 292482212011-12 32222825 808476 1205045464 31349732

Comparison of Derivatives Turnover with Equity turnover on BSE &NSE

Equity Turnover in BSE & NSE  BSE NSE

YearTraded Quantity

Turnover (Cr)

Traded Quantity

Turnover (Cr)

2001-02 182196 307292 278408 5131672002-03 221401 314073 364065 617989

58

2003-04 390441 505053 713301 10995342004-05

477171 518715 797685 1140072

2005-06

664455 816074 844486 1569558

2006-07

560777 956185 855456 1945287

2007-08

653010 1578857 1498469 3551038

2008-09

739600 1100074 1426355 2752023

2009-10

1136513 1378809 2215530 4138023

2010-11

990777 1105027 1824515 3577410

2011-12

654137 667498 1616978 2810893

Table showing comparison of Derivatives Turnover and Equity Turnover in BSE

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2011-120

200000

400000

600000

800000

1000000

1200000

1400000

1600000

1800000

Turnover of Derivatives in BSE (Cr)Turnover of Equity in BSE(Cr)

(source: sebi.gov.in)

59

Derivatives were introduced first time in India in 2001. There after Derivatives

market has seen a huge growth in terms traded contracts and turnover. From the above

chart we can see that derivatives turnover in the year 2001 – 02 was 1,926 crores

compared to equity turnover of 3, 07,292. In BSE the equity turnover is superior

compared to derivatives turnover but after the financial year 2011- 12 the momentum

has shifted from equity to derivatives and in the financial year 2011 – 2012 the

derivatives turnover overtook the equity turnover for the 1st time ever, the derivatives

turnover stood at 8, 08,476crores compared to equity turnover of 6, 67,498 which is

21% more of equity turnover clearly showing the emergence of derivatives market on

BSE.

Table showing comparison of Derivatives Turnover and Equity Turnover in NSE

60

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2011-120

5000000

10000000

15000000

20000000

25000000

30000000

35000000

Turnover of Derivatives in NSE(Cr)Turnover of Equity in NSE(Cr)

(source: sebi.gov.in)

Derivatives were introduced first time in India in 2001. There after Derivatives market

has seen a huge growth in terms traded contracts and turnover. From the above chart

we can see that derivatives turnover in the year 2001 – 02 was 1,01,925crores

compared to equity turnover of 5,13,167 but after the financial year 2003 -04

derivatives has seen a huge up growth, It has outperformed equity segment both in

volumes and turnover. In the financial year 2011 – 2012 the derivatives turnover stood

at 3, 13,49,732crores compared to equity turnover of 28,10,893 which is 1015% more

of equity turnover clearly showing the emergence of derivatives market on NSE.

Findings

84% of the respondents are Male and 16% of them are Female.

61

Most of the investors who invest in derivatives market are graduate.

Majority of the investors who invest in derivative market have a income of

above 1,50,001 – 3,00,00/-

46% of the respondents fall under the age category of 35 – 44 years

Investors generally perceive uncertainty of returns type of risk while investing

in derivative market.

Most of investor’s purpose of investing in derivative market is to hedge their

funds.

Most of investors participate in Index Options.

From this survey we come to know that most of investors make a contract of 1

month maturity period.

Investors invest 1 -10 times a year in Derivatives Market.

The result of investment in derivative market is generally moderate but

acceptable.

Hypothesis test shown that there is relationship between Income and

investment in different type of derivative instruments, Age and purpose of

Investing in Derivative market , Income per annum and monthly income

available for investment

Derivatives turnover compared to Equity turnover is superior on NSE

Recommendations

Knowledge needs to be spread concerning the risk and return of derivative

market.

62

Investors should have knowledge of technical analysis, especially 5 Day

moving averages as derivatives trading is for a short period of time Investors

should analysis their script with the help of 5 Day moving average before

making their trades.

Investors’ portfolio should only consist of 15 – 20% Derivatives contracts or

scripts. As derivatives trading is very risky investors should have only a small

portion of their portfolio consisting of derivatives.

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

As FII play a prominent role in Derivatives trading, an individual investor

should keep himself updated with various economic trends, government

policies, company and industry announcements.

ANNEXURE

SURVEY QUESTIONNAIRE FOR INVESTORS

Dear Sir/Mam,

This questionnaire is meant for educational purposes only.

The information provided by you will be kept secure and confidential.

63

1. Name: ___________________________________________

2. Gender

a) Male b) Female

3. Age

a. Below 18 Years

b. Between 18 – 24 Years

c. Between 25- 34 Years

d. Between 45 -54 Years

e. Above 55 Years

4. Occupation

a. Employee

b. Business

c. Student

d. Professional

5. Educational Qualification

a. Undergraduate

b. Graduate

c. Post Graduate

d. Professional Degree Holder

6. Income per Annum

a. Below 1,50,000

b. 1,50,000 – 3,00,000

c. 3,00,000 – 5,00,000

64

d. Above 5,00,000

7. Normally what percentage of your monthly household income could be

available for investment?

a. Between 5% to 10%

b. Between 11% to 15%

c. Between 16% to 20%

d. Between 21% to 25%

e. More than 25%

8. What kind of risk do you perceive while investing in the stock market?

a. Uncertainty of returns

b. Slump in stock market

c. Fear of being windup of company

d. Other

9. What is the purpose of investing in Derivative market?

a. To hedge funds

b. Risk control

c. More stable

d. Direct investment

10. In which of the following would you like to participate?

a. Index Futures

b. Index Options

c. Stock Futures

d. Stock Options

e. Currency Futures / Options

11. What contract maturity period would interest you for trading in?

65

a. 1 month

b. 2 months

c. 3 months

d. 6 months

e. 9 months

f. 12 months

12. How often do you invest in Derivative market?

a. 1-10 times in a year

b. 11-50 times

c. More than 50 times

d. Regularly

13. What was the result of your Investment?

a. Great results

b. Moderate but acceptable

c. Disappointed

Conclusion

Derivatives play a very important role in the up-bringing of an organization; it plays a major role in the equity market. Today, with the help of derivatives, the Indian stock exchange market has recently rocketed up to become Asia’s fourth largest exchange traded derivatives market. In terms of growth of derivative markets and a variety of derivatives users, the Indian market has exceeded or equaled many other Indian markets. The variety of instruments in derivatives instruments available for trading is also expanding. Corporations, private sectors institutions, state-owned and smaller companies are gradually getting into the act.

To conclude, the derivatives market in India has been expanding rapidly and will continue to grow. derivatives are very useful for hedging and risk transfer, and hence improve market efficiency, it is necessary to keep in view the risks of excessive leverage, lack of transparency particularly in complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden systemic risk.

66

Nevertheless, Indian Derivatives market is poised to grow at a very rapid pace in the years to come.

BIBLIOGRAPHY

1. N.D.Vohra & B.R.Bagri, “Future and Options”, Tata McGraw Hill, 3rd Edition.

2. www.derivative.com

3. www.google.com

67

68