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PROJECT REPORT

INDIAN DERIVATIVE MARKET

SUBMITTED BY: SIMRANJEET SINGH ANANDENROLLMENT NO: 1132

SUBMITTED TO:

DR. YP SINGH(Faculty)

INTERNATIONAL INSTITUTE FOR SPECIAL EDUCATIONKANCHANA BIHARI MARG, KALYANPUR, LUCKNOW, PIN-226022

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DECLARATION

I hereby declare that this project work entitled is PROJECT ON INDIAN

DERIVATIVE MARKET is my work, this report neither full nor in part

has ever been submitted for award of any other degree of either this

university or any other university.

SIMRANJEET SINGH ANAND

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CONTENTS

1.1 Early toothpastes1.2 Tooth powder

S.NO PARTICULARS PAGE

NO.1 ACKNOWLEDGEMENT 5

2 NEED OF THE STUDY 6

3 OBJECTIVE 7

4 SCOPE 8

5 RESEARCH METHODOLOGY 9

6 LIMITATIONS OF THE STUDY 10

7 LITERATURE REVIEW 11

8 EXECUTIVE SUMMARY 13

9 INTRODUCTION-INDIAN INVESTMENT

INDUSTRY

22

10 OVERVIEW:INDIAN SECURITIES MARKET 26

11 INDIAN DERIVATIVE MARKET 35

12 DERIVATIVE MARKET AND ITS INSTRUMENTS 44

13 MARKET TRENDS IN FUTURE AND OPTION 56

14 COMPARISION OF NEW SYSTEM WITH THE

EXISTING ONE

68

15 DEVELOPMENT OF DERIVATIVE MARKET IN

INDIA

77

1.1 Early toothpastes1.2 Tooth powder

S.NO PARTICULARS PAGE

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NO.

16 MAJOR APPLICATIONS OF FINANCIAL

DERIVATIVES

85

17 FINANCIAL DERIVATIVES-INSTRUMENTSIN STRATEGIC RISK MANAGEMENT

89

18 HEDGING 96

19 SPECULATION 111

20 FINDINGS AND CONCLUSION 112

21 RECOMMENDATIONS AND SUGGESTIONS 114

22 BIBLIOGRAPHY 116

ACKNOWLEDGEMENT

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I am extremely grateful to all those who have shared their views, opinions,

ideas and experiences which have significantly improved this Project Report.

I would like to express my sincere thanks to , Mr.YP SINGH International

Institute for Special Education, Lucknow for his guidance and sincere efforts

towards bringing in years of his vast industrial experience into this project. I

am very thankful to all the respondents and the employees for their

cooperation in the course of my study.

A special thanks to my friends and family for their encouragement and help

in the successful completion of the study.

SIMRANJEET SINGH ANAND

NEED OF THE STUDY

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To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives

To know the role of derivatives trading in India.

To analyse the performance of Derivatives Trading since 2001with

special reference to Futures & Options

To understand the concepts of hedging and speculation in Indian

derivative market

SCOPE OF THE PROJECT

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The project covers the derivatives market and its instruments. For better

understanding various strategies with different situations and actions have

been given. It includes the data collected in the recent years and also the

market in the derivatives in the recent years. This study extends to the

trading of derivatives done in the National Stock Markets.

RESEARCH METHODOLOGY

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Method of data collection:-

Secondary sources:-

It is the data which has already been collected by some one or an

organization for some other purpose or research study .The data for study

has been collected from various sources:

Books

Journals

Magazines

Internet sources

Time:

2 months

Statistical Tools Used:

Simple tools like bar graphs, tabulation, line diagrams have been used.

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LIMITATIONS OF STUDY

1. VOLATALITY:Share market is so much volatile and it is difficult to forecast any thing

about it whether you trade through online or offline

2. LIMITED TIME:

The time available to conduct the study was only 2 months. It being a

wide topic had a limited time.

3. LIMITED RESOURCES:

Limited resources are available to collect the information about the

commodity trading.

4. ASPECTS COVERAGE:

Some of the aspects may not be covered in my study.

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LITERATURE REVIEW

Derivative products initially emerged, as hedging devices against

fluctuations in commodity prices and commodity-linked derivatives

remained the sole form of such products for almost three hundred years. The

financial derivatives came into spotlight in post-1970 period due to growing

instability in the financial markets. However, since their emergence, these

products have become very popular and by 1990s, they accounted for about

two-thirds of total transactions in derivative products. In recent years, the

market for financial derivatives has grown tremendously both in terms of

variety of instruments available, their complexity and also turnover. In the

class of equity derivatives, futures and options on stock indices have gained

more popularity than on individual stocks, especially among institutional

investors, who are major users of index-linked derivatives.

The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averseeconomic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative

products, it is possible to partially or fully transfer price risks by locking-in

asset prices. As instruments of risk management, these generally do not

influence the fluctuations in the underlying asset prices. However, by

locking-in asset prices, derivative products minimize the impact of

fluctuations in asset prices on the profitability and cash flow situation of

risk-averse investors.

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Even small investors find these useful due to high correlation of the popular

indices with various portfolios and ease of use. The lower costs associated

with index derivatives vis-vis derivative products based on individual

securities is another reason for their growing use.

As in the present scenario, Derivative Trading is fast gaining

momentum, I have chosen this topic.

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EXECUTIVE SUMMARY

My project is all about THE INDIAN DERIVATIVE MARKET and its

instruments.a thorogh study has been conducted to know the recent trends

and factual aspects of Indian derivative market and its intruments

WEALTH CREATION

Starting the process of Investment of money is the first cornerstone to wealth

creation especially when we know that India is on a fast track growth. In in

the pre-independence era (before 1947) India was mainly characterized by

people who saves and saves-heavily. It was the country of savers. But post-

independence the growth has picked its pace and also is the rate of inflation.

Prices of essential commodities like food, housing, gas, electricity, education

etc has been increasing at a dramatic pace of more than 9%. This is one of

the biggest disadvantages of a growing economy; inflation rate seems to fly

like a limitless bull. Investment is required to fight inflation and in additionmake your money grow.

CHANGE OF SHIFT FROM SAVER TO AN INVESTOR

The transition form a "nation that only saves" to a "nation of investors" is

evident. Taking the statistics of last 35years, the number of retail as well as

institutional investors in India has multiplied several folds. Not only Indian

investors but international investors is eying India as an Investment heaven.

Only next to China, India has been rates as the fastest growing economies in

recent times. India has learned to differentiate between saving and

investment. If earning money is a need then savings and investment should

be a habit. Savings in isolation is not of much help because inflation is eating

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our money. Inflation makes our money less powerful each day. This is the

reason why we need to fight inflation (to protect our money) by a great tool

called investment. India is growing and a person who is investing is actually

contributing to the growth of the nation; in return he/she will get the desired

returns. Important is to identify a suitable "asset class" for oneself and start

investing in it. Like retired people would like to invest in bonds, deposits;

middle aged men would like to invest in mutual funds, real estate but people

who are young and dynamic would like to invest in direct equity like stocks.

CONFIDENCE OF INVESTORS AND GDP GROWTH

Why we have seen this transition and change of shift form savings to

investment? The answer clearly lies in the confidence of Indian Investors in

the future growth prospects of India. This confidence is fueled by a

consistent GDP growth of around 8%. Average performance of various asset

classes is as listed below:

Savings account (3% to 3.5%) Bonds (6% to 7%)

Bank or Companies Deposits (6% to 7%)

Gold (8% to 10%)

Real Estate (10% to 12%)

Stocks (12% to 15%)

Art (15% to 20%)

Talking about short term investment horizon and GDP growth almost

assured at 7% to 8%, the focus on investors in Indian market shall be more

on selecting a suitable asset class for investment rather then debating of

growth and risks of investment. India will grow and top brains are convinced

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and assures average retail investors of this growth scene. People who are

already in the boat (investing) might have realized the power of investment

in Indian economy, but for people who have not started yet for them its not

late. In long run India is certain to make big money for its investors but

consistent GDP growth rate proves very encouraging even for short-term

investors.

But India is India and volatility is only the other name for this dynamic

country. Changes in political scenario, inflation, drought, flood, rise of

interest rates, market demands all in totality effect the performance of the

market. People should realize that India is a growing economy and such

volatility is expected. The price of stocks may fall and rise but investors

must not loose faith; it is important to keep the focus and attention of the

bigger picture of India's growth.

With over 25 million shareholders, India has the third largest investor base in

the world after USA and Japan. Over 7500 companies are listed on the

Indian stock exchanges (more than the number of companies listed in

developed markets of Japan, UK, Germany, France, Australia, Switzerland,

Canada and Hong Kong.). The Indian capital market is significant in terms

of the degree of development, volume of trading, transparency and its

tremendous growth potential.

Indias market capitalization was the highest among the emerging markets.

Total market capitalization of The Bombay Stock Exchange (BSE), which,

as on July 31, 1997, was US$ 175 billion has grown by 37.5% percent every

twelve months and was over US$ 834 billion as of January, 2007. Bombay

Stock Exchanges (BSE), one of the oldest in the world, accounts for the

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largest number of listed companies transacting their shares on a nationwide

online trading system. The two major exchanges namely the National Stock

Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5

in the world, calculated by the number of daily transactions done on the

exchanges.

The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in

2006 An increase of 82% from US $ 1237 billion in 2004 in a short span of

2 years only. Turnover in the Spot and Derivatives segment both in NSE &

BSE was higher by 45% into 2006 as compared to 2005. With daily average

volume of US $ 9.4 billion, the Sensex has posted excellent returns in the

recent years. Currently the market cap of the Sensex as on July 4th, 2009

was Rs 48.4 Lakh Crore with a P/E of more than 20.

Derivatives trading in the stock market have been a subject of enthusiasm of

research in the field of finance the most desired instruments that allow

market participants to manage risk in the modern securities trading are

known as derivatives. The derivatives are defined as the future contracts

whose value depends upon the underlying assets. If derivatives are

introduced in the stock market, the underlying asset may be anything as

component of stock market like, stock prices or market indices, interest rates,

etc. The main logic behind derivatives trading is that derivatives reduce the

risk by providing an additional channel to invest with lower trading cost and

it facilitates the investors to extend their settlement through the future

contracts. It provides extra liquidity in the stock market.

Derivatives are assets, which derive their values from an underlying asset.

These underlying assets are of various categories like

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Commodities including grains, coffee beans, etc.

Precious metals like gold and silver.

Foreign exchange rate.

Bonds of different types, including medium to long-term negotiable debt

securities issued by governments, companies, etc.

Short-term debt securities such as T-bills.

Over-The-Counter (OTC) money market products such as loans or

deposits.

Equities

For example, a dollar forward is a derivative contract, which gives the buyer

a right & an obligation to buy dollars at some future date. The prices of the

derivatives are driven by the spot prices of these underlying assets.

However, the most important use of derivatives is in transferring market risk,

called Hedging, which is a protection against losses resulting from

unforeseen price or volatility changes. Thus, derivatives are a very important

tool of risk management.

Hedging risk has been an integral part of the financial markets for many

years. In the 1800s, commodity producers and merchants began using

forward contracts for protection against unfavorable price changes. This

system is still very active today.

The term "hedge fund" dates back to only 1949. In 1949, almost all

investment strategies took only long positions. A reporter for Fortune

magazine, named Alfred Winslow Jones, published an article pointing out

that investors could achieve higher returns if hedging were implemented into

an investment strategy. This was the beginning of the Jones model of

investing.

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To prove his hypothesis, Jones launched an investment partnership

incorporating two investment tools into his strategy: short selling and

leverage. The purpose of these two strategies was to limit risk and enhance

returns simultaneously.

In addition, Jones established two important characteristics that are still part

of the industry today. He used an incentive fee of 20% of profits and he kept

most of his own personal money in the fund. This ensured that his personal

goals and the goals of his investors were in alignment.

Exceptional results were obtained through this hedged approach. During the

period from 1962 to 1966, Jones outperformed the top mutual fund by more

than 85%, net of fees. The success of Jones stimulated the interest of high

net worth individuals in hedge funds.

Not only did Jones attract the interest of high net worth individuals to hedge

funds, but also many top money managers were drawn to hedge fund

because of the unique fee structure. A 20% incentive fee made it possible

for managers to earn 10 to 20 times as much in compensation when

compared to long-only money management services.

Between 1966 and 1968, nearly 140 new hedge funds were launched as a

consequence of the new dynamics of investing and managing money. Many

of these funds, however, did not follow the Jones model of hedging risk.

Instead of hedging, only leverage was used to enhance returns, ignoring the

short-selling aspect that Jones employed. Using a leveraged, long-only

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strategy made these funds highly susceptible to the market downturn that

began in late 1968. Some hedge funds dropped in value by more than 70%

within two years.

Large hedge fund losses due to the 1973-1974 bear market caused many

investors to turn away from hedge funds. For the next ten years, few

managers could attract the necessary capital to launch new partnerships. By

1984, there were only 68 funds in existence.

In the late 1980s, a small group of extremely talented hedge fund managers,

including George Soros, Michael Steinhart, and Julian Robertson, gave

hedge funds a restored credibility. Despite difficult market conditions, these

managers produced annual returns of greater than 50%.

Many of the worlds best money managers left the traditional institutional

and retail investment firms because of potentially higher fees and great

flexibility with managing hedge fund products. By 1990, there were over

500 hedge funds worldwide with assets of about $38 billion.

Hedge funds now represent one of the largest segments of the investment

management industry. Currently, it is estimated that there are over 6,000

hedge funds in existence with total money under management in excess of

$1 trillion.

There are various derivative products traded. They are;

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1. Forwards

2. Futures

3. Options

4. Swaps

A Forward Contract is a transaction in which the buyer and the seller

agree upon a delivery of a specific quality and quantity of asset usually a

commodity at a specified future date. The price may be agreed on in

advance or in future.

A Future contract is a firm contractual agreement between a buyer and

seller for a specified as on a fixed date in future. The contract price will vary

according to the market place but it is fixed when the trade is made. The

contract also has a standard specification so both parties know exactly what

is being done.

An Options contractconfers the right but not the obligation to buy (call

option) or sell (put option) a specified underlying instrument or asset at a

specified price the Strike or Exercised price up until or an specified future

date the Expiry date. The Price is called Premium and is paid by buyer of

the option to the seller or writer of the option.

A call option gives the holder the right to buy an underlying asset by a

certain date for a certain price. The seller is under an obligation to fulfill the

contract and is paid a price of this, which is called "the call option premium

or call option price".

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A put option, on the other hand gives the holder the right to sell an

underlying asset by a certain date for a certain price. The buyer is under an

obligation to fulfill the contract and is paid a price for this, which is called

"the put option premium or put option price".

Swaps are transactions which obligates the two parties to the contract to

exchange a series of cash flows at specified intervals known as payment or

settlement dates. They can be regarded as portfolios of forward's contracts. A

contract whereby two parties agree to exchange (swap) payments, based on

some notional principle amount is called as a SWAP. In case of swap, only

the payment flows are exchanged and not the principle amount

I had conducted this research to find out whether investing in the

derivative market is beneficial or not? You will be glad to know that

derivative market in India is the most booming now days.

So the person who is ready to take risk and want to gain more should

invest in the derivative market.

On the other hand RBI has to play an important role in derivative

market. Also SEBI must encourage investment in derivative market so

that the investors get the benefit out of it. Sorry to say that today even

educated persons are not willing to invest in derivative market because

they have the fear of high risk.

INDIAN INVESTMENT INDUSTRY

INVESTMENT-MEANING

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Investment is referred to as the concept of deferred consumption, which

might comprise of purchasing an asset, rendering a loan, keeping the saved

funds in a bank account such that it might generate lucrative returns in the

future. The options of investments are huge; all of them having different

risk-reward trade off. This concludes that the investment industry is really

broad and that is why understanding the core concepts of investments and

accordingly analyzing them is essential. After thorough understanding of the

investment industry, can an investor create and manage his own investment

portfolio such that the returns are maximized with the least risk exposure.

TYPES OF INVESTMENTS IN INDIA

As stated earlier, the investment industry is huge; therefore the types of

investments are also varied. Different types of investments are:

CASH INVESTMENTS: Cash investments comprise of savings bank

accounts, certificates of deposit (CDs) and treasury bills (TBs). All these

types of investments render a low interest rate and prove to be quite risky

during times of inflation.

DEBT SECURITIES: This type of investment gives returns in the form of

fixed periodic payments and the fixed capital appreciate at maturity. This is

safe bait for the investors in the investment industry and has always proved

to be the risk free investment tool. Though, it is generally low in risks, the

returns are also lower than the other peer securities.

STOCKS: Investors can also buy stocks (equities) from the secondary

markets and be a part of any business corporates that are listed in the

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bourses. By this way, one can become the part of the profits that the

company generates. But one should remember that stocks are generally more

volatile and carries more risk than bonds.

MUTUAL FUNDS: They are usually a collection of stocks and bonds that a

fund manager selects for an investor such that the returns are maximum. The

investor does not have to track the investment, be it a bond, stock- or index-

based mutual funds.

DERIVATIVES: Derivatives are financial contracts, whose value is derived

from the value of the underlying assets like equities, commodities and bonds.

They can take the form of futures, options and swaps. Investors choose

derivatives as they are used to minimize the risk of loss that result from

variations in the underlying asset values.

COMMODITIES: The items that are traded on the commodities market are

agricultural and industrial commodities and they need to be standardized.

Commodities trading have always been giving high returns and thus they are

the riskiest of all investment options. One, who trades in commodities,

requires specialize knowledge and analytical abilities

REAL ESTATE: Investing in real estate has to be a long term affair. Funds

get hooked into the real estate sector for a considerable time period.

THE INVESTMENT INDUSTRY IN INDIA

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India's equity market has doubled since March 2009, with ADRs like Dr.

Reddy's Laboratories and Tata Motors only getting doubled and tripled. So,

do we say that the Indian investment industry is overheated at the moment or

may we infer that the stocks are fairly valued?

Warren Buffett has always mentioned that investment in India should always

be a long-term story - as the industry has been growing from an emerging

market to a developed one. The next 10 years in India will surely give good

returns.

India's GDP growth would be around 6.5% to 7% in 2010. The sustainable

growth rate of India would however hover around 7%. Before becoming a

mature economy, India has another 20 to 40 years to spare.

CHALLENGES OF INDIAN INVESTMENT

INDUSTRY

The investing story in India has not been always that smooth. Pitfalls are

sure to co-exist. The main restraint on India's growth now happens to be its

infrastructure. On the other hand, infrastructure is India's biggest opportunity

as well. The fiscal deficit of India also poses a big threat to the investment

industry in India. For an emerging economy like India, it is recommended

that an investor always balances the unique risks against the potential for

high long-term growth. Accordingly the decision for investment should bemade.

Of late, the Indian economy is turning out to be extremely conducive in

terms of domestic and foreign investments. India Investments has been the

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major propelling force towards India's attainment of self-sustained growth by

way of rapid industrialization. The pioneers of the investment industry has

been Foreign Direct Investment (FDI) and Investments made by NRIs.

Foreign Direct Investments in India has been gearing up momentum every

passing day. So, to view an economy which is entirely open to the global

markets, the investment industry in India should be groomed in a manner

that the maximum returns are achieved. It is advisable that the investment

industry's potential should neither be overestimated nor underestimated. We

should know how to deal with the complexities of the investment industry

and grow along with it.

OVERVIEW OF THE INDIAN SECURITIES

MARKET

INTRODUCTION

The Indian securities market, considered one of the most promising

emerging markets, is among the top eight markets of the world. The Stock

Exchange, Mumbai, which was established in 1875 as The Native Share

and Stockbrokers Association (a voluntary non-profit making association),

has evolved over the years into its present status as the premier Stock

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Exchange in the country. At present 24 stock exchanges operate all over

India. These stock exchanges provide facilities for trading securities,

Securities markets provide a common platform for transfer of funds from the

person who has excess funds to those who need them. Securities market is

regulated by the Securities& Exchange Board of India (SEBI).

COMPONENTS OF SECURITY MARKET

1. The major components of the securities market are listed below:

2. Securities-Shares, Bonds, Debentures, Futures, Options, Mutual Fund

Units

3. Intermediaries-Brokers, Sub brokers, Custodians, Share transfer

agents,

4. Merchant Bankers

5. Issuers of securities-Companies, Bodies corporate, Government,

Financial

6. Institutions, Mutual funds, Banks

7. Investors-Individuals, Companies, Mutual funds, Financial

Institutions, Foreign

8. Institutional Investors

9. Market Regulators-SEBI, RBI, Department of Company Affairs

TYPES OF SECURITIES MARKETS

In the contest of equity products, which this publication seeks to cover indepth, the following markets could be defined:

Primary Market

Secondary Market

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Derivatives market

MARKETS CAN ALSO BE BROADLY CLASSIFIED INTO EQUITY

AND DEBT MARKETS.

Debt markets are characterized currently by a large institutional presence,

though an attempt is being made to attract retail participation in recent times.

Debt markets trade in Government securities, Treasury Bills, Corporate

Bonds and other debt instruments while Equity markets deal mainly in

equity shares and to a limited extent in preference shares and company

debentures. Futures and Options in indices and equity shares are of a

relatively recent origin and form part of equity markets.

INTERMEDIARIES

Intermediaries provide various services to investors and issuers and have

grown to become among both powerful and knowledgeable due to due to

substantial growth of securities markets over the last century. A large variety

and number of intermediaries provide intermediation services in the Indian

securities market.

ISSUERS OF SECURITIES

Every organisation, whether if be a company, institution or a Government

body needs funds for various operations. Organisations issue securities in the

primary market depending on their needs. The Securities market in India is

an important source for corporate and government. The corporate sector does

depend significantly on equity and debt markets for meeting its funding

requirements though the share of equity markets has been decreasing over

the recent years in view of the rather dull primary market. During the year

2001-02 total funds raised through capital issues were Rs. 43,700 crores

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approx. The share of the Public Sector was Rs. 33,300 crores and Private

Sector Rs. 10,400 crores. Equity component of the Capital Issues was 5,400

crores and whereas Debt component was the major one at Rs 38,300 crores.

Investors are those who have excess funds with them and want to employ it

for returns. Indian securities market has more than 20 million investors,

comprising Individuals, Companies, Mutual funds,Financial Institutions,

Foreign Institutional Investors. A review of shareholding pattern of all BSE

Companies shows that, more than 50% of the shares are heldby the

promoters of companies, whereas 15% by Institutional Investors.

After liberalization of the economy investments by foreign institutional

investors have shown a steadyincrease. Foreign direct investment has

increased from Rs. 174 crores in 1990-91 to Rs. 10,686 crores in 2000-01.

Portfolio Investment has shown a faster growth. It is increased from Rs 11

crores in 1990-91 to Rs. 12,609 crores in 2000-2001.

MARKET REGULATORS

Securities market is regulated by following governing bodies:

1. Securities and Exchange Board of India (SEBI)

2. Department of Economic Affairs (DEA)

3. Department of Company Affairs (DCA)

4. Reserve Bank of India

5. Stock exchanges

Significant among the legislations for the securities market are the following:

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1. The SEBI Act, 1992, which establishes SEBI to protect investors and

development and regulate securities market. All the powers under this act are

exercised by SEBI.

2. The Companies Act, 1956 which set out the code of conduct for the

corporate sectorin relation to issue, allotment and transfer of securities,

disclosures to be made in public issues and nonpayment of dividend. Powers

under this Act are exercised by SEBI in case of listed public companies and

public companies proposing to get their securities listed.

3. The Securities Contract (Regulation) Act, 1956, which provide forregulation of transaction in securities through control over stock exchanges,

Most of lthe powers under this act are exercised by Department of Economic

Affairs (DEA), some are concurrently exercised by DEA and SEBI and a

few powers by SEBI. 4. The Depository Act, 1996, which provides for

electronic maintenance and transfer of ownership of demateralised securities,

SEBI administers the rules and regulation under this Act.

The Securities and Exchange Board of India was established in 1988 to

regulate and develop the growth of the capital market. SEBI regulates the

working of stock exchanges and intermediaries such as stock brokers and

merchant bankers, accords approval for mutual funds, and registers

Foreign Institutional Investors who wish to trade in Indian scrips. Section

11(1) of the Sebi Act provides that it shall be the duty of the Board to protect

the interests of investors securities and to promote the development of, and

to regulate the securities market, by such measures as it thinks fit.

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SEBI regulates the business in stock exchanges and any other securities

markets and the working of collective investment schemes, including mutual

funds, registered by it. SEBI promotes investors education and training of

intermediaries of securities market. It prohibits fraudulent and unfair trade

practices relating to securities markets, and insider trading in securities, with

the imposition of monetary penalties, on erring market intermediaries, It also

regulates substantial acquisition of shares and takeover of companies and can

call for information from, carry out inspection, conduct inquiries and audits

of the stock exchanges and intermediaries and self regulatory organizations

in the securities market.

PRIMARY MARKET

Fresh issues of shares and other securities are effected though the Primary

market. It provides issuers opportunity to issue securities, to raise resources

to meet their requirements of business. Equity issues can be effected at face

value or at discount/premium. Issues at discounts are rare and almost

unheard of. Issuers can issue the securities in domestic market and/or

international market through ADR/GDR/ECB route.

SECONDARY MARKET

Investors can buy and sell securities in secondary market from/to other

investors. The securities are traded, cleared and settled through

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intermediaries as per prescribed regulatory framework under the supervision

of the Exchanges and oversight of SEBI. The regulatory framework has

prohibited trading of securities outside the exchanges. There are 24

exchanges (The Capital Stock Exchanges, the latest in the list, is yet to

commence trading) today recognised over a period of time to enable

investors across the length and breadth of the country to access the market.

DERIVATIVES MARKET

Derivatives are contracts that are based on or derived from some underlying

asset, reference rate, or index. Most common financial derivatives are:

forwards, futures, options and swaps.

Derivatives trading commenced in India in June 2000 after SEBI granted the

final approval to this effect in May 2000 for trading in index futures,

Currently, the Indian markets provide equity derivatives of the following

types:

Index Futures-Two Indices

Stock Futures-Twenty Nine stocks

Index Options-Two Indices

Stock Options-Twenty Nine Stocks

Derivatives help to improve market efficiencies because risks can be isolated

and sold to those who are willing to accept them at the least cost. Using

derivatives breaks risk into pieces that can be managed independently.

Corporations can keep the risks they are most comfortable managing and

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transfer those they do not want to other companies that are more willing to

accept them. From a market-oriented perspective, derivatives offer the free

trading of financial risks.

Financial derivatives have changed the face of finance by creating new ways

to understand, measure, and manage financial risks. Ultimately, derivatives

offer organizations the opportunity to break financial risks into smaller

components and then to buy and sell those components to best meet specific

risk-management objectives. Moreover, under a market-oriented philosophy,

derivatives allow for the free trading of individual risk components, thereby

improving market efficiency. Using financial derivatives should be

considered a part of any businesss riskmanagement strategy to ensure that

value-enhancing investment opportunity can be pursued.

The derivatives markets are the financial markets for derivatives, financial

instruments like futures contracts or options, which are derived from other

forms of assets.

The market can be divided into two, that for exchange traded derivatives and

that for over-the-counter derivatives. The legal nature of these products is

very different as well as the way they are traded, though many market

participants are active in both

what are derivatives:-

In most cases derivatives are contracts to buy or sell the underlying asset at a

future time, with the price, quantity and other specifications defined today.

The contract may bind both parties, and just one party with the other party

reserving the option to exercise or not. The underlying asset either has to be

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traded or some kind of cash settlement has to transpire. Derivatives are

traded either in organized exchanges or over the counter. Examples of

derivatives include forwards, futures, options, caps, floors, swaps, collars,

and many others.

ADVANTAGES OF TRADING IN DERIVATIVES

Derivative contracts are effective tool for hedging and thereby reducing the

potential of future risk. They also allow investors to take a leveraged

position in the market and hereby increase the possibilities of earning higher

returns.

DISADVANTAGES OF TRADING IN DERIVATIVES

Because of their ability to provide leveraging, derivative disasters are pretty

common in international markets. Just as there is huge potential of earning

higher returns, it also exposes individuals and corporations alike to lose

money in case the market moves against the positions held by them.

EQUITY MARKET

Publicly traded equities form a significant source of capital for firms, and

equity markets are a key part of the process of allocating capital among

competing uses in our economy, Through issuance of equities, companies

enable a broad set of investors to share in the risk and reward of economic

activities.

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MEANING EQUITY MARKET

The market in which shares are issued and traded, either through exchanges

or over-thecounter markets. Also known as the stock market, it is one of the

most vital areas of a market economy because it gives companies access to

capital and investors a slice of ownership in a company with the potential to

realize gains based on its future performance.

INDIAN DERIVATIVE MARKET

HISTORY

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 1700s 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

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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 1860s. In 1865, 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 in 1972 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.The first of the several networks, which offered

a trading link between two exchanges, was formed between the Singapore

International Monetary Exchange (SIMEX) and the CME on September 7,

1984.

Options are as old as futures. Their history also dates back to ancient Greece

and Rome. Options are very popular with speculators in the tulip craze of

seventeenth century Holland. Tulips, the brightly coloured flowers, were a

symbol of affluence; owing to a high demand, tulip bulb prices shot up.

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Dutch growers and dealers traded in tulip bulb options. There was so much

speculation that people even mortgaged their homes and businesses. These

speculators were wiped out when the tulip craze collapsed in 1637 as there

was no mechanism to guarantee the performance of the option terms.

The first call and put options were invented by an

American financier, Russell Sage, in 1872. These options were traded over

the counter. Agricultural commodities options were traded in the nineteenth

century in England and the US. Options on shares were available in the US

on the over the counter (OTC) market only until 1973 without much

knowledge of valuation. A group of firms known as Put and Call brokers and

Dealers Association was set up in early 1900s to provide a mechanism for

bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange

(CBOE) was set up at CBOT for the purpose of trading stock options. It was

in 1973 again that black, Merton, and Scholes invented the famous Black-

Scholes Option Formula. This model helped in assessing the fair price of an

option which led to an increased interest in trading of options. With the

options markets becoming increasingly popular, the American Stock

Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began

trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and

nineties. The collapse of the Bretton Woods regime of fixed parties and the

introduction of floating rates for currencies in the international financial

markets paved the way for development of a number of financial derivatives

which served as effective risk management tools to cope with market

uncertainties.

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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 48 futures and

option contracts (with the annual volume at more than 211 million in

2001).The CBOE is the largest exchange for trading stock options. The

CBOE trades options on the S&P 100 and 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 225 trade almost round the clock. The N225 is also traded on the

Chicago Mercantile Exchange.

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

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Bank of India's efforts in allowing forward contracts, cross currency

options etc. which have developed into a very large market.

TYPES OF DERIVATIVE MARKET IN INDIA

DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

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National Stock Exchange Bombay Stock Exchange National Commodity & Derivative

exchange

Index Future Index option Stock option Stock future

CHRONOLOGY OF INSTRUMENTS

1991 Liberalisation process initiated

14 December NSE asked SEBI for permission to trade index

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1995 futures.

18 November

1996

SEBI setup L.C.Gupta Committee to draft a

policy framework for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate

agreements (FRAs) and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and

options on an Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do

index futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at

BSE.12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

ABOUT DERIVATIVES

Derivatives are nothing but a kind of security whose price or value is

determined by the value of the underlying variables. It is more like a contract

of future date in which two or more parties are involved to alleviate future

risk. Usually, derivatives enjoy high leverage. Its value is affected by the

volatility in the rates of the underlying asset. Some of the widely known

underlying assets are:

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Indexes (consumer price index (CPI), stock market index, weather

conditions or inflation)

Bonds

Currencies

Interest rates

Exchange rates

Commodities

Stocks (equities)

TYPES OF DERIVATIVES

The range of derivatives is really wide. But some of the most commonly known

derivatives are:

FORWARDS-This is a tailor-made contract between two parties. In case of

this contract, a settlement is done on a scheduled future date at today's pre-

decided rate.

FUTURES-When two entities decide to purchase or sell an asset at a given

time in the future at a given price, it is called futures contract. Futures

contracts can be said to be a special kind of forward contracts, as they are

customized exchange-traded agreements.

OPTIONS-It is of two different kinds such as calls and puts. Those who

take calls option, they are not obligated to purchase given quantity of the

underlying variable, at a mentioned price on or prior to a scheduled future

date. On the other hand, buyers in case of puts option may not necessarily

sell a mentioned quantity of the underlying variable at a mentioned price on

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or prior to a given date.

SWAPS-These are private contracts between two entities to deal in cash

flows in the future following a pre-decided formula. They are somewhat like

forward contracts' portfolios. Swaps are also of two types such as interest

rate swaps and currency swaps.

INTEREST RATE SWAPS-in this case, only interest related cash flows

can be exchanged between the entities in one currency.

CURRENCY SWAPS-in this case of swapping, principal and interest can

be exchanged in one currency for the same in other form of currency.

IMPORTANCE OF DERIVATIVES

Financial transactions are fraught with several risk factors. Derivatives are

instrumental in alienating those risk factors from traditional instruments and

shifting risks to those entities that are ready to take them. Some of the basic

risk components in derivatives business are:

CREDIT RISK: When one of the two parties fails to perform its

role as per the agreement, this is called the credit risk. It can also be

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referred to as default or counterparty risk. It varies with different

sources.

MARKET RISK: This is a kind of financial loss that takes place

due to the adverse price movements of the underlying variable or

instrument.

LIQUIDITY RISK: When a firm is unable to devise a transaction

at current market rates, it can be referred to as liquidity risk. There are

two kinds of liquidity risks involved in the scenario. First is concerned

with the liquidity of separate items and second is related to supporting

the activities of the organization with funds comprising derivatives.

LEGAL RISK: Legal issues related with the agreement need to be

scrutinized well, as one can deal in derivatives across the different

judicial boundaries.

DERIVATIVE MARKETS IN INDIA

India had started with a controlled economic system and from there it moved

on to become a destination that witnesses constant fluctuation in prices on a

daily basis now. Persistent efforts of Reserve Bank of India (RBI) inbuilding currency forward market and liberalization process provided the

risk management agencies their much needed momentum. Derivatives are

the indispensable components of liberalization process to handle risk. With

National Stock Exchange (NSE) measuring the market demands, the process

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of launching derivative markets in India got started. In the year 1999,

derivatives trading took place in India.

Indian derivatives markets can be divided into two types including 1) the

transaction which depends on the exchange, and 2) the transaction which

takes place 'over the counter' in one-to-one scenario. They can thus be

referred to as:

Exchange Traded Derivatives

Over the Counter (OTC) Derivatives

Over the Counter (OTC) Equity Derivatives

Operators in the Derivatives Market

There are different kinds of traders in the derivatives market. These include:

HEDGERS-traders who are interested in transferring a risk

element of their portfolio.

SPECULATORS-traders who deliberately go for risk components

from hedgers in look out for profit.

ARBITRATORS-traders who work in various markets at the same

time in order to gain profit and do away with mis-pricing.

DERIVATIVE MARKETS AND

INSTRUMENTS

FORWARD CONTRACTS

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A forward contract is an agreement to buy or sell an asset on a specified

date for a specified price. One of the parties to the contract assumes a

long position and agrees to buy the underlying asset on a certain

specified future date for a certain specified price. The other party

assumes a short position and agrees to sell the asset on the same date

for the same price. Other contract details like delivery date, price and

quantity are negotiated bilaterally by the parties to the contract. The

forward contracts are n or mal l y traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

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

Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

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

asset.

If the party wishes to reverse the contract, it has to compulsorily go to

the same counter-party, which often results in high prices being

charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process ofstandardization 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

func tions of allocating risk in the presence of future price uncertainty.

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However futures are a significant improvement over the forward

contracts as they eliminate counterparty risk and offer more

liquidity.

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in

the future, at a pre-set price. The future date is called the delivery date or

final settlement date. The pre-set price is called the futures price. The price

of the underlying asset on the delivery date is called the settlement price. The

settlement price, normally, converges towards the futures price on the

delivery date.

A futures contract gives the holder the right and the obligation to buy or sell,

which differs from an options contract, which gives the buyer the right, but

not the obligation, and the option writer (seller) the obligation, but not the

right. To exit the commitment, the holder of a futures position has to sell his

long position or buy back his short position, effectively closing out the

futures position and its contract obligations. Futures contracts are exchange

traded derivatives. The exchange acts as counterparty on all contracts, sets

margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1.STANDARDIZATION:

Futures contracts ensure their liquidity by being highly standardized, usually

by specifying:

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The underlying. This can be anything from a barrel of sweet crude oil

to a short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amountand units of the underlying asset per contract. This can be

the notional amount of bonds, a fixed number of barrels of oil, units of

foreign currency, the notional amount of the deposit over which the

short term interest rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which

bonds can be delivered. In case of physical commodities, this specifiesnot only the quality of the underlying goods but also the manner and

location of delivery. The delivery month.

The last trading date.

Other details such as the tick, the minimum permissible price

fluctuation.

2. MARGIN:

Although the value of a contract at time of trading should be zero, its price

constantly fluctuates. This renders the owner liable to adverse changes in

value, and creates a credit risk to the exchange, who always acts as

counterparty. To minimize this risk, the exchange demands that contract

owners post a form of collateral, commonly known as Margin requirements

are waived or reduced in some cases for hedgers who have physical

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ownership of the covered commodity or spread traders who have offsetting

contracts balancing the position.

Initial Margin : is paid by both buyer and seller. It represents the loss

on that contract, as determined by historical price changes, which is

not likely to be exceeded on a usual day's trading. It may be 5% or

10% of total contract price.

Mark to market Margin : Because a series of adverse price changes

may exhaust the initial margin, a further margin, usually called

variation or maintenance margin, is required by the exchange. This is

calculated by the futures contract, i.e. agreeing on a price at the end of

each day, called the "settlement" or mark-to-market price of the

contract.

To understand the original practice, consider that a futures trader, when

taking a position, deposits money with the exchange, called a "margin". This

is intended to protect the exchange against loss. At the end of every trading

day, the contract is marked to its present market value. If the trader is on the

winning side of a deal, his contract has increased in value that day, and the

exchange pays this profit into his account. On the other hand, if he is on the

losing side, the exchange will debit his account. If he cannot pay, then the

margin is used as the collateral from which the loss is paid.

3. SETTLEMENT

Settlement is the act of consummating the contract, and can be done in one

of two ways, as specified per type of futures contract:

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Physical delivery - the amount specified of the underlying asset of the

contract is delivered by the seller of the contract to the exchange, and by

the exchange to the buyers of the contract. In practice, it occurs only on a

minority of contracts. Most are cancelled out by purchasing a covering

position - that is, buying a contract to cancel out an earlier sale (covering

a short), or selling a contract to liquidate an earlier purchase (covering a

long).

Cash settlement - a cash payment is made based on the underlying

reference rate, such as a short term interest rate index such as Euribor, or

the closing value of a stock market index. A futures contract might also

opt to settle against an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For

many equity index and interest rate futures contracts, this happens on the

Last Thursday of certain trading month. On this day the t+2 futures contract

becomes the t forward contract.

PRICING OF FUTURE CONTRACT

In a futures contract, for no arbitrage to be possible, the price paid on

delivery (the forward price) must be the same as the cost (including interest)

of buying and storing the asset. In other words, the rational forward price

represents the expected future value of the underlying discounted at the risk

free rate. Thus, for a simple, non-dividend paying asset, the value of the

future/forward, , will be found by discounting the present value at

time to maturity by the rate of risk-free return .

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In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying

today (on the spot market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and

receives the agreed forward price.

3. He then repays the lender the borrowed amount plus interest.

4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:1. The arbitrageur buys the futures contract and sells the underlying

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

2. On the delivery date, he cashes in the matured investment, which has

appreciated at the risk free rate.

3. He then receives the underlying and pays the agreed forward price

using the matured investment. [If he was short the underlying, he

returns it now.]

4. The difference between the two amounts is the arbitrage profit.

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DISTINCTION BETWEEN FUTURES AND

FORWARDS CONTRACTS

FEATURE FORWARD

CONTRACT

FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes

the counter party to all the trades

or unconditionally guarantees

their settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs of

the needs of the parties.

High, as contracts are

standardized exchange traded

contracts.

Price

discovery

Not efficient, as markets

are scattered.

Efficient, as markets are

centralized and all buyers and

sellers come to a common

platform to discover the price.

Examples Currency market in India. Commodities, futures, Index

Futures and Individual stock

Futures in India.

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OPTIONS -

A derivative transaction that gives the option holder the right but not the

obligation to buy or sell the underlying asset at a price, called the strikeprice, during a period or on a specific date in exchange for payment of a

premium is known as option. Underlying asset refers to any asset that is

traded. The price at which the underlying is traded is called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an

underlying asset-stock or any financial asset, at a specified price on or before

a specified date is known as a Call option. The owner makes a profit

provided he sells at a higher current price and buys at a lower future price.

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PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an

underlying asset-stock or any financial asset, at a specified price on or before

a specified date is known as a Put option. The owner makes a profit

provided he buys at a lower current price and sells at a higher future price.

Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally

preference shares, bonds and warrants become the subject of options.

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MARKET TRENDS IN FUTURES AND OPTIONS

Recent Market Volatility has impacted the Use of Derivatives

Volatility in the markets has affected both structured derivatives along with

futures and options

Research from the consulting firm Greenwich Associates indicates that while

the use of over-the-counter, dealer traded, structured derivatives has seen a

marked decline in recent months, the use of exchange traded standard futures

and option contracts has seen the opposite, a rise in their use by institutional

investors for a variety of reasons. Perhaps some of the strategies employed

by these institutions can help the average retail investor.

PRODUCT USAGE OVERALL

According to that same research, many institutions in North America use

futures and options as a means to take a position, whether long or short, in

the underlying issue or index. Given that, roughly two-thirds use equity

derivatives as a functional adjunct to their fundamental investment strategy

or philosophy.

Slightly less than two-thirds of institutions use futures and options to execute

their opinion on the general direction of the market, sector or individualissues and just under half use exchange traded derivatives to establish more

complex strategies.

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PRODUCT SECTOR USAGE

Just over half of North American institutions use index futures with hedge

funds participating in this sector at just under half. The opposite is true in

usage of Exchange Traded Funds (ETF) with just over a half of institutions

using ETFs and not quite two-thirds hedge funds.

To a lesser extent, institutions use futures and option contracts for index or

sector swaps and swaps on a particular portfolio or basket of stocks while

usage for access to the underlying sector or issue is a distant last.

POPULAR STRATEGIES

There are some slight differences between institutional investors overall and

hedge funds, but on balance the most popular strategy is single-stock listed

options with roughly three-quarters using them. The next most popular with

60% to 70% participation is listed index options and the third most popular

strategy with roughly half of institutions using them is options on sector

Exchange Traded Funds.

Much less popular were the more exotic type of uses such as futures and

options on volatility, dispersion and correlation type trades and variance

swaps on indexes and single stocks.

CONSIDERATIONS

There are a number of considerations any investor should make about their

broker. Being penny wise and pound foolish about commissions is a major

point. Institutional investors use a "high-touch" sales professional over half

the time for futures and three-quarters of he time for options. Electronic

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execution accounts for the reciprocal, whether to the brokers desk or

directly to an exchange.

Consider what institutional investors consider important factors in their

choice of brokers: Certainly pricing is important but so is the expertise of the

sales professional, their understanding of the clients investment strategy,

their market judgment and sense of timing and willingness to commit capital

to facilitate trades.

Remember to consult your own investment professional to determine if

employing futures and options is an appropriate and suitable vehicle for youto use.

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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.

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FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to

access one market and then exchange the liability for another type ofliability. It also allows the investors to exchange one type of asset for another

type of asset with a preferred income stream.

THE NO-ARBITRAGE PRINCIPLE

To discuss the no-arbitrage principle we first need to develop a basic

understanding of arbitrage. An arbitrage opportunity is a chance to

make riskless profit with no investment. An arbitrageur is a person who

engages in arbitrage.

Illustrative Example

Shares of IBM trade on both the New York Stock Exchange and the Pacific

Stock Exchange. Suppose the shares of IBM trade for $65 on the New

York market and for $60 on the Pacific Exchange. A trader could make

the following two transactions simultaneously: Buy 1 share of IBM on

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the Pacific Exchange for $60Sell 1 share of IBM on the New York

Exchange for $65 The two transactions generate a riskless profit of $5.

Because both trades are assumed to occur simultaneously, there is no

investment.

Thus this opportunity qualifies as an arbitrage opportunity.

The no-arbitrage principle states that any rational price for a financial

instrument must exclude arbitrage opportunities. This is one of the

minimal requirements for a feasible or rational price for any financial

instrument.

FINANCIAL DERIVATIVES AND THE MARKET

A derivative is a kind of financial instrument which is derived from some

other underlying assets. Trading using derivatives has been emerging and

many countries follow this method. Here, instead of trading or exchangingthe asset involved, traders can have agreement among themselves for

exchanging either cash or assets.

A good example of this kind is a future contract. Here the traders will

involve in an agreement that in a future date they both agree to exchange the

underlying asset. Derivatives usually have high leverage because even a

small change in the asset value can cause high difference in the derivative.Derivatives are used by investors mainly for speculating and making profit

in the financial market. But, this will work only if the value of the asset

follows the trend in the financial market as expected. If the asset price moves

in a downward direction in the financial market then it could prove risky. In

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such cases where traders are uncertain of the assert price trend they can use

hedge or can enter into agreement for which the opposite derivative moves in

opposite direction.

In the financial market, derivatives classified based on the following:

1. The link between the derivative and the underlying asset.

2. The kind of the underlying asset. This can be equity derivatives, interest

rate derivatives foreign exchange derivatives and credit derivatives.

3. The type of market where the trade happens. It can be traded over the

counter or using exchanges.

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INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world whereprices fluctuate every day. The introduction of risk management instruments

in India gained momentum in the last few years due to liberalisation process

and Reserve Bank of Indias (RBI) efforts in creating currency forward

market. Derivatives are an integral part of liberalisation process to manage

risk. NSE gauging the market requirements initiated the process of setting up

derivative markets in India. In July 1999, derivatives trading commenced in

India.

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 Indias 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

Indias efforts in allowing forward contracts, cross currency options etc.

which have developed into a very large market.

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MYTHS AND REALITIES ABOUT DERIVATIVES

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

have become the most important markets in the world. Financial derivatives

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

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

leading to introduction of currency derivatives followed by other innovations

including stock index futures. Today, derivatives have become part and

parcel of the day-to-day life for ordinary people in major parts of the world.

While this is true for many countries, there are still apprehensions about the

introduction of derivatives. There are many myths about derivatives but the

realities that are different especially for Exchange traded derivatives, which

are well regulated with all the safety mechanisms in place.

What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic

purpose

Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveraged

instruments.

Derivatives are complex and exotic instruments that Indian investors

will find difficulty in understanding Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economicpurpose:

Numerous studies of derivatives activity have led to a broad consensus, both

in the private and public sectors that derivatives provide numerous and

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

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

prices or exchange rates. The need for derivatives as hedging tool was felt

first in the commodities market. Agricultural futures and options helped

farmers and processors hedge against commodity price risk. After the fallout

of Bretton wood agreement, the financial markets in the world started

undergoing radical changes. This period is marked by remarkable

innovations in the financial markets such as introduction of floating rates for

the currencies, increased trading in variety of derivatives instruments, on-

line trading in the capital markets, etc. As the complexity of instruments

increased many folds, the accompanying risk factors grew in gigantic

proportions. This situation led to development derivatives as effective risk

management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities

through instruments like stock index futures and options. An equity fund, for

example, can reduce its exposure to the stock market quickly and at a

relatively low cost without selling off part of its equity assets by using stock

index futures or index options.

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

managing risks and raising capital, derivatives improve the allocation of

credit and the sharing of risk in the global economy, lowering the cost of

capital formation and stimulating economic growth. Now that world markets

for trade and finance have become more integrated, derivatives have

strengthened these important linkages between global markets, increasing

market liquidity and efficiency and facilitating the flow of trade and finance

(ii) Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian

capital market is not ready for derivatives trading. Here, we look into the

pre-requisites, which are needed for the introduction of derivatives, and how

Indian market fares:

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PRE-REQUISITES INDIAN SCENARIOLarge marketCapitalisation

India is one of the largest market-capitalisedcountries in Asia with a market capitalisation ofmore than Rs.765000 crores.

High Liquidity in theunderlying

The daily average traded volume in Indiancapital market today is around 7500 crores.Which means on an average every month 14%of the countrys Market capitalisation getstraded. These are clear indicators of highliquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeingtrades has become fully functional from July

1996 in the form of National Securities ClearingCorporation (NSCCL). NSCCL is responsiblefor guaranteeing all open positions on the

National Stock Exchange (NSE) for which itdoes the clearing.

A Strong Depository National Securities Depositories Limited(NSDL) which started functioning in the year1997 has revolutionalised the security settlement

in our country.

A Good legal guardian In the Institution of SEBI (Securities andExchange Board of India) today the Indiancapital market enjoys a strong, independent, andinnovative legal guardian who is helping themarket to evolve to a healthier place for trade

practices.

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COMPARISON OF NEW SYSTEM WITH EXISTING

SYSTEM

Many people and brokers in India think that the new system of Futures &

Options and banning of Badla is disadvantageous and introduced early, but I

feel that this new system is very useful especially to retail investors. It

increases the no of options investors for investment. In fact it should have

been introduced much before and NSE had approved it but was not active

because of politicization in SEBI.

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum

Trading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premiumhold till expiry.

Advantages

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

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Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game.another exchange. the Market moves. in weekly settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continues

more or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option.

3)Sell deep OTM call option

with underlying shares, earnpremium + profit with increase prcie

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Advantages

Availability of Leverage

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains

profit/loss. 2) Hedge position if protected &holding underlying upsidestock unlimited.

Advantages

Losses Protected.

EXCHANGE-TRADED VS. OTC DERIVATIVES MARKETSThe OTC derivatives markets have witnessed rather sharp growth over the

last few years, which has accompanied the modernization of commercial and

investment banking and globalisation of financial activities. The recentdevelopments in information technology have contributed to a great extent to

these developments. While both exchange-traded and OTC derivative

contracts offer many benefits, the former have rigid structures compared to

the latter. It has been widely discussed that the highly leveraged institutions

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

financial markets in 1998. These episodes of turbulence revealed the risks

posed to market stability originating in features of OTC derivative

instruments and markets.

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The OTC derivatives markets have the following features compared to

exchange-traded derivatives:

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

located within individual institutions,

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

leverage, or margining,

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

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

and integrity, and for safeguarding the collective interests of market

participants, and

5. The OTC contracts are generally not regulated by a regulatory

authority and the exchanges self-regulatory organization, although

they are affected indirectly by national legal systems, banking

supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.

The following features of OTC derivatives markets can give rise to

instability in institutions, markets, and the international financial system: (i)

the dynamic nature of gross credit exposures; (ii) information asymmetries;

(iii) the effects of OTC derivative activities on available aggregate credit;

(iv) the high concentration of OTC derivative activities in major institutions;

and (v) the central role of OTC derivatives markets in the global financial

system. Instability arises when shocks, such as counter-party credit events

and sharp movements in asset prices that underlie derivative contracts, occur

which significantly alter the perceptions of current and potential future credit

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exposures. When asset prices change rapidly, the size and configuration of

counter-party exposures can become unsustainably large and provoke a rapid

unwinding of positions.

There has been some progress in addressing these risks and perceptions.

However, the progress has been limited in implementing reforms in risk

management, including counter-party, liquidity and operational risks, and

OTC derivatives markets continue to pose a threat to international financial

stability. The problem is more acute as heavy reliance on OTC derivatives

creates the possibility of systemic financial events, which fall outside the

more formal clearing house structures. Moreover, those who provide OTC

derivative products, hedge their risks through the use of exchange traded

derivatives. In view of the inherent risks associated with OTC derivatives,

and their dependence on exchange traded derivatives, Indian law considers

them illegal.

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FACTORS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price

volatility, globalizations of the markets, technological developments and

advances in the financial theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects

having value maybe commodities, local currency or foreign currencies. The

concept of price is clear to almost everybody when we discuss commodities.

There is a price to be paid for the purchase of food grain, oil, petrol, metal,

etc. the price one pays for use of a unit of another persons money is called

interest rate. And the price one pays in ones own currency for a unit of

another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers

have demand and producers or suppliers have supply, and the collective

interaction of demand and supply in the market det