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UNIVERSITY OF MUMBAI
PROJECT ON
DERIVATIVES
Submitted
In Partial Fulfillment of the requirements
For the Award of the Degree of
Bachelor of banking and insurance
By
AKASH VIJAY PANDEY
PROJECT GUIDE
PROF. MRS. KEERTI CHUGH
BACHELOR OF BANKING AND INSURANCE
SEMESTER V
(2012-13)
K.V.PENDHARKAR COLLEGE OF ARTS, SCIENCE &
COMMERCE,
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DECLARATION
I AKASH VIJAY PANDEY Student of BBI Semester V (2012-13)
hereby declare that I have completed this project on 25-07-2012
.
The information submitted is true & original to the best of my
knowledge.
Students Signature
Name of Student
( AKASH VIJAY PANDEY)
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CERTIFICATE
This is to certify that MR. AKASH VIJAY PANDEY Of TYBBI has
successfully completed the project on 25-07-2012
under the guidance of PROF. MRS. KEERTI CHUGH
Project Guide Co-OrdinatorProf. KEERTI CHUGH Prof. Sneha Vaidya
External Examiner
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ACKNOWLEDGEMENT
This is to express my earnest gratitude and extreme joy at being bestowed
with an opportunity to get an opportunity to get an interesting and informative
project on DERIVATIVES. I would like to thank all the people who have
helped me in completion of project, I would avail this opportunity to express my
profound gratitude and indebtness to all those people.
I am extremely grateful to my project guide Prof. Mrs. KEERTI CHUGH
who has given an opportunity to work on such an interesting project. She proved to
be a constant source of inspiration to me and provided constructive comments on
how to make this report better. Credit also goes to my friends whose constant
encouragement kept me in good stead.
Lastly without fail I would thank all my faculties for providing all explicit
and implicit support to me during the course of my project.
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13. TYPES OF DERIVATIVES MARKET 30
14. . FUNCTION OF DERIVATIVES MARKET 31
15. HISTORY OF THE STOCK BROKING INDUSTRY 32
16. BSE (BOMBAY STOCK EXCHANGE) 33
17. NSE (NATIONAL STOCK EXCHANGE) 34
18. MCX (MULTI COMMODITY EXCHANGE) 35
19.NCDEX (NATIONAL COMMODITIES AND DERIVATIVES
EXCHANGE)36
20.EMERGENCE OF THE DERIVATIVE TRADING IN
INDIA37
21.
FACTORS CONTRIBUTING TO THE GROWTH OF
DERIVATIVES: 38
22. BENEFITS OF DERIVATIVES 43
23. RISK ASSOCIATED WITH DERIVATIVES: 45
24. INDIAN DERIVATIVE MARKET 47
25. CONCLUSION 49
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1.DEFINATIONS
According to JOHN.C.HUL A Derivative can be defined as a Financial
Instrument whose value depends on (or derives from) the values of other, more
basic underlying Variables.
According to ROBERT L. MCDONALD A Derivative is simply a Financial
Instrument (or even more simply an agreement between two people) which has a
value determined by the price of something else.
With Securuties Laws (Second Amendment) Act 1999, Derivatives have been
included in the definitions of Securities. The term Derivative have been defined in
Securities Contract Regulation Act as:-
A Derivative include:-
a. A Security derived from a debt instrument, Share, Loan, whether Secured or
unsecured, risk instrument or contract for differences or any form of
securities.
b. Contract which derives its value from the prices, or index of prices, of
underlying securities. Derivative were developed primarily to manage, offset
or Hedge against risk but some were developed primarily to provide the
potential for high returns.
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2.MEANINGDerivatives are the financial contracts whose value/price is dependent on the
behavior of the price of one or more basic underlying assets (often simply known
as the underlying). These contracts are legally binding agreements, made on the
trading screen of stock exchanges, to buy or sell an asset in future. The asset can be
a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil,
soybean, cotton, coffee etc.
In the Indian Context the Security Contracts (Regulation) Act, 1956 (SC(R) A)defines derivative to include
A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or other form of security.
A contract, which derives its value from the prices, or index of prices of
underlying securities.
In financial terms derivatives is a broad term for any instrumental whose value is
derived from the value of one more underlying assets such as commodities, forex,
precious metal, bonds, loans, stocks, stock indices, etc.
Derivatives were developed primarily to manage offset, or hedge against risk but
some were developed primarily to provide potential for high returns. In the context
of equity markets, derivatives permit corporations and institutional
Investors to effectively manage their portfolios of assets and liabilities through
instrument like stock index futures.
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3.NEED OF THE STUDYIn less than three decades of their coming into vogue, derivative markets have
become the most important markets in the world. Today, derivatives have become
part and parcel of day- to - day life of the ordinary people in major part of the
world.
The study has been done to know the different types of derivatives and also to
know the derivative market in India. This study also covers the recent
developments in the derivative market taking into account the trading in past years.
Through this study I came to know the trading done in derivatives and their use in
the stock markets.
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4.OBJECTIVES OF THE STUDY
To understand the concept of the Derivatives and Derivative Trading. To analyze the Derivative markets in India.
To analyze the operations of futures and options in India.
To know different types of Financial Derivatives
To know the role of derivatives trading in India.
To study the various trends that comes in the way of Derivatives market.
To find out that what would be the future and market potential of
derivative market in India.
To get knowledge about shortcomings in Indian derivative market.
To analyze the trading system of market players.
To analyse the performance of Derivatives Trading since 2001with
special reference to Futures & Options
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5.SCOPE OF THE PROJECT
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.
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6.HISTORY OF DERIVATIVESThe 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 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
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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. 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. 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.
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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.
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7.PARTICIPANTS OF THE DERIVATIVEMARKET:-
Market participants in the future and option markets are many and they
perform multiple roles, depending upon their respective positions. A trader acts as
a hedger when he transacts in the market for price risk management. He is a
speculator if he takes an open position in the price futures market or if he sells
naked option contracts. He acts as an arbitrageur when he enters in to simultaneous
purchase and sale of a commodity, stock or other asset to take advantage of
mispricing. He earns risk less profit in this activity. Such opportunities do not exist
for long in an efficient market. Brokers provide services to others, while market
makers create liquidity in the market.
Hedgers
Hedgers are the traders who wish to eliminate the risk (of price change) to
which they are already exposed. They may take a long position on, or short sell, a
commodity and would, therefore, stand to lose should the prices move in the
adverse direction.
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Speculators
If hedgers are the people who wish to avoid the price risk, speculators are
those who are willing to take such risk. These people take position in the market
and assume risk to profit from fluctuations in prices. In fact, speculators consume
information, make forecasts about the prices and put their money in these
forecasts. In this process, they feed information into prices and thus contribute to
market efficiency. By taking position, they are betting that a price would go up or
they are betting that it would go down.
The speculators in the derivative markets may be either day trader or
position traders. The day traders speculate on the price movements during one
trading day, open and close position many times a day and do not carry any
position at the end of the day.
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Arbitrageurs
Arbitrageurs thrive on market imperfections. An arbitrageur profits by
trading a given commodity, or other item, that sells for different prices in different
markets. The Institute of Chartered Accountant ofIndia, the word ARBITRAGE
has been defines as follows:-
Simultaneous purchase of securities in one market where the price there of
is low and sale thereof in another market, where the price thereof is comparatively
higher. These are done when the same securities are being quoted at different
prices in the two markets, with a view to make profit and carried on with
conceived intention to derive advantage from difference in prices of securities
prevailing in the two different markets
Thus, arbitrage involves making risk-less profits by simultaneously entering
into transactions in two or more markets.
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Derivatives
Future Option Forward Swaps
8.TYPES OF DERIVATIVES
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 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. Toexit 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.
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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 strike price, during a periodor 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.
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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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 theirhome 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 of
liability. It also allows the investors to exchange one type of asset for
another type of asset with a preferred income stream
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, priceand quantity are negotiated bilaterally by the parties to the contract. The forward
contracts are normally traded outside the exchanges.
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9.OTHER KINDS OF DERIVATIVESThe 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.
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10. FEATURES1) 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.
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2) FEATURES OF FUTURE CONTRACT:
1. STANDARDIZATION:
Futures contracts ensure their liquidity by being highly standardized, usually
by specifying:
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 amount and 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 grade of the deliverable. In case of bonds, this specifies which bonds
can be delivered. In case of physical commodities, this specifies not only the
quality of the underlying goods but also the manner and location of delivery.
The delivery month. The last trading date
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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
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.
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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:
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 ashort), or selling a contract to liquidate an earlier purchase (covering a long).
4. EXPIRY
It 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.
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11. DISTINCTION BETWEEN FUTURES ANDFORWARDS CONTRACTS
FEATURE FORWARDCONTRACT
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 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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12. INTRODUCTION TO DERIVATIVEMARKET
According to dictionary, derivative means something which is derived from
another source. Therefore, derivative is not primary, and hence not independent.
In financial terms, derivative is a product whose value is derived from the value of
one or more basic variables. These basic variable are called bases, which may be
value of underlying asset, a reference rate etc. the underlying asset can be equity,
foreign exchange, commodity or any asset.
For example: - the value of any asset, say share of any company, at a future
date depends upon the shares current price. Here, the share is underlying asset, the
current price of the share is the bases and the future value of the share is the
derivative. Similarly, the future rate of the foreign exchange depends upon its spot
rate of exchange. In this case, the future exchange rate is the derivative and the
spot exchange rate is the base.
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13. TYPES OF DERIVATIVES MARKET
Exchange Traded Derivatives Over The Counter Derivatives
National Stock Bombay Stock National Commodity &
Exchange Exchange Derivative Exchange
Index Future Index option Stock option Stock future
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14. FUNCTION OF DERIVATIVES MARKETThe derivative market performs a number of economic functions:-
Prices in an organized derivatives market reflect the perception of marketparticipants about the future and lead the prices of underlying to the
perceived future level. The prices of derivative 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
may not like them to those who have an appetite for them.
Derivatives, due to their inherent nature, are linked to the underlying cash
market. With the introduction of the derivatives, the underlying market
witnesses higher trading volumes because of the participation by more
players who would not otherwise participate for lack of arrangement to
transfer risk.
Speculative trades shift to a more controlled environment of derivatives
market. In the absence of an organized derivative market, speculators trade
in the underlying cash market.
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.
Derivatives markets help increase savings and investment in the end.
Transfer of risk enables market participants to expand their volumes.
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15. HISTORY OF THE STOCK BROKINGINDUSTRY
Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly200 years ago.
In 1887, they formally established in Bombay, the "Native Share and Stock
Brokers' Association" (which is alternatively known as "The Stock Exchange"). In
1895, the Stock Exchange acquired a premise in the same street and it was
inaugurated in 1899. Thus, the Stock Exchange at Bombay was consolidated.
Thus in the same way, gradually with the passage of time number of exchanges
were increased and at currently it reached to the figure of 24 stock exchanges.
This was followed by the formation of associations /exchanges in Ahmadabad
(1894), Calcutta (1908), and Madras (1937).
In order to check such aberrations and promote a more orderly development
of the stock market, the central government introduced a legislation called
the Securities Contracts (Regulation) Act, 1956. Under this legislation, it is
mandatory on the part of stock exchanges to seek government recognition.
As of January 2002 there were 23 stock exchanges recognized by the central
Government. They are located at Ahmadabad, Bangalore, Baroda,
Bhubaneswar, Calcutta, Chennai,(the Madras stock Exchanges ), Cochin,
Coimbatore, Delhi, Guwahati, Hyderabad, Indore, Jaipur, Kanpur, Ludhiana,
Mangalore, Mumbai(the National Stock Exchange or NSE), Mumbai (The
Stock Exchange), popularly called the Bombay Stock Exchange, Mumbai
(OTCExchange of India), Mumbai (The Inter-connected Stock Exchange of
India), Patna, Pune, and Rajkot.
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16. BSE (BOMBAY STOCK EXCHANGE)
The Stock Exchange, Mumbai, popularly known as "BSE" was established
in 1875 as "The Native Share and Stock Brokers Association". It is the oldest one
in Asia, even older than the Tokyo Stock Exchange, which was established in
1878. It is the first Stock Exchange in the Country to have obtained permanent
recognition in 1956 from the Govt. of India under the Securities Contracts
(Regulation) Act, 1956.
A Governing Board having 20 directors is the apex body, which decides the
policies and regulates the affairs of the Exchange. The Governing Board consists
of 9 elected directors, who are from the broking comm.
Unity (one third of them retire ever year by rotation), three SEBI nominees, six
public representatives and an Executive Director & Chief Executive Officer and a
Chief Operating Officer.
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17. NSE (NATIONAL STOCK EXCHANGE)
NSE was incorporated in 1992 and was given recognition as a stock
exchange in April 1993. It started operations in June 1994, with trading on the
Wholesale Debt Market Segment. Subsequently it launched the Capital Market
Segment in November 1994 as a trading platform for equities and the Futures and
Options Segment in June 2000 for various derivative instruments.
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18. MCX (MULTI COMMODITY EXCHANGE)
MULTI COMMODITY EXCHANGE of India limited is a new order
exchange with a mandate for setting up a nationwide, online multi-commodity
market place, offering unlimited growth opportunities to commodities marketparticipants. As a true neutral market, MCX has taken several initiatives for users
in a new generation commodities futures market in the process, become the
countrys premier exchange.
MCX, an independent and a de-mutualised exchange since inception, is all
set up to introduce a state of the art, online digital exchange for commodities
futures trading in the country and has accordingly initiated several steps to
translate this vision into reality.
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19. NCDEX (NATIONAL COMMODITIES ANDDERIVATIVES EXCHANGE)
NCDEX started working on 15th December, 2003. This exchange provides
facilities to their trading and clearing member at different 130 centres for contract.
In commodity market the main participants are speculators, hedgers and
arbitrageurs.
Facilities Provided By NCDEX
NCDEX has developed facility for checking of commodity and also
provides a ware house facility
By collaborating with industrial partners, industrial companies, news
agencies, banks and developers of kiosk network NCDEX is able to provide
current rates and contracts rate.
To prepare guidelines related to special products of securitization NCDEX
works with bank.
To avail farmers from risk of fluctuation in prices NCDEX provides special
services for agricultural. NCDEX is working with tax officer to make clear different types of sales
and service taxes.
NCDEX is providing attractive products like weather derivatives
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20. EMERGENCE OF THE DERIVATIVETRADING IN INDIA
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24 member committee under the
chairmanship of Dr. L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India.
The committee submitted its report on March 17, 1998 prescribing
necessary pre-conditions for introduction of derivatives trading in India.
The committee recommended that derivatives should be declared as
securities so that regulatory framework applicable to trading of securities
could also govern trading of securities. SEBI also set up a group in June 1998
under the chairmanship of Prof. J.R.Verma, to recommend measures for risk
containment in derivative market in India.
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21. FACTORS CONTRIBUTING TO THEGROWTH OF DERIVATIVES:
Factors contributing to the explosive growth of derivatives are price volatility,
globalisation 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 determines the price. These factors are
constantly interacting in the market causing changes in the price over a short
period of time. Such changes in the price are known as price volatility. This hasthree factors: the speed of price changes, the frequency of price changes and the
magnitude of price changes.
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The changes in demand and supply influencing factors culminate in market
adjustments through price changes. These price changes expose individuals,
producing firms and governments to significant risks.
The break down of the BRETTON WOODS agreement brought an end to the
stabilising role of fixed exchange rates and the gold convertibility of the dollars.
The globalisation of the markets and rapid industrialisation of many
underdeveloped countries brought a new scale and dimension to the markets.
Nations that were poor suddenly became a major source of supply of goods. The
Mexican crisis in the south east-Asian currency crisis of 1990s has also brought
the price volatility factor on the surface.
The advent of telecommunication and data processing bought information very
quickly to the markets. Information which would have taken months to impact the
market earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates rapidly.
These price volatility risks pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against adverse
price changes in commodity, foreign exchange, equity shares and bonds.
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B.} Globalisation of markets:
Earlier, managers had to deal with domestic economic concerns; what happened in
other part of the world was mostly irrelevant. Now globalisation has increased the
size of markets and as greatly enhanced competition .it has benefited consumers
who cannot obtain better quality goods at a lower cost. It has also exposed the
modern business to significant risks and, in many cases, led to cut profit margins
In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis--vis depreciated currencies. Export of certain
goods from India declined because of this crisis. Steel industry in 1998 suffered its
worst set back due to cheap import of steel from south East Asian countries.
Suddenly blue chip companies had turned in to red. The fear of china devaluing its
currency created instability in Indian exports. Thus, it is evident that globalisation
of industrial and financial activities necessitates use of derivatives to guard against
future losses. This factor alone has contributed to the growth of derivatives to a
significant extent.
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C.} Technological advances:
A significant growth of derivative instruments has been driven by technological
breakthrough. Advances in this area include the development of high speed
processors, network systems and enhanced method of data entry. Closely related to
advances in computer technology are advances in telecommunications.
Improvement in communications allow for instantaneous worldwide conferencing,
Data transmission by satellite. At the same time there were significant advances in
software programmes without which computer and telecommunication advances
would be meaningless. These facilitated the more rapid movement of informationand consequently its instantaneous impact on market price.
Although price sensitivity to market forces is beneficial to the economy as a whole
resources are rapidly relocated to more productive use and better rationed overtime
the greater price volatility exposes producers and consumers to greater price risk.
The effect of this risk can easily destroy a business which is otherwise well
managed. Derivatives can help a firm manage the price risk inherent in a market
economy. To the extent the technological developments increase volatility,
derivatives and risk management products become that much more important.
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D.} Advances in financial theories:
Advances in financial theories gave birth to derivatives. Initially forward contracts
in its traditional form, was the only hedging tool available. Option pricing models
developed by Black and Scholes in 1973 were used to determine prices of call and
put options. In late 1970s, work of Lewis Edeington extended the early work of
Johnson and started the hedging of financial price risks with financial futures. The
work of economic theorists gave rise to new products for risk management which
led to the growth of derivatives in financial markets.The above factors in combination of lot many factors led to growth of derivatives
instruments.
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22. BENEFITS OF DERIVATIVESDerivative markets help investors in many different ways:
1.] RISK MANAGEMENT
Futures and options contract can be used for altering the risk of investing in spot
market. For instance, consider an investor who owns an asset. He will always be
worried that the price may fall before he can sell the asset. He can protect himself
by selling a futures contract, or by buying a Put option. If the spot price falls, the
short hedgers will gain in the futures market, as you will see later. This will help
offset their losses in the spot market. Similarly, if the spot price falls below the
exercise price, the put option can always be exercised.
2.] PRICE DISCOVERY
Price discovery refers to the markets ability to determine true equilibrium prices.
Futures prices are believed to contain information about future spot prices and help
in disseminating such information. As we have seen, futures markets provide a low
cost trading mechanism. Thus information pertaining to supply and demand easily
percolates into such markets. Accurate prices are essential for ensuring the correct
allocation of resources in a free market economy. Options markets provide
information about the volatility or risk of the underlying asset.
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3.] OPERATIONAL ADVANTAGES
As opposed to spot markets, derivatives markets involve lower transaction costs.
Secondly, they offer greater liquidity. Large spot transactions can often lead to
significant price changes. However, futures markets tend to be more liquid than
spot markets, because herein you can take large positions by depositing relatively
small margins. Consequently, a large position in derivatives markets is relatively
easier to take and has less of a price impact as opposed to a transaction of the same
magnitude in the spot market. Finally, it is easier to take a short position in
derivatives markets than it is to sell short in spot markets.
4.] MARKET EFFICIENCY
The availability of derivatives makes markets more efficient; spot, futures and
options markets are inextricably linked. Since it is easier and cheaper to trade in
derivatives, it is possible to exploit arbitrage opportunities quickly and to keep
prices in alignment. Hence these markets help to ensure that prices reflect truevalues.
5.] EASE OF SPECULATION
Derivative markets provide speculators with a cheaper alternative to engaging in
spot transactions. Also, the amount of capital required to take a comparable
position is less in this case. This is important because facilitation of speculation is
critical for ensuring free and fair markets. Speculators always take calculated risks.
A speculator will accept a level of risk only if he is convinced that the associated
expected return is commensurate with the risk that he is taking.
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23. RISK ASSOCIATED WITH DERIVATIVES:
While derivatives can be used to help manage risks involved in investments,
they also have risks of their own. However, the risks involved in derivatives
trading are neither new nor uniquethey are the same kind of risks associated with
traditional bond or equity instruments.
MARKET RISK
Derivatives exhibit price sensitivity to change in market condition, such as
fluctuation in interest rates or currency exchange rates. The market risk of
leveraged derivatives may be considerable, depending on the degree of leverage
and the nature of the security.
LIQUIDITY RISKMost derivatives are customized instrument and could exhibit substantial
liquidity risk implying they may not be sold at a reasonable price within a
reasonable period. Liquidity may decrease or evaporate entirely during unfavorable
markets.
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CREDIT RISK
Derivatives not traded on exchange are traded in the over-the-counter (OTC)
market. OTC instrument are subject to the risk of counter party defaults.
HEDGING RISK
Several types of derivatives, including futures, options and forward are used
as hedges to reduce specific risks. If the anticipated risks do not develop, the hedge
may limit the funds total return.
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24. INDIAN DERIVATIVE MARKETStarting from a controlled economy, India has moved towards a world where prices
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
1991 Liberalisation process initiated
14th December
1995
NSE asked SEBI for permission to trade index futures.
18th November
1996
SEBI setup L.C.Gupta Committee to draft a policy
framework for index futures.
11th May 1998 L.C.Gupta Committee submitted report.7th July 1999 RBI gave permission for OTC forward rate agreements
(FRAs) and interest rate swaps.
24th May 2000 SIMEX chose Nifty for trading futures and options on
an Indian index.
25th May 2000 SEBI gave permission to NSE and BSE to do index
futures trading.
9th June 2000 Trading of BSE Sensex futures commenced at BSE.
12th June 2000 Trading of Nifty futures commenced at NSE.
25th September
2000
Nifty futures trading commenced at SGX.
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2nd June 2001 Individual Stock Options & Derivatives
4th June 2001 The NSE introduced trading on index options based on
the S&P CNX Nifty.
2nd July 2001 Trading on stock options commences on NSE
9th November
2001
Trading on stock futures commences on NSE
29th August 2008 Currency derivatives trading commences on the NSE
31st August 2009 Interest rate derivatives commences on NSE
February 2010 Launch of currency futures on additional currency
pairs28th October 2010 Introduction of European style Stock Options
29th October 2010 Introduction of Currency Options
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25. CONCLUSION
Derivatives allow firms and individuals to hedge risks and to take risks efficiently.
They also can create risk at the firm level, especially if a firm uses
Derivatives episodically and is inexperienced in their use. For the economy as a
whole, a collapse of a large derivatives user or dealer may create systemic risks.
On balance, derivatives help make the economy more efficient.
However, neither users of derivatives nor regulators can be complacent. Firms
have to make sure that derivatives are used properly. This means that the risks of
derivatives positions have to be measured and understood. Those in charge of
taking derivatives positions must have the proper training. It also means that firms
must have well-defined policies for derivatives use. A firms board must know
how risk is managed within the firm and which role derivatives play. Regulators
have to make sure to monitor carefully financial firms with large derivatives
positions.
Though regulators seem to be doing a good job in monitoring banks and brokerage
houses, the risks taken by insurance companies, hedge funds and government
sponsored enterprises should be understood and monitored.
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