DERIVATIVES

{A TWO EDGED SWORD}

with

LUDHIANA STOCK EXCHANGE Ltd.

TRAINING REPORT SUBMITTED IN THE PARTIAL FULFILMENT FOR THE

“MASTERS OF BUSINESS ADMINISTRATION(2011-13)”

Submitted to: Mrs. JIWAN JYOTI MAINI Submitted by:- VANDANA Roll no.-1174501

Malout institute of Management and Technology (Malout)

{aff. PTU jalandhar}

Acknowledgement

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“You cannot discover new oceans unless you have the courage to lose sight of the share”

The world of capital market was far from us,but we got an opportunity to emission the capital mkt at Ludhiana stock exchange. We are indebted to our Teachers and Gurus who molded at this junction of our career from where we can take off better in the competitive scenario of today’s world.

We would like to thanks Mrs. Pooja M Kohli Ludhiana stock exchange limited for giving me an opportunity to do our SUMMER TRAINING in this esteemed organization.

It’s my privilege to express the everlasting feeling of indebtness to Mr. Sadhram for their valuable suggestions constructive outcome and untiring help during the summer training.

my heartiest thanks, deep sense of gratitude to all member who deliver lectures and share

their valueable experiences with us.

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EXECUTIVE SUMMARY

New ideas and innovations have always been the hallmark of progress made by mankind. At

every stage of development, there have been two core factors that drives man to ideas and

innovation. These are increasing returns and reducing risk, in all facets of life.

The financial markets are no different. The endeavour has always been to maximize returns

and minimize risk. A lot of innovation goes into developing financial products centred on

these two factors. It has spawned a whole new area called financial engineering.

Derivatives are among the forefront of the innovations in the financial markets and aim to

increase returns and reduce risk. They provide an outlet for investors to protect themselves

from the vagaries of the financial markets. These instruments have been very popular with

investors all over the world.

Indian financial markets have been on the ascension and catching up with global standards in

financial markets. The advent of screen based trading, dematerialization, rolling settlement

have put our markets on par with international markets.

As a logical step to the above progress, derivative trading was introduced in the country in

June 2000. Starting with index futures, we have made rapid strides and have four types of

derivative products- Index future, index option, stock future and stock options. Today, there

are 30 stocks on which one can have futures and options, apart from the index futures and

options. This market presents a tremendous opportunity for individual investors .The markets

have performed smoothly over the last two years and has stabilized. The time is ripe for

investors to make full use of the advantage offered by this market.

We have tried to present in a lucid and simple manner, the derivatives market, so that the

individual investor is educated and equipped to become a dominant player in the market

1] INTRODUCTION TO STOCK EXCHANGE

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A stock exchange is an institution of capital mkt which generates capital and provides the same to industrial houses. A stock exchange is nervous system of capital mkt. the changes in the capital mkt are brought about by a complex set of factore, all operating on the mkt simultaneously.

A stock exchange is the key institution facilitating the issues and sale of various types of securities it is a pivot around which every activity of the capital mkt revolves. In the absence of stock exchanges, the people with saving would hardly invest in cooperate securities for which there would no liquidity (buying and selling facility). Corperate investments from the general public would have been thus lower.

Stock exchanges thus represent the mkt place for buying and selling of securities and ensuring liquidity to them in interest of the investors. The stock exchanges are virtually the nerve centre of the capital mkt and reflect the health of the country’s economy as a whole.

The stock exchange is a place or a mkt were securities, shares, debentures, bonds. Mutual funds of join stock companies, central and state govt. organization, local bodies and foreign govt. are brought and sold. A stock exchange is a plateform for the trade of already issued securities through primary mkt. It is the essential pillar of the private sector and corporate economy. It is the open auction mkt were buyer and seller meet and evolve a competitive price for the security. It reflect hope aspiration and fears of people regarding the performance of the economy.

It is a mkt as well as the sources for the capital. Corporate and government raise sources from the mkt. The house hold invest there savings in the securities.

Stock exchange

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A stock exchange is a form of exchange which provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and dividends. Securities traded on a stock exchange include shares issued by companies, unit trusts,derivatives, pooled investment products and bonds.

To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there is a central location at least for record keeping, but trade is increasingly less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of increased speed and reduced cost of transactions. Trade on an exchange is by members only.

The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets are driven by various factors that, as in all free markets, affect the price of stocks (see stock valuation).

There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that derivatives and bonds are traded. Increasingly, stock exchanges are part of a global market for securities.

The supreme court of India has defined the role of stock exchanges in these words:

“A stock exchange fulfills the vital function in the economic development of a nation. Its main function is to liquefy capital by enabling a person who has invested money in, say a factory or a railway to convert it in by disposing off his share in the enterprises to someone else.”

1.1) HISTORY OF STOCK EXCHANGE IN INDIA

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The stock started in the pre independence era. It is discussed as below:-

S.No YEAR Development of stock exchanges

1. 18th century Trading of shares of east India company in kolkata and Mumbai was started.

2. 1850 Joint stock companies came into existence

3. 1860 Speculations in securities was done for first.

4. 1875 Formation of stock exchange in Mumbai.

5. 1894 Formation of Ahmadabad stock exchange.

6. 1908 Formation of Calcutta stock exchange

7. 1939 Formation of Lahore and madras stock exchange.

8. 1940 Formation of U.P and Delhi stock exchange

9. 1956 Securities contract(regulation)Act was enacted

10. 1988 SEBI was setup.

11. 1992 SEBI was given statutory powers under SEBI Act.

12. 1993 NSE was formed for first.

13. 2000 Depositories was introduced.

14. 2002 Start of rolling settlement and banning of BADLA trading.

15. 2003 Introduction of T+2 settelment.

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1.2) LIST OF VARIOUS REGIONAL STOCK EXCHANGES:

S.NO Name of Stock Exchange Year of establishment

Type of Organizations

1. Bombay stock exchange 1875 Voluntary non-profit organization

2. Ahmadabad Stock exchange 1897 Voluntary non-profit organization

3. Calcatta stock exchange 1908 Public limited company

4. M.P stock exchange Indore 1930 Voluntary non-profit organization

5. Madras stock exchange 1937 Co. limited by guarantee

6. Delhi stock exchange 1940 Public limited company

7. Hydrabad stock exchange 1943 Co. limited by guarantee

8. Banglore stock exchange 1957 Pvt. Converted into public ltd. Company

9. Cochin stock exchange 1978 Public limited company

10. U.P stock exchange kanpur 1982 Public limited company

11. Pune stock exchange 1982 Co. ltd. By guarantee

12. Ludhiana stock exchange 1983 Public limited company

13. Jaipur stock exchange 1983 Public limited company

14. Gwahati stock exchange 1984 Public limited company

15. Kanaar stock exchange 1985 Public limited company

16. Magadh stock exchange 1986 Co. ltd. By guarantee

17. Bhubaneshwar stock exchange 1989 Co. ltd. By guarantee

18. Saurashtra stock exchange 1990 Co. ltd. By guarantee, unrecognised

19. Vadodara stock exchange 1990 Private limited company.

20. Meerut stock exchange 1991 Private limited company

21. OTCEI stock exchange 1993 Pure demutulised

22. National stock exchange 1995 Pure demutulised

23. Coimbatore stock exchange 1997 Private limited company

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24. Sikkim stock exchange 1997 Private limited company

25. Multi commodity exchange(MCX)

2008 Public limited company

26. NCDEX 2009 Private limited organisation

From above Saurashtra, Magadh, Hyderabad,and Mangalore are unrecognized and rest are recognized. BSE is in worlds 5th position in transaction.

MCX and NCDEX are the new exchanges which only deals in commodities.

2]Ludhiana stock exchange

The Ludhiana Stock Exchange Limited was established in 1981, by Sh. S.P. Oswal of

Vardhman Group and Sh. B.M. Lal Munjal of Hero Group, leading industrial luminaries, to

fulfill a vital need of having a Stock Exchange in the region of Punjab, Himachal Pradesh,

Jammu & Kashmir and Union Territory of Chandigarh. Since its inception, the Stock

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Exchange has grown phenomenally. The Stock Exchange has played an important role in

channelizing savings into capital for the various industrial and commercial units of the State

of Punjab and other parts of the country. The Exchange has facilitated the mobilization of

funds by entrepreneurs from the public and thereby contributed in the overall, economic,

industrial and social development of the States under its jurisdiction.

Ludhiana Stock Exchange is one of the leading Regional Stock Exchange and has been in the

forefront of other Stock Exchange in every spheres, whether it is formation of subsidiary for

providing the platform of trading to investors, for brokers etc. in the era of Screen based

trading introduced by National Stock Exchange and Bombay Stock Exchange, entering into

the field of Commodities trading or imparting education to the Public at large by way of

starting Certification Programmes in Capital Market.

The vision and mission of Stock Exchange is:

"Reaching small investors by providing services relating to Capital Market including

Trading, Depository Operations etc. and creating Mass Awareness by way of education and

training in the field of Capital Market.To create educated investors and fulfilling the gap of

skilled work force in the domain in Capital Market."

Further, the Exchange has 295 members out of which 162 are registered with National Stock Exchange as Sub-brokers and 121 with Bombay Stock Exchange as sub-brokers through our subsidiary.

2.2) DETAILS OF PRESIDENTS AND VICE PRESIDENTS

LSE SALUTES ITS PRESIDENT/ CHAIRMEN VICE PRESIDENT/ VICE CHAIRMEN

PRESIDENTS/ CHAIRMEN

Sr. No. Name of the person Tenure

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1 Sh. S.P. Oswal 16.08.1983 to 27.07.1986

2 Sh. B.M. Lal Munjal 28.07.1986 to 15.10.1989

3 Sh. V.N. Dhiri 16.10.1989 to 30.10.1992 30.09.1998 to 04.10.2000

4 Sh. G.S. Dhodi 31.10.1992 to 22.12.1993

5 Sh. Jaspal Singh 23.12.1993 to 05.10.1995 01.10.1996 to 29.09.199806.10.2001 to 01.07.2002

6 Sh. M.S. Gandhi 06.10.1995 to 30.09.1996

7 Sh. R.C. Singal 05.10.2000 to 05.10.2001

8 Dr. B. B. Tandon, Chairman 25.06.2007 to 10.12.2007

9 Sh. S.P. Sharma, Chairman 15.07.2007 to 23.09.2008

10 Sh. Jagmohan Krishan 23.09.2008 to 29.09.2009

11 Prof Padam Parkash Kansal 30.09.2009 to till date

VICE PRESIDENTS/ VICE CHAIRMEN

Sr. No. Name of the person Tenure

1 Sh. Rajinder Verma 14.07.1984 to 08.08.1987

2 Sh. B.K. Arora 09.08.1987 to 15.10.198931.10.1992 to 22.12.1993

3 Sh. G.S. Dhodi 28.10.1991 to 30.10.1992

4 Sh. B.S. Sidhu 16.10.1989 to 27.10.199123.12.1993 to 05.10.1995

5 Sh. D.P. Gandhi 06.10.1995 to 26.09.1997

6 Sh. M. S. Sarna 27.09.1997 to 29.09.1998

7 Sh. T.S. Thapar 30.09.1998 to 04.10.2000

8 Sh. Tarvinder Dhingra 05.10.2000 to 05.10.2001

9 Dr. Rajiv Kalra 06.10.2001 to 01.07.2002

10 Sh. D.K. Malhotra, Vice Chairman 025.06.2007 to 10.12.2007

11 Sh. Jagmohan Krishan, Vice Chairman 15.07.2007 to 23.09.2008

12 Sh. Ravinder Nath Sethi 23.09.2008 to 08.10.2008

13 Prof Padam Parkash Kansal 09.10.2008 to 29.09.2009

14 Sh. Joginder Kumar 30.09.2009 to till date

Governance and management:

LSE has a strong governance and administration, which encompasses a right balance of Industry Experts with highest level educational background, practicing professionals and

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independent experts in various fields of Financial Sector. The administration is presently headed by Sr. General Manager CUM Company Secretary and team of persons having in-depth knowledge of Secretarial, Legal and Education & Training.The Governing Board of our Exchange comprises of eleven members, out of which two are Public Interest Directors, who are eminent persons in the fields of Finance and Accounts, Education, Law, Capital Markets and other related fields, Six are Shareholder Directors, and Three are Broker Member Director and the Exchange has four Statutory Committees namely Disciplinary Committee, Arbitration Committee, Defaults Committee and Investor Services Committee. In addition, it has advisory and standing committees to assist the administration.LSE has a Code of Conduct in place that governs the elected Board Members and the Senior Management Team. The same is monitored through periodic disclosure procedures. The Exchange has an Ethics Committee, which looks into any issue of conflict of interest and has in place general code of conduct for the Senior Officials.The composition of the Governing Board is as under:-

Composition of the Governing Board

Sr. No. Name of Director Category

1 Prof. Padam Parkash Kansal Chairman (Shareholder Director)

2 Sh. Joginder Kumar Vice Chairman(Shareholder Director)

3 Sh. Rajinder Mohan Singla Shareholder Director

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4 Sh. Satish Nagpal Shareholder Director

5 Sh. Vikas Batra Shareholder Director

6 Sh. Ashok kumar Shareholder Director

7 Dr. Raj Singh Registrar of Companies (Public Interest Director)

8 Sh. Ashwani Kumar Public Interest Director

9 Sh. V.P. Gaur Public Interest Director

10 Sh. Jaspal Singh Trading member Director

11 Sh. Sunil Gupta Trading Member Director

12 Sh. Sanjay Anand Trading member Director

2.3) Infrastructure and asset base at Ludhiana stock exchange

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The Exchange building is situated at Feroze Gandhi Market, Ferozepur Road, Ludhiana. It is a six storeyed building, which is centrally air-conditioned. The building has 262 rooms, which are located on various floors ranging from second to fifth. The first floor of the building houses the administrative office and rooms from second to fifth floors have been leased out to brokers. The first floor also has canteen and banking facilities. Investor Service Centre is also located at first floor which houses a well-equipped library and view-terminals to provide “live” rates of NSE and BSE to investors. Investors are also provided with Cable TV for the purpose of viewing the latest happenings in the Capital Market and around. Basement of the building has air-conditioning plant and Generators to provide air-conditioned environment and twenty-four hours power back up.

The Exchange has also an additional plot of land measuring 2333 sq. yards in the prime location of city, to enhance its infrastructure and source of income.

The Company in its continuous endeavour to provide qualitative services to its valued clients, has started e-broking trading services for its clients, thereby increasing the geographical reach of the company.

2.4) ACHIEVEMENTS OF LSE

First regional stock exchange to give proposal of making subsidiary as broker of NSE and BSE for survival of stock exchange and second to start operations like broker of NSE and BSE.

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First regional stock exchange to starttrading in commodities market by subsidiary.

First regional stock exchange to start courses on capital market,only BSE is performing this sort of activities andNSE uis also performing courses on capitqal market only for members but LSE will star outsiders also.

Derivative trading is done in LSE. Commodity trading is also done here. LSE also introduced a settlement guarantee fund (SGF). The SGF guarantees

settlement of transactions and the carryforward facility provides liquidity to the market.

LSE became the first in India to start LSE Securities Ltd., a 100% owned subsidiary of the exchange. The LSE Securities got the ticket as sub-broker of the NSE. In 1998, the exchange also got permission to start derivative trading.

For the settlement of dematerialised securities, the Ludhiana Stock Exchange has also been linked up with National Securities Depository Ltd. (NSDL).

Beside them some more achievements are:- 1. “LSE” brand is popular among masses. The brand image of LSE can be

capitalized. 2.LSE have requisite infrastructure for the Capital Market activities which

includes a multi-storeyed, centrally air conditioned building situated in the financial hub of the city i.e. Feroze Gandhi Market.

3. LSE have well experienced staff handling operations of Stock Exchange. 4. LSE have competent Board and professional management. 5. LSE have much needed networking of sub brokers in the entire region, who are

having rich experience in Stock Market operations for the last 25 years. 6. LSE have more than 40,000 clients spread across Punjab, Himachal Pardesh,

Jammu & Kashmir and adjoining areas of Haryana and Rajasthan. 7. The turnover of LSE subsidiary is the highest amongst all subsidiaries of

Regional Stock Exchanges in India.

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3] Derivatives

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 share’s 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

Derivatives are contract for future delivery of assets at price agreed at the time of the

contract. The quantity and quality of the asset is specified in the contract. The buyer of the

asset will make the cash payment at the time of delivery.

Meaning:

Derivatives 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.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 unique – they are the

same kind of risks associated with traditional bond or equity instruments.

Market Risk

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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 Risk

Most 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.

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 fund’s

total return.

3..1)FUNCTION OF DERIVATIVES MARKET:-

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The derivative market performs a number of economic functions:-

Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the perceived future

level. The prices of 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.

An important incidental benefit that flows from derivatives trading is that it acts as a

catalyst for new entrepreneurial activity.

The derivatives have a history of attracting many bright, creative, well-educated

people with an entrepreneurial attitude. They often energize others to create new

businesses, new products and new employment opportunities, the benefit of which

are immense.

Derivatives markets help increase savings and investment in the end. Transfer of risk

enables market participants to expand their volumes of activity

3.2)PARTICIPANTS OF THE DERIVATIVE MARKET:-

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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.they always try to

minimize risk.

Speculators

If hedgers are the people who wish to avoid the price risk, speculators are those who are

willing to take such risk to maximize their profits. 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.

They monitor the prices continuously and generally attempt to make profit from just a few

ticks per trade. On the other hand, the position traders also attempt to gain from price

fluctuations but they keep their positions for longer durations may is for a few days, weeks

or even months.

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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 of India, 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 Forward Option Swaps

3.3] TYPES OF DERIVATIVE

There are four basic types of derivative products which are:

Futures contract:

A futures contract is an agreement between two parties to buy or sell an asset at a certain

time in the future at a certain price. Futures contracts are special types of forward contracts in

the sense that the former are standardized exchange-traded contracts.

FUTURES PAYOFFS

A payoff is the likely profit/loss that would accrue to a market participant with change in the

price of the underlying asset. This is generally depicted in the form of payoff diagrams which

show the price of the underlying asset on the X-axis and the profits/losses on the Y-axis.

Futures contracts have linear payoffs. In simple words, it means that the losses as well as

profits for the buyer and the seller of a futures contract are unlimited. Options do not have

linear payoffs. Their pay offs are non-linear. These linear payoffs are fascinating as they can

be combined with options and the underlying to generate various complex payoffs.

Payoff for buyer of futures: Long futures

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PROFIT

LOSS

USDD

0

43.19

The payoff for a person who buys a futures contract is similar to the payoff for a person who

holds an asset. He has a potentially unlimited upside as well as a potentially unlimited

downside. Take the case of a speculator who buys a two-month currency futures contract

when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD.

When the value of dollar moves up, i.e. when Rupee depreciates, the long futures position

starts making profits, and when the dollar depreciates, i.e. when rupee appreciates, it starts

making losses. Figure shows the payoff diagram for the buyer of a futures contract.

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PROFIT

LOSS

USDD

0

43.19

Payoff for seller of futures:

The payoff for a person who sells a futures contract is similar to the payoff for a person who

shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited

downside. Take the case of a speculator who sells a two month currency futures contract

when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD.

When the value of dollar moves down, i.e. when rupee appreciates, the short futures position

starts 25 making profits, and when the dollar appreciates, i.e. when rupee depreciates, it starts

making losses. The Figure below shows the payoff diagram for the seller of a futures

contract.

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Forwards contract:

A forward contract is a customized contract between two entities, where settlement takes

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

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.

Liquidaty 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.

sattlement At the end of period Daily/as per contract

Options

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Options are of two types - calls and puts. Calls give the buyer the right but not the obligation

to buy a given quantity of the underlying asset, at a given price on or before a given future

date. Puts give the buyer the right, but not the obligation to sell a given quantity of the

underlying asset at a given price on or before a given date.

OPTION

CALL PUT

Buyer Seller Buyer Seller

Call Option :

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Obligation to sell

Right to sell

No obligation

Obligation to buy

Right to buy

No obligation

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.

Call Option (Buyer)

Why call option ?

If u think market will rise

Example

.Buy a call with a strike of Rs .2340(NIFTY) at a premium of Rs. 50

Maximum Profit Potential : Unlimited.

Maximum Risk Potential : Limited to Rs. 50

Break Even : Rs.2390

Pay off call option (Buyer)

2340

0

50 index

loss

Call option (Seller)

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Why sell Option : If u think market will remain neutral or slightly bearish .

Example

Sell a call with a strike price of Rs.2340(Nifty) at a premium of Rs.50

Maximum Profit Potential : Rs.50

Maximum Risk Potential : Unlimited

Break Even : Rs. 2390

Desired Movement :Market will not go down

Seller call option

0 1250 index

loss

Put Option

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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.

Why Buy a Put Option (Buyer)

If u think market will fall

Example

Buy a Put with a strike of Rs.2360(Nifty) at a premium of Rs.25

Maximum Profit Potential : Substantial

Maximum Risk Potential.

Break Even : 2335

Desired Movement : Bearish

Put Option Buyer

Profit

0 2360

index

loss

Put Option seller

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Why Sell a Put Option

If u think market will remain neutral or moderately bullish

Example

Sell a put with a strike of Rs.2360(Nifty) at a premium of Rs.50

Maximum Profit Potential : Rs 50

Maximum Risk Potential : Substantial

Break Even : Rs. 2310

Desired Movement : Market will not go down

Pay off put option (seller)

profit

0 2360

index

loss

TABLE SHOWING THE DEALING OF CALL & PUT OPTION

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Call Option Holder (Buyer) Call Option Writer (Seller) Pays Premium Right to exercise & buy the shares Profit from rising prices Limited losses, potentially

unlimited gains

Receives premium Obligation to sell shares if exercised Profits from falling prices or

remaining neutral Potentially unlimited losses, limited

gains

Put Option Holder (Buyer) Put Option Holder (Seller)

Pays Premium Right to exercise & buy the shares Profit from rising prices Limited losses, potentially

unlimited gains

Receives premium Obligation to buy shares if

exercised Profits from rising prices or

remaining neutral Potentially limited losses, unlimited

gains

OPTION TERMINOLOGY

1. Buyer of an option : The buyer of an option is the one who by paying the option

premium buys the right but not the obligation exercise his option on the seller/writer.

2. Writer of an option : The writer of a call/put option is the one who receives the

option premium and is thereby obliged to sell/buy the asset if the buyer exercise on

him.

3. Option price : Option price is the price, which the option buyer pays to the option

seller. It is also referred as option premium.

4. Expiration date : The date specified in the options contract is known as expiration

date, the exercise date, the strike date or the maturity.

5. Strike Price : The price specified in the options contract is known as strike price or

the exercise price.

6. American options : these are the options that can be exercised at any time upto the

expiration date. Most exchange-traded options are Americans.

7. European options: These are the options that can be exercised only on the expiration

date itself. These are easier or analyze than American option, and properties of

American options are frequently deducted from those of its European counterpart.

8. In the money option : An in the money option is an option that would lead to a

positive cash flow to the holder if it will exercise immediately. A call option in the

index is set to be in-the-money when the current index stands at a level higher than

the strike price (i.e. spot price>strike price). If the index is much higher than the

strike price, the call is set to deep ITM. In the case of a put, the put is ITM if the

index is below the strike price.

9. At-money option : (ATM) option is an option that would lead to zero cash flow if it

were exercised immediately. An option on the index is at-the-money when the current

index equals the strike price.

10. Out-of-the money option : (OTM) options is an option that would lead to a negative

cash flow it was exercised immediately. A call option on the index is OTM when the

current index stands at a level, which is less than the strike price (spot price<strike

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price). If the index is much lower than the strike price, the call is set to be deep OTM.

In the case of a put, the put is OTM if the index is above the strike price.

Swaps

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

according to a prearranged formula. They can be regarded as portfolios of forward contracts.

The two commonly used swaps are:

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

between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the

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

the opposite direction.

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3.4)Derivatives: two edged sword

I view derivatives as time bombs, both for the parties that deal in them and the economic

system. Basically these instruments call for money to change hands at some future date,

with the amount to be determined by one or more reference items, such as interest rates,

stock prices, or currency values. For

example, if you are either long or short an S&P 500 futures contract, you are a party to a

very simple derivatives transaction, with your gain or loss derived from movements in the

index. Derivatives contracts are of varying duration, running sometimes to 20 or more

years, and their value is often tied to several variables.Unless derivatives contracts are

collateralized or guaranteed, their ultimate value also depends on the creditworthiness of

the counter-parties to them. But before a contract is settled, the counter-parties record

profits and losses – often huge in amount – in their current earnings statements without so

much as a penny changing hands. Reported earnings on derivatives are often wildly

overstated. That’s because today’s earnings are in a significant way based on estimates

whose inaccuracy may not be exposed for many years.

In 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term

Capital Management, caused the Federal Reserve anxieties so severe that it hastily

orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged

that, had they not intervened, the

outstanding trades of LTCM – a firm unknown to the general public and employing only a

few hundred people – could well have posed a serious threat to the stability of American

markets. In other words, the Fed acted because its leaders were fearful of what might have

happened to other financial institutions had the LTCM domino toppled. And this affair,

though it paralyzed many parts of the fixed-income market for weeks, was far from a

worst-case scenario.

Purposes of derivative investments

33

the main purposes of derivative investments and why it is necessary for all investors. 1. Discovery of prices. The prices in the market depend on the climate conditions, the current situation in politics, the supply and demand of basic commodities, among many factors. All these affect market prices and with derivative investment investors are able to see how volatile their markets could be or how much losses or gains will they get. 2. Risk management. This is often one of the most important benefits of derivative investments. With a derivatives market, investors can easily identify the actual level of risk in the market. This is usually associated with hedging and speculation, which are both useful tools for companies in managing their risks effectively. 3. Reduce market transaction costs. Since derivatives investments are like forms of insurance, it is cost-efficient. With derivatives, investors may avoid involuntary risks; they can also easily implement different marketing ideas on many markets at a low cost, avoiding clashes and compromises. 4. Improve market efficiency. For instance, investors can invest in risk-free bonds. Doing so, investors can be neutral and have the freedom to choose whether to sell richer assets or buy the cheaper ones until equilibrium in prices is reached.

Benefits of derivatives

Derivatives help in transferring risks from risk-averse people to risk-oriented people. Derivatives assist business growth by disseminating effective price signals

concerning exchange rates, indices and reference rates or other assets and thereby, render both cash and derivatives markets more efficient.

Derivatives catalyze entrepreneurial activities. By allowing transfer of unwanted risks, derivatives can promote more efficient

allocation of capital across the economy and, thus, increasing productivity in the economy.

Derivatives increase the volume traded in markets because of participation of risk-averse people in greater numbers.

Derivatives increase savings and investment in the long run.

Risks involved with derivates

34

Needs proper knowledge:- while investing in derivatives an investor must know everything deeply about derivative market .because with half or without investor can,t know about volatility of market and he/she can earn maximum loss.

Large investment:- in derivatives large investment is involved because of lot size trades.Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers ... which can trigger serious systemic problems Warren Buffett

Rapid growth:- Know days derivative market growing fastly which cause increse in prices fastly and make share too expensive.

The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.But Mr Buffett argues that such highly complex financial instruments are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system.

Dependent:- derivative market is dependent on cash market or other factor.a small change in cash market cause a huge effect on derivative market.

3.5)OPERATIONAL MECHANISM OF DERIVATIVES

35

1. Registration with broker : The first step towards trading in the derivatives market

is selection of a proper broker with whom the investor would trade. Investors should

complete all the registration formalities with the broker before commencement of

trading in the derivatives market. The investors should also ensure to deal with a

broker (member of the exchange) who is a SEBI registered broker and possesses a

SEBI registration certificate.

2. Client Agreement : The investor should sign the Client Agreement with the broker

before the broker can place any order on his behalf. The client agreement includes

provisions specified by SEBI and the derivatives segment.

3. Unique Client Identification Number : After signing the client agreement, the

investors gets a unique identification number (ID). The broker would key this

identification number in the system at the time of placing the order on behalf of the

investors. This ID is broker specific i.e. if the investors chooses to deal with different

brokers, he needs to sign the client agreement with each one of them and resultantly,

he would have different Ids.

4. Risk Disclosure Documents : As stipulated in the Bye-Laws provide his particulars

to the investors. The particulars would include his SEBI registration number, the

name of the employees who would be primarily responsible for the client’s affairs,

the precise nature of his liability towards the client in respect of the business done on

behalf of the investor. The broker must also apprise the investor about the risk

associated with the business in derivative trading and the extent of his liability. This

information forms part of the Risk Disclosure document, which the broker issues to

the client. The investor should carefully read the risk disclosure document and

understand the risks involved in the derivatives trading before committing any

position in the market. The risk disclosure document has to be sign3ed by the client

and a copy of the same is retained by the broker for his records.

5. Free Copy of Relevant Regulations : The client is also entitled to a free copy of the

extracts or relevant provisions governing the rights and obligations of clients,

relevant manuals, notifications, circulars and any additions or amendments etc. of the

derivatives segment or of any regulatory authority to the extent it governs the

relationship between the broker and the client.

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6. Placing order with the broker : The investor should place orders only after

understanding the monetary implications in the event of execution of the trade. After

the trade is executed, the investor can request for a copy of the trade confirmation slip

generated on the systems on execution of the trade. The investor should also obtain

from the broker, a contract note for the trade executed within 24 hours. The contract

note should be time (order receipt and order execution) and price stamped. Execution

prices, brokerage and other charges, if any, should be separately mentioned in the

contract note. If desired, the investors may change an order anytime before the same

is executed on the exchange.

7. Margining System in Derivatives : The aim of margin money is to minimize the

risk of default by either counter-party. The payment of margin ensures that the risk is

limited to the previous day’s price movement on each outstanding position. The

different types of margins are:

a) Initial Margin : The basic aim of initial margin is to cover the largest

potential loss in one day. Both buyer and seller have to deposited before the

opening of the position in the futures transaction. This margin is calculated by

SPAN by considering the worst case scenarion.

b) Mark to market margin : All daily losses must be met by depositing of

further collateral-known as variation margin, which is required by the close of

business, the following day. Any profits on the contract are credited to the

client’s variation margin account.

8. Investors Protection Fund: The derivatives segment has established an “Investors

Protection Fund” which is independent of the cash segment to protect the interest of

the investors in the derivatives market.

9. Arbitration : In case of any dispute between the members and the clients arising out

of the trading or in relation to trading/settlement, the party thereto shall resolve such

complaint, dispute by arbitrations procedure as defined in the rules and regulations

and Bye-Laws of the respective exchanges.

3.6)REGULATORY FRAMEWORK

37

The trading of derivatives is governed by the provisions contained in the SC (R) A, the SEBI

Act, the rules and regulations framed there under and the rules and bye-laws of stock-

exchanges.

Securities contracts (Regulation) Act, 1956

SC(R) A aims at preventing undesiarable transactions in securities by regulating the business

of dealing therein and by providing for certain other matters connected therewith. This is the

principal Act, which governs the trading of securities in India. The term “securities” has been

defined in the SC(R)A. As per Section 2(h), the ‘Securities’ include:

1. Shares, scrips, stock, bonds, debentures, stock or other marketable securities of a like

nature in or of any incorporated company or other body corporate.

2. Derivative

3. Units or any other instrument issued by any collective investment scheme to the

investors in such schemes.

4. Government securities.

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

securities.

6. Rights or interests in securities

“Derivative” is defined to includes:

A security derived from a debt instrument, share, loan whether secured or unsecured,

risk instrument or contract differences or any other form of security.

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

securities.

Section 18A provides that notwithstanding anything contained in any other law for

the time being in force, contracts in derivative shall be legal and valid if such

contracts are:

Traded on a recognized stock exchange.

Settled on the clearing house of the recognized stock exchange, in accordance with the rules

and bye-laws of such stock exchanges.

4] RESEARCH METHODOLOGY

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Research is a procedure of logical and systematic application of the fundamentals of science

to the general and overall questions of a study and scientific technique by which provide

precise tools, specific procedures and technical, rather than philosophical means for getting

and ordering the data prior to their logical analysis and manipulations.

Different type of research design is available depending upon the nature of research project,

availability of able manpower and circumstances.

The study about DERIVATIVES A TWO EDGED SWORD” is exploratory as well as

descriptive in nature .Discussion with experts, internet surfing, and journals were studied to

explore more about the concerned objective and better understanding of the problem. After

that questionnaire was prepared to meet the desired objective

Sources of Data:

The source of data includes primary and secondary data sources.

Primary Sources

Primary data is data collected for first time specially for the purpose for which study is being

conducted i.e. the problem under study..

Secondary Sources

The secondary data is data, which is collected and compiled for the different purpose, which

are used in research for this study. The secondary data include material collected from:

- Newspaper

- Magazine.

- Internet.

Data Collection Instruments

39

The various methods of data gathering involves the use of appropriate recording forms.

These are called ‘tools’ or ‘instruments of data collection. Data was collected through

structured questionnaire administered by sitting with guide and discussing problems

Sampling Technique

The small representative selected out of large population is selected at random is called

sample. Well-selected sample may reflect fairly, accurately the characteristic of population.

The chief aim of sampling is to make an inference about unknown parameters from a

measurable sample statistics. Sampling technique used was Snowball sampling was used for

the purpose of data collection as reference was taken form sample to reach other sample.

Sample Size : Sample size refers to the number of items to be selected from the universe to

constitute a sample. Due to constraints of cost and time, the sample size selected for the

research is 50.

Sampling Unit : The sampling unit was the person who had an account and was investing

in stock market and broker who were trading in stock market .

4.1) DATA ANALYSIS AND INTERPATION

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1) Education qualification

From the total respondents 40% are professionals,30% have done PG, 20% and 10% are

graduate and under graduate simultaneously. this shows all the respondents are well

qualified

2) Participation in derivative market as

40%

10%30%

20%

role

investorspeculatorsbrokerhedgers

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40% of respondents are investors who invest their money where 30% are brokers

3) Participation in derivative products

40%

50%

10%

Partication

future

option

swap

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Half of the respondents i.e 50% participate in future and 40% are in option.so the major

products of intrest are future and option.

4) Income used for investment

20%

15%

35%

30%

income invested

b/w 5-10%b/w 11-15%b/w 16-20%more than 20%

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From about analysis we get to know that b16-20% of household income is invested in

derivative market by most of investors.

5) Purpose of investment

30%

30%

25%

15%

Purpose

hedgingrisk controlstabilitydirect investment

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Most of people invest in derivatives to control their risk of cash market and to achieve

stability.

6) why people not invest in derivative market

45

People rate riskiness of market as major decision for why people not invest in derivatives and

its less knowledge as 2nd and so on.

7) People invest for period of

55%

25%

20%

contract

1 month2 months3 maonths

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Most of the respondents invest in 1 month contract that is upto 55%.

8) number of investment in derivative market per year

20%

22%

40%

18%

no. of times

1-10 times11-50 timesmore than 50regular

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From the total respondents 40% of respondents take part in derivative market more then 50

times per year.meams all are the regular investors.

9) Result of investment

48%

25%

27%

results

great resultsacceptabledisappointed

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48% of total respondents get great results from investment they earn maximum profits.and

the other 25% says results are acceptable means they bear loss as well as they earn profits,but

the 27% people bear much loss because they invest without proper consideration/knowledge.

10) Still doing investment

85%

15%

yesno

49

From the total respondents 85% means approx 42 respondents are still investing in market

some of which are those who earn good profits in past and some are who bear loss i.e 10.

FINDINGS AND CONCLUSION

1) From the study I get to know that the derivative market is fastest growing market. its

highly volatile.

2) Trading is done in lot size so it can’t attract small investors

3) Derivatives are the main instrument to control or minimize risk.

4) Now days speculation became major aspect it also de motivate the investors

5) Derivatives are the instruments which gives much as profits and also takes more and

give loss.

6) Proper knowledge is required to get success

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SUGGESTIONS

1) LOT SIZE :

Lot size should be reduced so that the major segment of an India society i.e. small

saving class can come under F & O trading. There is strong need for revision of lot

sizes as the lot sizes of some of the individual scrips that were worth of Rs. 200000 in

starting, now same lot size amount to a much larger value.

2) SCRIPS :

More scrips of reputed companies etc. should be introduced in "F & O segment".

3) TRAINING CLASSES OR SEMINARS :

There should be proper classes on derivatives for investors, traders, brokers, students

and employees of stock exchanges. Because lack of knowledge is the main reason of

its less development. The first step towards it should be seminars provide to brokers

& LSE employees and secondly seminar to students.

4) Speculation :

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SEBI should take proper steps to control speculation

LIMITATIONS OF THE STUDY

No study is complete in itself, however, good it may and every study has some limitations:

Time is the main constraint of my study.

Availability of information was not sufficient because of less awareness among

investors / brokers.

Sample size is not enough to have a clear opinion.

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SURVEY QUESTIONNAIRE OF INVESTORS

Sir/Ma’am,

This questionnaire is meant for educational purposes only. The information provided by you

will be kept secure and confidential.

NAME- __________________________________________________

CONTACT- ______________________________________________

GENDER-________________________________________________

OCCUPATION-___________________________________________

1. Educational Qualification

Undergraduate

Graduate

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Post Graduate

Professional Degree Holder

2. You participate in derivative market as:

Investor

Speculator

Broker/Dealer

Hedger

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

Future

Options

Swap

4. Normally what percentage of your monthly household income could be available for

investment?

Between 5% to 10%

Between 11% to 15%

Between 16% to 20%

More than 20%

5. What is the purpose of investing in derivative market?

To hedge their fund

Risk control

More stable

Direct investment without buying and holding assets

6. Why people do not invest in derivative market? (Rank your preference 1-4)

Lack of knowledge and difficulty in understanding

Increase speculation

Very risky and highly leveraged instrument

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Counter party risk

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

1 month

2 month

3 month

8. How often do you invest in derivative market per year?

1-10 times in a year

11-50 times

More than 50 times

Regularly

9. What was the result of your investment?

Great results

Moderate but acceptable

Disappointed

10.Are you investing in market?

Yes No

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