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A Project report On “Derivatives Market” In partial fulfillment of the requirements of the Summer Internship of Post Graduate Diploma in Business Management Through Rizvi Academy of Management under the guidance of Prof. Tariq Sayyed Submitted by Ankit Gupta PGDBM Batch: 2010-2012
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Page 1: Derivatives Market

A

Project report

On

“Derivatives Market”

In partial fulfillment of the requirements of

the Summer Internship of

Post Graduate Diploma in Business Management

Through

Rizvi Academy of Management

under the guidance of

Prof. Tariq Sayyed

Submitted by

Ankit Gupta

PGDBM

Batch: 2010-2012

Page 2: Derivatives Market

CERTIFICATE

This is to certify that Mr. Ankit Gupta a student of Rizvi Academy of Management, of

PGDBM III bearing Roll No.7 and specializing in Finance has successfully completed the

project titled “DERIVATIVES MARKET” under the guidance of Prof. Tariq Sayyed in

partial fulfillment of the requirement of Post Graduate Diploma in Business Management by

Rizvi Academy of Management for the academic year 2010 – 2012.

_______________

Prof. Tariq Sayyed

Project Guide

_______________ _______________

_______________

Prof. Umar Farooq Dr. Kalim Khan

Academic Coordinator Director

Dr. Kalim Khan

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ACKNOWLEDGEMENT

I would like to express my gratitude towards my project guide Prof. Tariq Sayyed

without whose, continuous guidance and encouragement, this project would not have been

possible.

Also I would like to thank our director Dr. Kalim Khan who has provided the necessary

infrastructure and guidance in the course of the project. Also I would like to take this

opportunity to thank all the teaching as well as non-teaching staff for their continuous help

and support.

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EXECUTIVE SUMMARY-Derivatives are an important class of financial instruments that

are central to today’s financial and trade markets. They offer various types of risk protection

and allow innovative investment strategies. Around 25 years ago, the derivatives market was

small and domestic. Since then it has grown impressively – around 24 percent per year in the

last decade – into a sizeable and truly global market with about €457 trillion of notional

amount outstanding. No other class of financial instruments has experienced as much

innovation. Product and technology innovation together with competition have fuelled the

impressive growth that has created many new jobs both at exchanges and intermediaries as

well as at related service providers.

As global leaders driving the market’s development, European derivatives players

today account for more than 20 percent of the European wholesale financial services sector’s

revenues and contribute 0.4 percent to total European GDP. Given the derivatives market’s

global nature, users can trade around the clock and make use of derivatives that offer

exposure to almost any “underlying” across all markets and asset classes. The derivatives

market is predominantly a professional wholesale market with banks, investment firms,

insurance companies and corporate as its main participants. There are two competing

segments in the derivatives market: the off-exchange or over-the-counter (OTC) segment and

the on-exchange segment. Only around 16 percent of the notional amount outstanding is

traded on exchanges.

From a customer perspective, on-exchange trading is approximately eight times less

expensive than OTC trading. By and large, the derivatives market is safe and efficient. Risks

are particularly well controlled in the exchange segment, where central counterparties (CCPs)

operate very efficiently and mitigate the risks for all market participants.

In this respect, derivatives have to be distinguished from e.g. structured credit linked

security such as collateralized debt obligations that triggered the financial crisis in 2007. The

derivatives market has successfully developed under an effective regulatory regime. All three

prerequisites for a well-functioning market – safety, efficiency and innovation – are fulfilled.

While there is no need for structural changes in the framework under which OTC players and

exchanges operate today, improvements are possible. Particularly in the OTC segment,

increasing operating efficiency, market transparency and enhancing counterparty risk

mitigation would help the global derivatives market to function even more effectively.

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TABLE OF CONTENTS

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Sr. No. Topics Page No.

1 Introduction 1

1.1 A Study on derivatives 1

1.2 Objectives of study 1

1.3 Need of the study 2

1.4 Scope of the study 2

1.5 Limitations of the study 3

2 Stock Exchange 4

2.1 Regulations of Stock Exchange 5

2.2 Securities and Exchange Board of India 5

2.3 Bombay Stock Exchange 6

2.4 National Stock Exchange 7

2.5 List of Stock Exchanges 9

3 Derivatives 11

3.1 Definition 12

3.2 Participants in the Derivatives Market 12

3.3 Functions of the Derivatives Market 13

3.4 Types of Derivatives 14

3.5 Derivatives Instruments in India 16

3.6 Derivatives Segment in BSE & NSE 16

3.7 Contract Period 17

3.8 Settlement 17

3.9 Regulations for Derivatives Trading 17

4 Futures 21

4.1 Stock Index Futures 21

4.2 Futures Terminology 22

4.3 Pay-off for Futures 24

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1 INTRODUCTION

1.1 A STUDY ON DERIVATIVES:

The only stock exchanges operating in the 19th century were those of Bombay set up

in 1875 and Ahmadabad set up in 1894. These were organized as voluntary non-profit-

making association of brokers to regulate and protect their interests. Before the control on

securities trading became a central subject under the constitution in 1950, it was a state

subject and the Bombay securities contracts (control) Act of 1925 used to regulate trading in

securities. Under this Act, The Bombay stock exchange was recognized in 1927 and

Ahmedabad in 1937.

During the war boom, a number of stock exchanges were organized even in Bombay,

Ahmedabad and other centers, but they were not recognized. Soon after it became a central

subject, central legislation was proposed and a committee headed by A.D.Gorwala went into

the bill for securities regulation. On the basis of the committee's recommendations and public

discussion, the securities contracts (regulation) Act became law in 1956.

1.2 OBJECTIVES OF STUDY:

1. To study various trends in derivative market.

2. Comparison of the profits/losses in cash market and derivative market.

3. To study in detail the role of the future and options.

4. To study the role of derivatives in Indian financial market.

1.3 NEED OF THE STUDY

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Different investment avenues are available investors. Stock market also offers

good investment opportunities to the investor alike all investments, they also carry certain

risks. The investor should compare the risk and expected yields after adjustment off tax

on various instruments while talking investment decision the investor may seek advice

from ex-party and consultancy include stock brokers and analysts while making

investment decisions. The objective here is to make the investor aware of the functioning

of the derivatives.

Derivatives act as a risk hedging tool for the investors. The objective if to help the

investor in selecting the appropriate derivates instrument to the attain maximum risk and

to construct the portfolio in such a manner to meet the investor should decide how best to

reach the goals from the securities available.

To identity investor objective constraints and performance, which help formulate the

investment policy?

The develop and improvement strategies in the with investment policy formulated. They

will help the selection of asset classes and securities in each class depending up on their

risk return attributes.

1.4 SCOPE OF THE STUDY

The study is limited to “Derivatives” with special reference to futures and options in

the Indian context; the study is not based on the international perspective of derivative

markets.

The study is limited to the analysis made for types of instruments of derivates each

strategy is analyzed according to its risk and return characteristics and derivatives

performance against the profit and policies of the company.

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1.5 LIMITATION OF THE STUDY

The subject of derivates if vast it requires extensive study and research to understand

the dept of the various instrument operating in the market only a recent plenomore. But

various international examples have also been added to make the study more comfortable.

There are various other factors also which define the risk and return preferences of an

investor however the study was only contained towards the risk maximization and profit

maximization objective of the investor.

The derivative market is a dynamic one premiums, contract rates strike price fluctuate

on demand and supply basis. Therefore data related to last few trading months was only

consider and interpreted.

2 STOCK EXCHANGE

"Stock exchange means anybody or individuals whether incorporated or not,

constituted for the purpose of assisting, regulating or controlling the business of buying,

selling or dealing in securities."

It is an association of member brokers for the purpose of self-regulation and

protecting the interests of its members. It can operate only if it is recognized by the

Government under the securities contracts (regulation) Act, 1956. The recognition is granted

under section 3 of the Act by the central government, Ministry of Finance.

BYLAWS:

Besides the above act, the securities contracts (regulation) rules were also made in

1957 to regulate certain matters of trading on the stock exchanges. There are also bylaws of

the exchanges, which are concerned with the following subjects.

Opening/closing of the stock exchanges, timing of trading, regulation of blank transfers,

regulation of badla or carryover business, control of the settlement and other activities of the

stock exchange, fixation of margins, fixation of market prices or making up prices, regulation

of taravani business (jobbing), etc., regulation of brokers trading, brokerage charges, trading

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Rizvi Academy of Management Ankit Gupta

rules on the exchange, arbitration and settlement of disputes, settlement and clearing of the

trading etc.

2.1 REGULATION OF STOCK EXCHANGES:

The securities contracts (regulation) act is the basis for operations of the stock

exchanges in India. No exchange can operate legally without the government permission or

recognition. Stock exchanges are given monopoly in certain areas under section 19 of the

above Act to ensure that the control and regulation are facilitated. Recognition can be granted

to a stock exchange provided certain conditions are satisfied and the necessary information is

supplied to the government. Recognition can also be withdrawn, if necessary. Where there

are no stock exchanges, the government can license some of the brokers to perform the

functions of a stock exchange in its absence.

2.2 SECURITIES AND EXCHANGE BOARD OF INDIA(SEBI):

SEBI was set up as an autonomous regulatory authority by the Government of India in

1988 " to protect the interests of investors in securities and to promote the development of,

and to regulate the securities market and for matters connected therewith or incidental

thereto." It is empowered by two acts namely the SEBI Act, 1992 and the securities

contract(regulation)Act, 1956 to perform the function of protecting investor's rights and

regulating the capital markets.

2.3 BOMBAY STOCK EXCHANGE

This stock exchange, Mumbai, popularly known as "BSE" was established in 1875 as "

The Native share and stock brokers association", as a voluntary non-profit making

association. It has an evolved over the years into its present status as the premiere stock

exchange in the country. It may be noted that the stock exchanges the oldest one in Asia,

even older than the Tokyo Stock exchange which was founded in 1878.

The exchange, while providing an efficient and transparent market for trading in

securities, upholds the interests of the investors and ensures redressed of their grievances,

whether against the companies or its own member brokers. It also strives to educate and

enlighten the investors by making available necessary informative inputs and conducting

investor education programmes.

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A governing board comprising of 9 elected directors, 2 SEBI nominees, 7 public

representatives and an executive director is the apex body, which decides the policies and

regulates the affairs of the exchange. The Executive director as the chief executive officer is

responsible for the day today administration of the exchange.

BSE INDICES:

In order to enable the market participants, analysts etc., to track the various

ups and downs in the Indian stock market, the Exchange has introduced in 1986 an equity

stock index called BSE-SENSEX that subsequently became the barometer of the moments of

the share prices in the Indian stock market. It is a "Market capitalization-weighted" index of

30 component stocks representing a sample of large, well-established and leading companies.

The base year of Sensex is 1978-79. The Sensex is widely reported in both domestic and

international markets through print as well as electronic media.

Sensex is calculated using a market capitalization weighted method. As per this

methodology, the level of the index reflects the total market value of all 30-component stocks

from different industries related to particular base period. The total market value of a

company is determined by multiplying the price of its stock by the number of shares

outstanding. Statisticians call an index of a set of combined variables (such as price and

number of shares) a composite Index. An Indexed number is used to represent the results of

this calculation in order to make the value easier to work with and track over a time. It is

much easier to graph a chart based on Indexed values than one based on actual values world

over majority of the well-known Indices are constructed using “Market capitalization

weighted method ".

In practice, the daily calculation of SENSEX is done by dividing the aggregate market

value of the 30 companies in the Index by a number called the Index Divisor. The Divisor is

the only link to the original base period value of the SENSEX. The Divisor keeps the Index

comparable over a period of time and if the reference point for the entire Index maintenance

adjustments. SENSEX is widely used to describe the mood in the Indian Stock markets. Base

year average is changed as per the formula

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New base year average = Old base year average*(New market Value/old market value)

2.4 NATIONAL STOCK EXCHANGE

The NSE was incorporated in Nov 1992 with an equity capital of Rs. 25 crs. The

International securities consultancy (ISC) of Hong Kong has helped in setting up NSE. ISC

has prepared the detailed business plans and installation of hardware and software systems.

The promotions for NSE were financial institutions, insurances companies, banks and SEBI

capital market ltd, Infrastructure leasing and financial services ltd and stock holding

corporation ltd.

It has been set up to strengthen the move towards professionalization of the capital

market as well as provide nationwide securities trading facilities to investors.

NSE is not an exchange in the traditional sense where brokers own and manage the

exchange. A two tier administrative set up involving a company board and a governing

aboard of the exchange is envisaged.

NSE is a national market for shares PSU bonds, debentures and government securities

since infrastructure and trading facilities are provided.

NSE - NIFTY:

The NSE on April 22, 1996 launched a new equity Index. The NSE-50. The new

Index which replaces the existing NSE-100 Index is expected to serve as an appropriate Index

for the new segment of futures and options.“Nifty “means National Index for Fifty Stocks.

The NSE-50 comprises 50 companies that represent 20 broad Industry groups with an

aggregate market capitalization of around Rs. 1,70,000 crs. All companies included in the

Index have a market capitalization in excess of Rs 500 crs each and should have traded for

85% of trading days at an impact cost of less than 1.5%.

The base period for the index is the close of prices on Nov 3, 1995, which makes one

year of completion of operation of NSE’s capital market segment. The base value of the

Index has been set at 1000.

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NSE - MIDCAP INDEX:

The NSE midcap Index or the Junior Nifty comprises 50 stocks that represents 21 board

Industry groups and will provide proper representation of the midcap segment of the Indian

capital Market. All stocks in the Index should have market capitalization of greater than Rs.

200 crs and should have traded 85% of the trading days at an impact cost of less 2.5%.

The base period for the index is Nov 4, 1996, which signifies two years for completion

of operations of the capital market segment of the operations. The base value of the Index

has been set at 1000

At present, there are 24 stock exchanges recognized under the securities contract

(regulation) Act, 1956. They are

2.5 LIST OF STOCK EXCHANGES RECOGNIZED UNDER THE SECURITIES

CONTRACT (REGULATION) ACT, 1956

NAME OF THE STOCK EXCHANGE YEAR

Bombay stock exchange,

Ahmedabad share and stock brokers association

Calcutta stock exchange association Ltd,

Delhi stock exchange association Ltd,

Madras stock exchange association Ltd,

Indoor stock brokers association,

Bangalore stock exchange,

Hyderabad stock exchange,

Cochin stock exchange,

Pune stock exchange Ltd,

1875

1957

1957

1957

1957

1958

1963

1943

1978

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U.P stock exchange association Ltd,

Ludhiana stock exchange association Ltd,

Jaipur stock exchange Ltd,

Gauhathi stock exchange Ltd,

Mangalore stock exchange Ltd,

Maghad stock exchange Ltd, Patna,

Bhubaneswar stock exchange association Ltd,

Over the counter exchange of India, Bombay,

Saurasthra Kutch stock exchange Ltd,

Vsdodara stock exchange Ltd,

Coimbatore stock exchange Ltd,

The Meerut stock exchange Ltd,

National stock exchange Ltd,

Integrated stock exchange,

1982

1982

1983

1983-84

1984

1985

1986

1989

1989

1990

1991

1991

1991

1991,1999

3 DERIVATIVES

MEANING:

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

and options, can be traced back to the willingness of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. By their very

nature, the financial markets are marked very high degree of volatility. Through the use of

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

prices. As instruments of risk management, these generally do not influence the fluctuations

in the underlying asset prices. However, by locking-in asset prices, derivative products

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

of risk-averse investors.

Derivatives are risk management instruments, which derive their value from an

underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest

etc. Annual turnover of the derivatives is increasing each year from 1986 onwards,

Year Annual turnover

1986 146 millions

1992 453 millions

1998 1329 millions

2002 & 2003 it has reached to equivalent stage of cash market

Derivatives are used by banks, securities firms, companies and investors to hedge risks,

to gain access to cheaper money and to make profits Derivatives are likely to grow even at a

faster rate in future they are first of all cheaper to world have met the increasing volume of

products tailored to the needs of particular customers, trading in derivatives has increased

even in the over the counter markets. In Britain unit trusts allowed to invest in futures &

options .The capital adequacy norms for banks in the European Economic Community

demand less capital to hedge or speculate through derivatives than to carry underlying assets.

Derivatives are weighted lightly than other assets that appear on bank balance sheets. The

size of these off-balance sheet assets that include derivatives is more than seven times as

large as balance sheet items at some American banks causing concern to regulators

3.1 DEFINITION:

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

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

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

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines

“derivative” to include-

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

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

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

securities.

Derivatives are the securities under the SC(R)A and hence the trading of derivatives is

governed by the regulatory framework under the SC(R)A.

3.2 PARTICIPANTS IN THE DERIVATIVES MARKET

The following three broad categories of participants who trade in the derivatives market:

1. Hedgers

2. Speculators and

3. Arbitrageurs

Hedgers:

Hedgers face risk associated with the price of an asset. They use futures or options

markets to reduce or eliminate this risk.

Speculators:

Speculators wish to bet on future movements in the price of an asset. Futures and

Options contracts can give them an extra leverage; that is, they can increase both the potential

gains and potential losses in a speculative venture.

Arbitrageurs:

Arbitrageurs are in business to take advantage of a discrepancy between prices in two

different markets.

For example, they see the futures price of an asset getting out of line with the cash

price; they will take offsetting positions in the two markets to lock in a profit.

3.3 FUNCTIONS OF THE DERIVATIVES MARKET:

The derivatives market performs a number of economic functions. They are:

1. Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level.

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

the introduction of derivatives, the underlying market witnesses higher trading volumes

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because of participation by more players who would not otherwise participate for lack of

an arrangement to transfer risk.

3. Speculative trades shift to a more controlled environment of derivatives market. In the

absence of an organized derivatives market, speculators trade in the underlying cash

markets.

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

catalyst for new entrepreneurial activity.

5. Derivatives markets help increase savings and investment in the long run. Transfer of risk

enables market participants to expand their volume of activity.

3.4 TYPES OF DERIVATIVES

The most commonly used derivatives contracts are forwards, futures and

options. Here various derivatives contracts that have come to be used are given briefly:

1. Forwards

2. Futures

3. Options

4. Warrants

5. LEAPS

6. Baskets

7. Swaps

8. Swaptions

1. Forwards:

A forward contract is customized contract between two entities, where

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

2. Futures:

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

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

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

3. Options:

Options are of two types – calls and puts

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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 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.

4. Warrants:

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

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

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

5. Leaps:

The acronym LEAPS means Long-term Equity Anticipation Securities. These

are options having a maturity of up to three years.

6. Baskets:

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

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

basket options.

7. 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.

8. Swaptions:

Swaptions are options to buy or sell that will become operative at the expiry

of the options. Thus a swaption is an option on a forward swap. Rather than have calls

and puts, the swaptions markets has receiver swaptions and payer swaptions. A receiver

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

pay fixed and receive floating.

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3.5 DERIVATIVES INSTRUMENTS IN INDIA

The first derivative product to be introduced in the Indian securities market is going to be

"INDEX FUTURES". In the world, first index futures were traded in U.S. on Kansas City

Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982.

Organized exchanges began trading options on equities in 1973, whereas exchange traded

debt options did not appear until 1982, on the other hand fixed income futures began trading

in 1975, but equity related futures did not begin until 1982.

3.6 DERIVATIVES SEGMENT IN BSE & NSE

On June 9,2000 BSE & NSE became the first exchanges in India to introduce trading in

exchange traded derivative product with the launch of index futures on sense and Nifty

futures respectively.

Index futures was follows by launch of index options in June 2001, stock options in July

2001 and stock futures in Nov 2001.Presently stock futures and options available on 41 well-

capitalized and actively traded scripts mandated by SEBI.

Nifty is the underlying asset of the Index Futures at the Futures & Options segment of

NSE with a market lot of 200 and the BSE 30 Sensex is the underlying stock index with the

market lot of 50. This difference of market lot arises due to a minimum specification of a

contract value of Rs. 2 lakhs by Securities Exchange Board of India. A contract value is

contracting Index laid by its market lot. For e.g. If Sensex is 4730 then the contract value of a

futures Index having Sensex as underlying asset will Be 50 x 4730 = Rs. 2,36,500. Similarly

if Nifty is 1462.7, its futures contract value will be 200 x 1462.7 = Rs.2, 92,540/-.

Every transaction shall be in multiple of market lot. Thus, Index futures at NSE shall be

traded in multiples of 200 and at BSE in multiples of 50

3.7 CONTRACT PERIODS:

At any point of time there will always be available near three months contract periods.

For e.g. in the month of June 2009 one can enter into either June Futures contract or July

Futures contract or August Futures Contract. The last Thursday of the month specified in the

contract shall be the final settlement date for that contract at both NSE as well BSE. Thus

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June 29, July 27 and August 31 shall be the last trading day or the final settlement date for

June Futures contract, July Futures Contract and August Futures Contract respectively.

When one futures contract gets expired, a new futures contract will get introduced

automatically. For instance, on 30th June, June futures contract becomes invalidated and a

September Futures Contract gets activated.

3.8 SETTLEMENT:

Settlement of all Derivatives trades is in cash mode. There is Daily as well as

Final Settlement. Outstanding positions of a contract can remain open till the last Thursday of

that month. As long as the position is open, the same will be marked to Market at the Daily

Settlement Price, the difference will be credited or debited accordingly and the position shall

be brought forward to the next day at the daily settlement price. Any position which remains

open at the end of the final settlement day (i.e., last Thursday) shall be closed out by the

Exchange at the Final Settlement Price which will be the closing spot value of the underlying

(Nifty or Sensex, or respective stocks as the case may be).

3.9 REGULATION FOR DERIVATIVES TRADING:

SEBI set up a 24-member committee under Chairmanship of Dr.L.C. Gupta to

develop the appropriate regulatory framework for derivatives trading in India. The committee

submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of

the committee and approved the phased introduction of derivatives trading in India beginning

with stock index futures. SEBI also approved the “suggestive bye-laws” recommended by the

committee for regulation and control of trading and settlement of derivatives contracts.

The provisions in the SC(R) A and the regulatory framework developed there

under govern trading in securities. The amendment of the SC(R) A to include derivatives

within the ambit of ‘securities’ in the SC(R) A made trading in derivatives possible within the

framework of the Act.

1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee

report may apply to SEBI for grant of recognition under Section 4 of the SC(R) a, 1956 to

start trading derivatives. The derivatives exchange/segment should have a separate

governing council and representation of trading / clearing members shall be limited to

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maximum of 40% of the total members of the governing council. The exchange shall

regulate the sales practices of its members and will obtain approval of SEBI before start

of trading in any derivative contract

2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically become the

members of derivative segment. The members of the derivative segment need to fulfill the

eligibility conditions as laid down by the L C Gupta committee.

4. The clearing and settlement of derivatives trades shall be through a SEBI approved

clearing corporation / house. Clearing corporation / houses complying with the eligibility

conditions as laid down by the committee have to apply to SEBI for grant of approval.

5. Derivative brokers/dealers and clearing members are required to seek registration from

SEBI.

6. The minimum contract value shall not be less than Rs. 2 Lakh. Exchanges should also

submit details of the futures contract they propose to introduce.

7. The trading members are required to have qualified approved user and sales person who

have passed a certification programme approved by SEBI.

While from the purely regulatory angle, a separate exchange for trading would be a better

arrangement. Considering the constraints in infrastructure facilities, the existing stock (cash)

exchanges may also be permitted to trade derivatives subject to the following conditions.

I. Trading should take place through an on-line screen based trading system.

II. An independent clearing corporation should do the clearing of the derivative market.

III. The exchange must have an online surveillance capability, which monitors positions,

price and volumes in real time so as to deter market manipulation price and position

limits should be used for improving market quality.

IV. Information about trades quantities, and quotes should be disseminated by the exchange

in the real time over at least two information-vending networks, which are accessible to

investors in the country.

V. The exchange should have at least 50 members to start derivatives trading.

VI. The derivatives trading should be done in a separate segment with separate

membership; That is, all members of the cash market would not automatically become

members of the derivatives market.

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VII. The derivatives market should have a separate governing council which should not have

representation of trading by clearing members beyond whatever percentage SEBI may

prescribe after reviewing the working of the present governance system of exchanges.

VIII. The chairman of the governing council of the derivative division / exchange should be a

member of the governing council. If the chairman is broker / dealer, then he should not

carry on any broking or dealing on any exchange during his tenure.

IX. No trading/clearing member should be allowed simultaneously to be on the governing

council both derivatives market and cash market.

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4. FUTURES

Futures contract is a firm legal commitment between a buyer & seller in which

they agree to exchange something at a specified price at the end of a designated period of

time. The buyer agrees to take delivery of something and the seller agrees to make delivery.

4.1 STOCK INDEX FUTURES

Stock Index futures are the most popular financial futures, which have

been used to hedge or manage the systematic risk by the investors of Stock Market. They are

called hedgers who own portfolio of securities and are exposed to the systematic risk. Stock

Index is the apt hedging asset since the rise or fall due to systematic risk is accurately shown

in the Stock Index. Stock index futures contract is an agreement to buy or sell a specified

amount of an underlying stock index traded on a regulated futures exchange for a specified

price for settlement at a specified time future.

Stock index futures will require lower capital adequacy and margin

requirements as compared to margins on carry forward of individual scrips. The brokerage

costs on index futures will be much lower.

Savings in cost is possible through reduced bid-ask spreads where stocks are

traded in packaged forms. The impact cost will be much lower in case of stock index futures

as opposed to dealing in individual scrips. The market is conditioned to think in terms of the

index and therefore would prefer to trade in stock index futures. Further, the chances of

manipulation are much lesser.

The Stock index futures are expected to be extremely liquid given the

speculative nature of our markets and the overwhelming retail participation expected to be

fairly high. In the near future, stock index futures will definitely see incredible volumes in

India. It will be a blockbuster product and is pitched to become the most liquid contract in the

world in terms of number of contracts traded if not in terms of notional value. The advantage

to the equity or cash market is in the fact that they would become less volatile as most of the

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speculative activity would shift to stock index futures. The stock index futures market should

ideally have more depth, volumes and act as a stabilizing factor for the cash market.

However, it is too early to base any conclusions on the volume or to form any firm trend.

The difference between stock index futures and most other financial futures

contracts is that settlement is made at the value of the index at maturity of the contract.

4.2 FUTURES TERMINOLOGY

Contract Size

The value of the contract at a specific level of Index. It is

Index level * Multiplier.

Multiplier

It is a pre-determined value, used to arrive at the contract size. It

is the price per index point.

Tick Size

It is the minimum price difference between two quotes

of similar nature.

Contract Month

The month in which the contract will expire.

Expiry Day

The last day on which the contract is available for trading.

Open interest

Total outstanding long or short positions in the market at any specific point

in time. As total long positions for market would be equal to total short positions,

for calculation of open Interest, only one side of the contracts is counted.

Volume

No. Of contracts traded during a specific period of time. During a day, during

a week or during a month.

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Long position

Outstanding/unsettled purchase position at any point of time.

Short position

Outstanding/ unsettled sales position at any point of time.

Open position

Outstanding/unsettled long or short position at any point of time.

Physical delivery

Open position at the expiry of the contract is settled through delivery of the

underlying. In futures market, delivery is low.

Cash settlement

Open position at the expiry of the contract is settled in cash. These contracts

Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is

settled by two parties - one buyer and one seller, at the terms other than defined by the

exchange. Worldwide a significant portion of the energy and energy related contracts

(crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.

4.3 Pay off for futures:

A Pay off is the likely profit/loss that would accrue to a market participant with

change in the price of the underlying asset. Futures contracts have linear payoffs. In simple

words, it means that the losses as well as profits, for the buyer and the seller of futures

contracts, are unlimited.

Pay off for Buyer of futures: (Long futures)

The pay offs for a person who buys a futures contract is similar to the pay off

for a person who holds an asset. He has potentially unlimited upside as well as downside.

Take the case of a speculator who buys a two-month Nifty index futures contract when

the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the

index moves up, the long futures position starts making profits and when the index moves

down it starts making losses

Pay off for seller of futures: (short futures)

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The pay offs for a person who sells a futures contract is similar to the pay off

for a person who shorts an asset. He has potentially unlimited upside as well as downside.

Take the case of a speculator who sells a two-month Nifty index futures contract when

the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the

index moves down, the short futures position starts making profits and when the index

moves up it starts making losses.

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5.OPTIONS

An option agreement is a contract in which the writer of the option grants the buyer of

the option the right to purchase from or sell to the writer a designated instrument at a specific

price within a specified period of time.

Certain options are shorterm in nature and are issued by investors another group of

options are long-term in nature and are issued by companies.

5.1 OPTIONS TERMINOLOGY:

Call option:

A call is an option contract giving the buyer the right to purchase the stock.

Put option:

A put is an option contract giving the buyer the right to sell the stock.

Expiration date:

It is the date on which the option contract expires.

Strike price:

It is the price at which the buyer of a option contract can purchase or sell the

stock during the life of the option

Premium:

Is the price the buyer pays the writer for an option contract.

Writer:

The term writer is synonymous to the seller of the option contract.

Holder:

The term holder is synonymous to the buyer of the option contract.

Straddle:

A straddle is combination of put and calls giving the buyer the right to either

buy or sell stock at the exercise price.

Strip:

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A strip is two puts and one call at the same period.

Strap:

A strap is two calls and one put at the same strike price for the same period.

Spread:

A spread consists of a put and a call option on the same security for the same

time period at different exercise prices.

The option holder will exercise his option when doing so provides him a benefit

over buying or selling the underlying asset from the market at the prevailing price. These are

three possibilities.

1. In the money: An option is said to be in the money when it is

advantageous to exercise it.

2. Out of the money: The option is out of money if it not advantageous to exercise it.

3. At the money: IF the option holder does not lose or gain whether he exercises his

option or buys or sells the asset from the market, the option is said to be at the money. The

exchanges initially created three expiration cycles for all listed options and each issue was

assigned to one of these three cycles.

January, April, July, October.

February, March, August, November.

March, June, September, and December.

In India, all the F and O contracts whether on indices or individual stocks are

available for one or two or three months series and they expire on the Thursday of the

concerned month.

5.2 CALL OPTION:

An option that grants the buyer the right to purchase a designated instrument is

called a call option. A call option is a contract that gives its owner the right, but not the

obligation, to buy a specified price on or before a specified date. An American call option can

be exercised on or before the specified date only. European options can be exercised on the

specified date only.

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5.3 PUT OPTION:

An option contract giving the owner the right, but not the obligation, to sell a

specified amount of an underlying security at a specified price within a specified time. This is

the opposite of a call option, which gives the holder the right to buy shares.

A put becomes more valuable as the price of the underlying stock

depreciates relative to the strike price. For example, if you have one Mar 09 Taser 10 put, you

have the right to sell 100 shares of Taser at $10 until March 2008 (usually the third Friday of

the month). If shares of Taser fall to $5 and you exercise the option, you can purchase 100

shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each,

which means you make $500 (100 x ($10-$5)) on the put option. Note that the maximum

amount of potential profit in this example ignores the premium paid to obtain the put option.

5.4 FACTORS DETERMINIG OPTION VALUE:

Stock price

Strike price

Time to expiration

Volatility

Risk free interest rate

Dividend

5.5. DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES

1) Both the parties are obligated to perform.

OPTIONS

1) Only the seller (writer) is obligated to perform.

2) With options, the buyer pays the seller a

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2) With futures premium is paid by either party.

3) The parties to futures contracts must perform

at the settlement date only. They are not

obligated to perform before that date.

4) The holder of the contract is exposed to the

entire spectrum of downside risk and had the

potential for all upside return.

5) In futures margins to be paid. They are

approximate 15-20% on the current stock

price.

premium.

3) The buyer of an options contract can exercise

any time prior to expiration date.

4) The buyer limits the downside risk to the option

premium but retain the upside potential.

5) In options premiums to be paid. But they are

very less as compared to the margins.

5.6 Advantages of option trading:

Risk management: put option allow investors holding shares to hedge against a

possible fall in their value. This can be considered similar to taking out insurance

against a fall in the share price.

Time to decide: By taking a call option the purchase price for the shares is locked in.

This gives the call option holder until the Expiry day to decide whether or exercised

the option and buys the shares. Likewise the taker of a put option has time to decide

whether

or not to sell the shares.

Speculations: The ease of trading in and out of option position makes it possible to

trade options with no intention of ever exercising them. If investor expects the market

to rise, they may decide to buy call options. If expecting a fall, they may decide to buy

put options. Either way the holder can sell the option prior to expiry to take a profit or

limit a loss. Trading options has a lower cost than shares, as there is no stamp duty

payable unless and until options are exercised.

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Leverage: Leverage provides the potential to make a higher return from a smaller

initial outlay than investing directly however leverage usually involves more risks

than a direct investment in the underlying share. Trading in options can allow

investors to benefit from a change in the price of the share without having to pay of

the share.

5.7 Summary of options

Call option buyer Call option writer (seller)

Pays premium

Right to exercise and buy the share

Profits from rising prices

Limited losses, potentially

unlimited gain

Receives premium

Obligation to sell shares if exercised

Profits from falling prices or remaining

neutral

Potentially unlimited losses, limited

gain

Put option buyer Put option writer (seller)

Pays premium

Right to exercise and sell shares

Profits from falling prices

Limited losses, potentially

unlimited gain

Receives premium

Obligation to buy shares if exercised

Profits from rising prices or remaining

neutral

Potentially unlimited losses, limited

gain

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6. ABOUT SHAREKHAN

Sharekhan is one of India's largest and leading financial services companies. It is an

online stock trading company of SSKI Group (S.S. Kantilal Ishwarlal Securities Limited)

which has been a provider of India-based investment banking and corporate finance service

for over 80 years.SSKI caters to most of the prominent financial institutions, foreign and

domestic, investing in Indian equities. It has been valued for its strong research-led

investment ideas, superior client servicing track record and exceptional execution skills.

The key features of sharekhan are as follows:

You get freedom from paperwork.

There are instant credit and money transfer facilities.

You can trade from any net enabled PC.

After hour orders facilities.

You can go for online orders over the phone.

Timely advice and research reports

Real-time Portfolio tracking.

Information and Price alerts.

Sharekhan provides assistance and the advice like no one else could. It has created

special information tools to help answer any queries. Share khan’s first step program, built

specifically for new investors, is testament to of its commitment to being your guide

throughout your investing life cycle.

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6.1 SHAREKHAN SERVICES:

The tag line of Sharekhan says that it is your guide to the financial jungle. As per the

tag line there are many amazing services that Sharekhan offers like technical research,

fundamental research, share shops, portfolio management, dial-n-trade, commodities trade,

online services, depository services, equity and derivatives trading (including currency

trading). With Share khan’s online trading account, you can buy and sell shares at anytime

and from anywhere you like.

With a physical presence in over 300 cities of India through more than 800 "Share

Shops" with more than 3000 employees, and an online presence through Sharekhan.com,

India's premier, it reaches out to more than 8, 00,000 trading customers.

A Sharekhan outlet online destination offers the following services:

Online BSE and NSE executions (through BOLT & NEAT terminals)

Free access to investment advice from Share khan’s Research team

Sharekhan Value Line (a monthly publication with reviews of recommendations,

stocks to watch out for etc)

Daily research reports and market review (High Noon & Eagle Eye)

Pre-market Report (Morning Cuppa)

Daily trading calls based on Technical Analysis

Cool trading products (Daring Derivatives and Market Strategy)

Personalized Advice

Live Market Information

Depository Services: Demat Transactions

Derivatives Trading (Futures and Options)

Commodities Trading

IPOs & Mutual Funds Distribution

Internet-based Online Trading: Speed Trade

Sharekhan has one of the best state-of-art web portals providing fundamental and

statistical information across equity, mutual funds and IPOs. Surfing can be done across

5,500 companies for in-depth information, details about more than 1,500 mutual fund

schemes and IPO data. Other market related details such as board meetings, result

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announcements, FII transactions, buying/selling by mutual funds and much more can also be

accessed.

It provides a complete life-cycle of investment solution in Equities, Derivatives,

Commodities, IPO, Mutual Funds, Depository Services, Portfolio Management Services and

Insurance. It also offers personalized wealth management services for High Net worth

individuals.

6.2 ONLINE SERVICES

The online trading account can be chosen as per trading habits and preferences, that is

the classic account for most investors and speed trade for active day traders. Sharekhan also

provides a free software called “Trade tiger” to all its account holders.

The Classic Account enables you to trade online for investing in Equities and

Derivatives on the NSE via sharekhan.com; it gives access to all the research content and also

comes with a free Dial-n-Trade service enabling to buy shares using the telephone.

Its features are:

Streaming quotes (using the applet based system)

Multiple watch lists

Integrated Banking, demat and digital contracts

Instant credit and transfer

Real-time portfolio tracking with price alerts and, of course, the assurance of secure

transactions

The Trade Tiger is a next-generation online trading product that brings the power of

the broker's terminal to your PC. It's the perfect trading platform for active day traders. Its

features are:

A single platform for multiple exchange BSE & NSE (Cash & F&O), MCX, NCDEX,

Mutual Funds, IPO’s

Multiple Market Watch available on Single Screen

Multiple Charts with Tick by Tick Intraday and End of Day Charting powered with

various Studies

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Graph Studies include Average, Band- Bollinger, Know Sure Thing, MACD, RSI,

etc

Apply studies such as Vertical, Horizontal, Trend, Retracement & Free lines

User can save his own defined screen as well as graph template, that is, saving the

layout for future use

User-defined alert settings on an input Stock Price trigger

Tools available to gauge market such as Tick Query, Ticker, Market Summary,

Action Watch, Option Premium Calculator, Span Calculator

Shortcut key for FAST access to order placements & reports

Online fund transfer activated with 12 Banks

Sharekhan provides you the facility to trade in Commodities through Sharekhan

Commodities Pvt. Ltd. a wholly owned subsidiary of its parent SSKI. It trades on two

major commodity exchanges of the country:

Multi Commodity Exchange of India Ltd, Mumbai (MCX) and

National Commodity and Derivative Exchange, Mumbai (NCDEX).

For trading in any commodity, initial margin of around 10% on any commodity is to

be maintained. Sharekhan has launched its own commodity derivatives micro-site. The site is

available through the Sharekhan home page www.sharekhan.com. Along with the site

Sharekhan has launched several commodity derivatives products (both research and trading)

too. The products have been listed below:

Commodities Buzz: a daily view on precious metals and agro commodities.

Commodities Beat: a summary of the days trading activity.

Traders Corner: Under commodity trading calls, there are two types of trading calls:

Rapid Fire: (short-term calls for 1 day to 5 days updated daily)

Medium-term Plays: (medium-term calls for 1 month to 3 months

updated weekly or in between if needed)

Share khan Xclusive: the commodity research reports and analyses (periodical).

Market Scan: the daily commodity market data and statistics (end of day).

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All these products are both e-mailed as newsletters and published on the commodity

derivatives site.

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7. BIBLIOGRAPHY

www.rbi.org.in

www.sebi.gov.in/faq/ derivatives faq.html

Finance.indiamart.com/markets/commodity/derivatives.html

Financial Management by Prasanna Chandra

S.N. Shridhar ( Financial management )

Derivatives markets (ICFAI)

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