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Hera Final

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    SESSION (2011-2013)








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    I would like to express my deep and sincere gratitude to Integral University for

    having provided me with the opportunity to do my project on such an interesting

    topic through their esteemed MBA program in which I have enrolled.

    The project was a great source of learning and a good experience as it

    made me aware of the Islamic business ethics and its relevance to the business

    in modern era.

    Though at the onset of ambitious project one always encounters

    certain difficulties in the beginning, however, overcoming these difficulties of the

    project as well as making it a success, greatly depends on the encouragement,

    inspiration, and help given by my Dean PROF. DR ZEESHAN AMIR and HOD

    MS. ASMA FAR00QUE through her invaluable guidance and help. I would also

    like to thank my guide MR. AMIT KUMAR GOEL for his unconditional support

    and guidance. I would also like to thank all faculty members for their continuous


    And finally I would like to thank God & my parents who inspired me a lotfor the successful completion of the project.



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    This is to certify that HERA JAMAL a student of MBA first year having Roll no: -

    1100122038, has completed her project report on the subject DERIVATIVES

    MARKET IN INDIA under my supervision and guidance.

    The behavior of the student during the project work was found to be

    highly appreciable and satisfactory.

    I wish her all the best for future.


    Asstt Prof.

    Faculty of Management and Research

    Integral University

    Lucknow- 226026



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    1. Executive Summary.....................................................................62. Introduction................................................................................103.





    Need of the Study......................................................................11

    Literature Review.......................................................................12

    Objective of the Study................................................................13Scope of the Study.....................................................................14

    Research Methodology...............................................................15

    Limitations of Study.....................................................................169. Main Topics of Study...................................................................17

    1) Introduction to Derivative2) Derivative Defined3) Types of Derivatives Market4) Types of Derivatives

    i) Forward Contracts

    ii) Future Contractsiii)



    Swap.5) Other Kinds of Derivatives.

    10. History of Derivatives...................................................................3311. Indian Derivative Market .......................36








    Need of Derivatives in India today

    Myths and realities about derivatives

    Derivatives increase speculation and do not serve any

    economic purpose

    Indian Market is not ready for derivative trading

    Comparison of New System with Existing System

    Exchange-traded vs. OTC derivatives markets

    Factors Contributing To The Growth Of Derivativesi) Price Volatility


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    Globalisation of Markets

    Technological Advancesiv) Advances in Financial Theories

    12. Development of Derivative Markets in India.........4813.






    Benefits of Derivatives..................................52

    Risk Management

    Price Discovery

    Operational Advantages

    Market Efficiency

    Easy to Speculation

    14. National Exchanges..................................................................5415.






    Findings & Conclusion..............................................................57

    Recommendations & Suggestions............................................58.

    Bibliography ......59


    Firstly I am briefing the current Indian market and comparing it with it past. I am

    also giving brief data about foreign market. Then at the last I am giving my

    suggestions and recommendations.


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

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

    exchanges (more than the number of companies listed in developed markets of

    Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.).

    The Indian capital market is significant in terms of the degree of development,

    volume of trading, transparency and its tremendous growth potential.

    Indias market capitalization was the highest among the emerging markets. Total

    market capitalization of The Bombay Stock Exchange (BSE), which, as on July

    31, 1997, was US$ 175 billion has grown by 37.5% percent every twelve months

    and was over US$ 834 billion as of January, 2007. Bombay Stock Exchanges

    (BSE), one of the oldest in the world, accounts for the largest number of listed

    companies transacting their shares on a nationwide online trading system. The

    two major exchanges namely the National Stock Exchange (NSE) and the

    Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the world, calculated by the

    number of daily transactions done on the exchanges.

    The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006

    An increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years

    only. Turnover in the Spot and Derivatives segment both in NSE & BSE was

    higher by 45% into 2006 as compared to 2005. With daily average volume of US

    $ 9.4 billion, the Sensex has posted excellent returns in the recent years.

    Currently the market cap of the Sensex as on July 4th, 2009 was Rs 48.4

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

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

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

    participants to manage risk in the modern securities trading are known as

    derivatives. The derivatives are defined as the future contracts whose valuedepends upon the underlying assets. If derivatives are introduced in the stock

    market, the underlying asset may be anything as component of stock market like,

    stock prices or market indices, interest rates, etc. The main logic behind

    derivatives trading is that derivatives reduce the risk by providing an additional


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    channel to invest with lower trading cost and it facilitates the investors to extend

    their settlement through the future contracts. It provides extra liquidity in the stock


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

    underlying assets are of various categories like

    Commodities including grains, coffee beans, etc.

    Precious metals like gold and silver.

    Foreign exchange rate.

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

    securities issued by governments, companies, etc.

    Short-term debt securities such as T-bills.

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


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

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

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

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

    called Hedging, which is a protection against losses resulting from unforeseen

    price or volatility changes. Thus, derivatives are a very important tool of risk


    There are various derivative products traded. They are;

    1. Forwards

    2. Futures

    3. Options

    4. Swaps


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

    upon a delivery of a specific quality and quantity of asset usually a commodity at

    a specified future date. The price may be agreed on in advance or in future.

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

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

    to the market place but it is fixed when the trade is made. The contract also has

    a standard specification so both parties know exactly what is being done.

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

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

    the Strike or Exercised price up until or an specified future date the Expirydate. The Price is called Premium and is paid by buyer of the option to the seller

    or writer of the option.

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

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

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


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

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

    fulfill the contract and is paid a price for this, which is called "the put option

    premium or put option price".

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

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

    settlement dates. They can be regarded as portfolios of forward's contracts. Acontract whereby two parties agree to exchange (swap) payments, based on

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

    payment flows are exchanged and not the principle amount


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

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

    derivative market in India is the most booming now days.

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

    invest in the derivative market.

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

    Also SEBI must encourage investment in derivative market so that the

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

    persons are not willing to invest in derivative market because they have the

    fear of high risk.

    So, SEBI should take necessary steps for improvement in Derivative Market

    so that more investors can invest in Derivative market.

    A Derivative is a financial instrument whose value depends on other, more

    basic, underlying variables. The variables underlying could be prices of traded

    securities and stock, prices of gold or copper.


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    Derivatives have become increasingly important in the field of finance,

    Options and Futures are traded actively on many exchanges, Forward

    contracts, Swap and different types of options are regularly traded outside

    exchanges by financial intuitions, banks and their corporate clients in what

    are termed as over-the-counter markets in other words, there is no single

    market place or organized exchanges.


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    The study has been done to know the different types of derivatives and also

    to know the derivative market in India. This study also covers the recent

    developments in the derivative market taking into account the trading in past


    Through this study I came to know the trading done in derivatives and their

    use in the stock markets.


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

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

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

    fluctuations in the underlying asset prices. However, by locking-in asset prices,

    derivative products minimize the impact of fluctuations in asset prices on theprofitability and cash flow situation of risk-averse investors.

    Derivative products initially emerged, as hedging devices against fluctuations in

    commodity prices and commodity-linked derivatives remained the sole form of

    such products for almost three hundred years. The financial derivatives came

    into spotlight in post-1970 period due to growing instability in the financial

    markets. However, since their emergence, these products have become very

    popular and by 1990s, they accounted for about two-thirds of total transactions in

    derivative products. In recent years, the market for financial derivatives has

    grown tremendously both in terms of variety of instruments available, their

    complexity and also turnover. In the class of equity derivatives, futures and

    options on stock indices have gained more popularity than on individual stocks,

    especially among institutional investors, who are major users of index-linked


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

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

    index derivatives vis-vis derivative products based on individual securities is

    another reason for their growing use.

    As in the present scenario, Derivative Trading is fast gaining momentum,

    I have chosen this topic.


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    To understand the concept of the Derivatives and Derivative Trading.

    To know different types of Financial Derivatives

    To know the role of derivatives trading in India.

    To analyse the performance of Derivatives Trading since 2001with special

    reference to Futures & Options


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

    understanding various strategies with different situations and actions have

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

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

    of derivatives done in the National Stock Markets.


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    Method of data collection:-

    Secondary sources:-

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

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

    been collected from various sources:



    Magazines Internet sources


    3 months

    Statistical Tools Used:

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


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

    topic had a limited time.


    Limited resources are available to collect the information about the

    commodity trading.


    Share market is so much volatile and it is difficult to forecast any thing about itwhether you trade through online or offline


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


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    The origin of derivatives can be traced back to the need of farmers to protectthemselves against fluctuations in the price of their crop. From the time it was

    sown to the time it was ready for harvest, farmers would face price uncertainty.

    Through the use of simple derivative products, it was possible for the farmer to

    partially or fully transfer price risks by locking-in asset prices. These were simple

    contracts developed to meet the needs of farmers and were basically a means of

    reducing risk.

    A farmer who sowed his crop in June faced uncertainty over the price he

    would receive for his harvest in September. In years of scarcity, he would

    probably obtain attractive prices. However, during times of oversupply, he would

    have to dispose off his harvest at a very low price. Clearly this meant that the

    farmer and his family were exposed to a high risk of price uncertainty.

    On the other hand, a merchant with an ongoing requirement of grains too

    would face a price risk that of having to pay exorbitant prices during dearth,

    although favourable prices could be obtained during periods of oversupply.

    Under such circumstances, it clearly made sense for the farmer and the

    merchant to come together and enter into contract whereby the price of the grain

    to be delivered in September could be decided earlier. What they would then

    negotiate happened to be futures-type contract, which would enable both parties

    to eliminate the price risk.

    In 1848, the Chicago Board Of Trade, or CBOT, was established to bring

    farmers and merchants together. A group of traders got together and created the

    to-arrive contract that permitted farmers to lock into price upfront and deliver the

    grain later. These to-arrive contracts proved useful as a device for hedging and


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    speculation on price charges. These were eventually standardized, and in 1925

    the first futures clearing house came into existence.

    Today derivatives contracts exist on variety of commodities such as corn,

    pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also

    exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.


    A derivative is a product whose value is derived from the value of one or more

    underlying variables or assets in a contractual manner. The underlying asset can

    be equity, forex, commodity or any other asset. In our earlier discussion, we saw

    that wheat farmers may wish to sell their harvest at a future date to eliminate the

    risk of change in price by that date. Such a transaction is an example of a

    derivative. The price of this derivative is driven by the spot price of wheat which

    is the underlying in this case.

    The Forwards Contracts (Regulation) Act, 1952, regulates the

    forward/futures contracts in commodities all over India. As per this the Forward

    Markets Commission (FMC) continues to have jurisdiction over commodity

    futures contracts. However when derivatives trading in securities was introducedin 2001, the term security in the Securities Contracts (Regulation) Act, 1956

    (SCRA), was amended to include derivative contracts in securities.

    Consequently, regulation of derivatives came under the purview of Securities

    Exchange Board of India (SEBI). We thus have separate regulatory authorities

    for securities and commodity derivative markets.

    Derivatives are securities under the SCRA and hence the trading of

    derivatives is governed by the regulatory framework under the SCRA. The

    Securities Contracts (Regulation) Act, 1956 defines derivative to include-

    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 prices, of

    underlying securities.


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    Future Option Forward Swaps


    Exchange Traded Derivatives Over The Counter Derivatives

    National Stock Bombay Stock National Commodity &Exchange Exchange Derivative Exchange

    Index Future Index option Stock option Stock future

    Figure.1 Types of Derivatives Market


    Figure.2 Types of Derivatives


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

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

    position and agrees to buy the underlying asset on a certain specified future

    date for a certain specified price. The other party assumes a short position

    and agrees to sell the asset on the same date for the same price. Other

    contract details like delivery date, price and quantity are negotiated bilaterally

    by the parties to the contract. The forward contracts are n o r m a l l y traded

    outside the exchanges.


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

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

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

    The contract price is generally not available in public domain.

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


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

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

    However forward contracts in certain markets have become very

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

    transaction costs and increasing transactions volume. This process of

    standardization reaches its limit in the organized futures market. Forward

    contracts are often confused with futures contracts. The confusion is

    primarily because both serve essentially the same economic functions

    of allocating risk in the presence of future price uncertainty. However futures

    are a significant improvement over the forward contracts as they

    eliminate counterparty risk and offer more liquidity.


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

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

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

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

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

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


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

    which differs from an options contract, which gives the buyer the right, but not theobligation, and the option writer (seller) the obligation, but not the right. To exit

    the commitment, the holder of a futures position has to sell his long position or

    buy back his short position, effectively closing out the futures position and its

    contract obligations. Futures contracts are exchange traded derivatives. The

    exchange acts as counterparty on all contracts, sets margin requirements, etc.


    Futures contracts ensure their liquidity by being highly standardized, usually by


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

    short term interest rate.

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

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

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

    currency, the notional amount of the deposit over which the short term

    interest rate is traded, etc.


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    The currency in which the futures contract is quoted.

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

    can be delivered. In case of physical commodities, this specifies not only

    the quality of the underlying goods but also the manner and location of

    delivery. The delivery month.

    The last trading date.

    Other details such as the tick, the minimum permissible price fluctuation.

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

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

    and creates a credit risk to the exchange, who always acts as counterparty. To

    minimize this risk, the exchange demands that contract owners post a form of

    collateral, commonly known as Margin requirements are waived or reduced in

    some cases for hedgers who have physical ownership of the covered commodity

    or spread traders who have offsetting contracts balancing the position.

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

    contract, as determined by historical price changes, which is not likely to be

    exceeded on a usual day's trading. It may be 5% or 10% of total contract price.

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

    exhaust the initial margin, a further margin, usually called variation or

    maintenance margin, is required by the exchange. This is calculated by the

    futures contract, i.e. agreeing on a price at the end of each day, called the

    "settlement" or mark-to-market price of the contract.

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

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

    to protect the exchange against loss. At the end of every trading day, the contract

    is marked to its present market value. If the trader is on the winning side of a

    deal, his contract has increased in value that day, and the exchange pays this

    profit into his account. On the other hand, if he is on the losing side, the


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    exchange will debit his account. If he cannot pay, then the margin is used as the

    collateral from which the loss is paid.

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

    two ways, as specified per type of futures contract:

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

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

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

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

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

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

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

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

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

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

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

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

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

    the t forward contract.

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

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

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

    expected future value of the underlying discounted at the risk free rate. Thus, for

    a simple, non-dividend paying asset, the value of the future/forward, , will

    be found by discounting the present value at time to maturity by the rate

    of risk-free return .


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    This relationship may be modified for storage costs, dividends, dividend yields,

    and convenience yields. Any deviation from this equality allows for arbitrage as


    In the case where the forward price is higher:

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

    (on the spot market) with borrowed money.

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

    receives the agreed forward price.

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

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

    In the case where the forward price is lower:

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

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

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

    appreciated at the risk free rate.

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

    the matured investment. [If he was short the underlying, he returns it now.]

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


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    TABLE 1-





    Traded directly between

    two parties (not traded on

    the exchanges).

    Traded on the exchanges.



    Differ from trade to trade. Contracts are standardized




    Exists. Exists. However, assumed by the

    clearing corp., which becomes the

    counter party to all the trades or

    unconditionally guarantees their




    Low, as contracts are

    tailor made contracts

    catering to the needs ofthe 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


    Examples Currency market in India. Commodities, futures, Index Futures

    and Individual stock Futures in India.


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

    obligation to buy or sell the underlying asset at a price, called the strike price,

    during a period or on a specific date in exchange for payment of a premium isknown as option. Underlying asset refers to any asset that is traded. The price

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

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


    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.


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

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

    date is known as a Put option. The owner makes a profit provided he buys at a

    lower current price and sells at a higher future price. Hence, no option will be

    exercised if the future price does not increase.

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

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


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    SWAPS -

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

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

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

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

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

    payment flows are exchanged and not the principle amount. The two commonly

    used swaps are:

    -12 19-Apr-12 13-Apr-12 21-Mar-12 21-Apr-11

    Rate RateChg








    Interest Rate Swaps - ISDA Mid-Market Par Swap Rates

    1-Year 0.51% 0.51% - 0.50% +1 0.52% -1 0.40% +11

    2-Year 0.57% 0.57% - 0.56% +1 0.65% -8 0.85% -28

    3-Year 0.69% 0.69% - 0.70% -1 0.85% -16 1.40% -71

    4-Year 0.90% 0.90% - 0.92% -2 1.14% -24 1.88% -98

    5-Year 1.14% 1.14% - 1.17% -3 1.43% -29 2.30% -116

    7-Year 1.60% 1.60% - 1.65% -5 1.94% -34 2.92% -132

    10-Year 2.08% 2.09% -1 2.15% -7 2.43% -35 3.47% -139

    30-Year 2.82% 2.85% -3 2.91% -9 3.16% -34 4.21% -139


    Interest rate swaps is an arrangement by which one party agrees to exchange

    his series of fixed rate interest payments to a party in exchange for his variable

    rate interest payments. The fixed rate payer takes a short position in the forward

    contract whereas the floating rate payer takes a long position in the forward



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    Currency swaps is an arrangement in which both the principle amount and the

    interest on loan in one currency are swapped for the principle and the interestpayments on loan in another currency. The parties to the swap contract of

    currency generally hail from two different countries. This arrangement allows the

    counter parties to borrow easily and cheaply in their home currencies. Under a

    currency swap, cash flows to be exchanged are determined at the spot rate at a

    time when swap is done. Such cash flows are supposed to remain unaffected by

    subsequent changes in the exchange rates.


    Financial swaps constitute a funding technique which permit a borrower toaccess one market and then exchange the liability for another type of liability. It

    also allows the investors to exchange one type of asset for another type of asset

    with a preferred income stream.

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


    Baskets options are option on portfolio of underlying asset. Equity Index Options

    are most popular form of baskets.


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    LEAPS -

    Normally option contracts are for a period of 1 to 12 months. However,

    exchange may introduce option contracts with a maturity period of 2-3 years.These long-term option contracts are popularly known as Leaps or Long term

    Equity Anticipation Securities.


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

    options exchanges having a maximum maturity of nine months. Longer-datedoptions are called warrants and are generally traded over-the-counter.


    Swap options are options to buy or sell a swap that will become operative at the

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

    Rather than have calls and puts, the swap options market has receiver swapoptions and payer swap options. A receiver swap options is an option to receive

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



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    Business Growth in Derivatives segment (NSE)

    TABLE 11A Index futures

    FIGURE 11A Number of contracts per year

    Year No. of contracts

    2011-12 4116649

    2010-11 156598579

    2009-10 81487424

    2008-09 58537886

    2007-08 21635449

    2006-07 17191668

    2005-06 2126763

    2004-05 1025588


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    INTERPRETATION: From the data and the bar diagram above, there is highbusiness growth in the derivative segment in India. In the year 2006-07, thenumber of contracts in Index Future were 1025588 where as a significantincrease of 4116679 is observed in the year 2011-12.


    Year No. of contracts

    2011-12 51449737

    2010-11 203587952

    2009-10 104955401

    2008-09 80905493

    2007-08 47043066

    2006-07 32368842

    2005-06 10676843

    2004-05 1957856


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    FIGURE 12A Number of contracts per year in stock future


    From the data and bar diagram above there were no stock futures available but

    in the year 2004-05, it predominently increased to 1957856. Then there was a

    huge increase of 20, 35, and 87,952 in the year 2007-08 but there was a steady

    decline to 51449737 in the year 2011-12.


    Year No. of contracts

    2011-12 24008627


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    2010-11 55366038

    2009-10 25157438

    2008-09 12935116

    2008-07 3293558

    2007-06 17324142006-07 442241

    2005-06 175900

    FIGURE 13A Number of contracts per year


    From the data and bar chart above, the no of contracts of index option was nil in

    the year 2005-2006. But there was a predominant increase of 1,75,900 in the

    year 2005-2006. In the year 2010-2011 there was a huge increase in the index

    option contracts to 55366038 and a decline of 24008627 in the year 2011-2012.


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    The history of derivatives is quite colourful and surprisingly a lot longer than most

    people think. Forward delivery contracts, stating what is to be delivered for afixed price at a specified place on a specified date, existed in ancient Greece and

    Rome. Roman emperors entered forward contracts to provide the masses with

    their supply of Egyptian grain. These contracts were also undertaken between

    farmers and merchants to eliminate risk arising out of uncertain future prices of

    grains. Thus, forward contracts have existed for centuries for hedging price risk.

    The first organized commodity exchange came into existence

    in the early 1700s in Japan. The first formal commodities exchange, the Chicago

    Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem

    of credit risk and to provide centralised location to negotiate forward contracts.

    From forward trading in commodities emerged the commodity futures. The first

    type of futures contract was called to arrive at. Trading in futures began on the

    CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives

    contract, known as the futures contracts. Futures trading grew out of the need for

    hedging the price risk involved in many commercial operations. The Chicago

    Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it

    did exist before in 1874 under the names of Chicago Produce Exchange (CPE)

    and Chicago Egg and Butter Board (CEBB). The first financial futures to emerge

    were the currency in 1972 in the US. The first foreign currency futures were

    traded on May 16, 1972, on International Monetary Market (IMM), a division of

    CME. The currency futures traded on the IMM are the British Pound, the

    Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the

    Australian Dollar, and the Euro dollar. Currency futures were followed soon byinterest rate futures. Interest rate futures contracts were traded for the first time

    on the CBOT on October 20, 1975. Stock index futures and options emerged in

    1982. The first stock index futures contracts were traded on Kansas City Board of

    Trade on February 24, 1982.The first of the several networks, which offered a


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    trading link between two exchanges, was formed between the Singapore

    International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

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

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

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

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

    and dealers traded in tulip bulb options. There was so much speculation that

    people even mortgaged their homes and businesses. These speculators were

    wiped out when the tulip craze collapsed in 1637 as there was no mechanism to

    guarantee the performance of the option terms.

    The first call and put options were invented by an American

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

    Agricultural commodities options were traded in the nineteenth century in

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

    counter (OTC) market only until 1973 without much knowledge of valuation. A

    group of firms known as Put and Call brokers and Dealers Association was set

    up in early 1900s to provide a mechanism for bringing buyers and sellers


    On April 26, 1973, the Chicago Board options Exchange

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

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

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

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

    becoming increasingly popular, the American Stock Exchange (AMEX) and the

    Philadelphia Stock Exchange (PHLX) began trading in options in 1975.

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

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

    introduction of floating rates for currencies in the international financial markets


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    paved the way for development of a number of financial derivatives which served

    as effective risk management tools to cope with market uncertainties.

    The CBOT and the CME are two largest financial exchanges in the world on

    which futures contracts are traded. The CBOT now offers 48 futures and option

    contracts (with the annual volume at more than 211 million in 2001).The CBOE is

    the largest exchange for trading stock options. The CBOE trades options on the

    S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the

    premier exchange for trading foreign options.

    The most traded stock indices include S&P 500, the Dow Jones

    Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the

    Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago

    Mercantile Exchange.


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    Starting from a controlled economy, India has moved towards a world where

    prices fluctuate every day. The introduction of risk management instruments in

    India gained momentum in the last few years due to liberalisation process andReserve Bank of Indias (RBI) efforts in creating currency forward market.

    Derivatives are an integral part of liberalisation process to manage risk. NSE

    gauging the market requirements initiated the process of setting up derivative

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

    Table 2. Chronology of instruments

    1991 Liberalisation process initiated14 December 1995 NSE asked SEBI for permission to trade index futures.

    18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy

    framework for index futures.11 May 1998 L.C.Gupta Committee submitted report.7 July 1999 RBI gave permission for OTC forward rate agreements

    (FRAs) and interest rate swaps.24 May 2000 SIMEX chose Nifty for trading futures and options on an

    Indian index.25 May 2000 SEBI gave permission to NSE and BSE to do index

    futures trading.

    9 June 2000 Trading of BSE Sensex futures commenced at BSE.12 June 2000 Trading of Nifty futures commenced at NSE.25 September


    Nifty futures trading commenced at SGX.

    2 June 2001 Individual Stock Options & Derivatives

    (1) Need for derivatives in India today

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

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

    become part and parcel of the day-to-day life for ordinary people in major part of


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    the world.

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

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

    was a huge gap between the investors aspirations of the markets and the

    available means of trading. The opening of Indian economy has precipitated the

    process of integration of Indias financial markets with the international financial

    markets. Introduction of risk management instruments in India has gained

    momentum in last few years thanks to Reserve Bank of Indias efforts in allowing

    forward contracts, cross currency options etc. which have developed into a very

    large market.

    (2) Myths and realities about derivatives

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

    become the most important markets in the world. Financial derivatives came into

    the spotlight along with the rise in uncertainty of post-1970, when US announced

    an end to the Bretton Woods System of fixed exchange rates leading to

    introduction of currency derivatives followed by other innovations including stock

    index futures. Today, derivatives have become part and parcel of the day-to-day

    life for ordinary people in major parts of the world. While this is true for many

    countries, there are still apprehensions about the introduction of derivatives.

    There are many myths about derivatives but the realities that are different

    especially for Exchange traded derivatives, which are well regulated with all the

    safety mechanisms in place.

    What are these myths behind derivatives?

    Derivatives increase speculation and do not serve any economic purpose

    Indian Market is not ready for derivative trading

    Disasters prove that derivatives are very risky and highly leveragedinstruments.

    Derivatives are complex and exotic instruments that Indian investors will

    find difficulty in understanding

    Is the existing capital market safer than Derivatives?


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    (i) Derivatives increase speculation and do not serve any


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

    the private and public sectors that derivatives provide numerous and substantialbenefits to the users. Derivatives are a low-cost, effective method for users to

    hedge and manage their exposures to interest rates, commodity prices or

    exchange rates. The need for derivatives as hedging tool was felt first in the

    commodities market. Agricultural futures and options helped farmers and

    processors hedge against commodity price risk. After the fallout of Bretton wood

    agreement, the financial markets in the world started undergoing radical

    changes. This period is marked by remarkable innovations in the financial

    markets such as introduction of floating rates for the currencies, increased

    trading in variety of derivatives instruments, on-line trading in the capital markets,

    etc. As the complexity of instruments increased many folds, the accompanying

    risk factors grew in gigantic proportions. This situation led to development

    derivatives as effective risk management tools for the market participants.

    Looking at the equity market, derivatives allow corporations and institutional

    investors to effectively manage their portfolios of assets and liabilities through

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

    reduce its exposure to the stock market quickly and at a relatively low cost

    without selling off part of its equity assets by using stock index futures or index


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

    managing risks and raising capital, derivatives improve the allocation of credit

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

    formation and stimulating economic growth. Now that world markets for trade and

    finance have become more integrated, derivatives have strengthened these

    important linkages between global markets, increasing market liquidity and


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    efficiency and facilitating the flow of trade and finance

    (ii) Indian Market is not ready for derivative trading

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

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

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

    market fares:

    TABLE 3.

    PRE-REQUISITES INDIAN SCENARIOLarge marketCapitalisation

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

    High Liquidity in theunderlying

    The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which meanson an average every month 14% of the countrysMarket capitalisation gets traded. These are clearindicators of high liquidity in the underlying.

    Trade guarantee The first clearing corporation guaranteeing tradeshas become fully functional from July 1996 in theform of National Securities Clearing Corporation(NSCCL). NSCCL is responsible for guaranteeing

    all open positions on the National Stock Exchange(NSE) for which it does the clearing.

    A Strong Depository National Securities Depositories Limited (NSDL)which started functioning in the year 1997 hasrevolutionalised the security settlement in ourcountry.

    A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital marketenjoys a strong, independent, and innovative legal

    guardian who is helping the market to evolve to ahealthier place for trade practices.

    (3) Comparison of New System with Existing System

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

    and banning of Badla is disadvantageous and introduced early, but I feel that this


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    new system is very useful especially to retail investors. It increases the no of

    options investors for investment. In fact it should have been introduced much

    before and NSE had approved it but was not active because of politicization in


    The figure 3.3a 3.3d shows how advantages of new system (implemented from

    June 20001) v/s the old system i.e. before June 2001

    New System Vs Existing System for Market Players


    Existing SYSTEM New

    Approach Peril &Prize Approach Peril &Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premiumhold till expiry.

    Advantages Greater Leverage as to pay only the premium.

    Greater variety of strike price options at a given time.


    Existing SYSTEM New


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    Approach Peril &Prize Approach Peril &Prize1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game.

    another exchange. the Market moves. in weekly settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continuesmore or less than Fair price

    Fair Price = Cash Price + Cost of Carry.


    Existing SYSTEM New

    Approach Peril &Prize Approach Peril

    &Prize1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional

    offload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.

    market conditions on market prices Option. If market goes up,

    as circuit filters long position benefit elselimit to curtail losses. exercise the option.

    3)Sell deep OTM call option

    with underlying shares, earnpremium + profit with increase prcie


    Availability of Leverage

    Small Investors


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    Existing SYSTEM New

    Approach Peril &Prize Approach Peril

    &Prize1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downside

    stocks else sell it. implies unlimited based on market outlook remainsprofit/loss. 2) Hedge position if protected &

    holding underlying upside

    stock unlimited.


    Losses Protected.


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    4. Exchange-traded vs. OTC derivatives markets

    The OTC derivatives markets have witnessed rather sharp growth over the last

    few years, which has accompanied the modernization of commercial and

    investment banking and globalisation of financial activities. The recent

    developments in information technology have contributed to a great extent to

    these developments. While both exchange-traded and OTC derivative contracts

    offer many benefits, the former have rigid structures compared to the latter. It has

    been widely discussed that the highly leveraged institutions and their OTC

    derivative positions were the main cause of turbulence in financial markets in

    1998. These episodes of turbulence revealed the risks posed to market stability

    originating in features of OTC derivative instruments and markets.

    The OTC derivatives markets have the following features compared to exchange-

    traded derivatives:

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

    located within individual institutions,

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


    3. There are no formal rules for risk and burden-sharing,4. There are no formal rules or mechanisms for ensuring market stability and

    integrity, and for safeguarding the collective interests of market

    participants, and

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

    and the exchanges self-regulatory organization, although they are

    affected indirectly by national legal systems, banking supervision and

    market surveillance.

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

    market stability.


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    The following features of OTC derivatives markets can give rise to instability in

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

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

    OTC derivative activities on available aggregate credit; (iv) the high concentration

    of OTC derivative activities in major institutions; and (v) the central role of OTC

    derivatives markets in the global financial system. Instability arises when shocks,

    such as counter-party credit events and sharp movements in asset prices that

    underlie derivative contracts, occur which significantly alter the perceptions of

    current and potential future credit exposures. When asset prices change rapidly,

    the size and configuration of counter-party exposures can become unsustainably

    large and provoke a rapid unwinding of positions.

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

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

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

    derivatives markets continue to pose a threat to international financial stability.

    The problem is more acute as heavy reliance on OTC derivatives creates the

    possibility of systemic financial events, which fall outside the more formal

    clearing house structures. Moreover, those who provide OTC derivative products,

    hedge their risks through the use of exchange traded derivatives. In view of the

    inherent risks associated with OTC derivatives, and their dependence on

    exchange traded derivatives, Indian law considers them illegal.


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    Factors contributing to the explosive growth of derivatives are price volatility,

    globalisation of the markets, technological developments and advances in the

    financial theories.


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

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

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

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

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

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

    is called as an exchange rate.

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

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

    of demand and supply in the market determines the price. These factors are

    constantly interacting in the market causing changes in the price over a short

    period of time. Such changes in the price are known as price volatility. This has

    three factors: the speed of price changes, the frequency of price changes and the

    magnitude of price changes.

    The changes in demand and supply influencing factors culminate in market

    adjustments through price changes. These price changes expose individuals,

    producing firms and governments to significant risks. The break down of the

    BRETTON WOODS agreement brought and end to the stabilising role of fixed

    exchange rates and the gold convertibility of the dollars. The globalisation of the

    markets and rapid industrialisation of many underdeveloped countries brought a

    new scale and dimension to the markets. Nations that were poor suddenly

    became a major source of supply of goods. The Mexican crisis in the south east-


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    Asian currency crisis of 1990s has also brought the price volatility factor on the

    surface. The advent of telecommunication and data processing bought

    information very quickly to the markets. Information which would have taken

    months to impact the market earlier can now be obtained in matter of moments.

    Even equity holders are exposed to price risk of corporate share fluctuates


    These price volatility risks pushed the use of derivatives like futures and options

    increasingly as these instruments can be used as hedge to protect against

    adverse price changes in commodity, foreign exchange, equity shares and



    Earlier, managers had to deal with domestic economic concerns; what happened

    in other part of the world was mostly irrelevant. Now globalisation has increased

    the size of markets and as greatly enhanced competition .it has benefited

    consumers who cannot obtain better quality goods at a lower cost. It has also

    exposed the modern business to significant risks and, in many cases, led to cut

    profit margins

    In Indian context, south East Asian currencies crisis of 1997 had affected the

    competitiveness of our products vis--vis depreciated currencies. Export of

    certain goods from India declined because of this crisis. Steel industry in 1998

    suffered its worst set back due to cheap import of steel from south East Asian

    countries. Suddenly blue chip companies had turned in to red. The fear of china

    devaluing its currency created instability in Indian exports. Thus, it is evident that

    globalisation of industrial and financial activities necessitates use of derivatives to

    guard against future losses. This factor alone has contributed to the growth of

    derivatives to a significant extent.


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    A significant growth of derivative instruments has been driven by technological

    breakthrough. Advances in this area include the development of high speed

    processors, network systems and enhanced method of data entry. Closely

    related to advances in computer technology are advances in

    telecommunications. Improvement in communications allow for instantaneous

    worldwide conferencing, Data transmission by satellite. At the same time there

    were significant advances in software programmes without which computer and

    telecommunication advances would be meaningless. These facilitated the more

    rapid movement of information and consequently its instantaneous impact on

    market price.

    Although price sensitivity to market forces is beneficial to the economy as a

    whole resources are rapidly relocated to more productive use and better rationed

    overtime the greater price volatility exposes producers and consumers to greater

    price risk. The effect of this risk can easily destroy a business which is otherwise

    well managed. Derivatives can help a firm manage the price risk inherent in a

    market economy. To the extent the technological developments increase

    volatility, derivatives and risk management products become that much more



    Advances in financial theories gave birth to derivatives. Initially forward contracts

    in its traditional form, was the only hedging tool available. Option pricing models

    developed by Black and Scholes in 1973 were used to determine prices of call

    and put options. In late 1970s, work of Lewis Edeington extended the early work

    of Johnson and started the hedging of financial price risks with financial futures.

    The work of economic theorists gave rise to new products for risk management

    which led to the growth of derivatives in financial markets.

    The above factors in combination of lot many factors led to growth of derivatives



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    The first step towards introduction of derivatives trading in India was the

    promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

    withdrew the prohibition on options in securities. The market for derivatives,

    however, did not take off, as there was no regulatory framework to govern trading

    of derivatives. SEBI set up a 24member committee under the Chairmanship of

    Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory

    framework for derivatives trading in India. The committee submitted its report on

    March 17, 1998 prescribing necessary preconditions for introduction of

    derivatives trading in India. The committee recommended that derivatives should

    be declared as securities so that regulatory framework applicable to trading of

    securities could also govern trading of securities. SEBI also set up a group in

    June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures

    for risk containment in derivatives market in India. The report, which was

    submitted in October 1998, worked out the operational details of margining

    system, methodology for charging initial margins, broker net worth, deposit

    requirement and realtime monitoring requirements. The Securities Contract

    Regulation Act (SCRA) was amended in December 1999 to include derivativeswithin the ambit of securities and the regulatory framework were developed for

    governing derivatives trading. The act also made it clear that derivatives shall be

    legal and valid only if such contracts are traded on a recognized stock exchange,

    thus precluding OTC derivatives. The government also rescinded in March 2000,

    the three decade old notification, which prohibited forward trading in securities.

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

    approval to this effect in May 2001. SEBI permitted the derivative segments of

    two stock exchanges, NSE and BSE, and their clearing house/corporation to

    commence trading and settlement in approved derivatives contracts. To begin

    with, SEBI approved trading in index futures contracts based on S&P CNX Nifty

    and BSE30 (Sense) index. This was followed by approval for trading in options

    based on these two indexes and options on individual securities.


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    The trading in BSE Sensex options commenced on June 4, 2001 and the trading

    in options on individual securities commenced in July 2001. Futures contracts on

    individual stocks were launched in November 2001. The derivatives trading on

    NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The

    trading in index options commenced on June 4, 2001 and trading in options on

    individual securities commenced on July 2, 2001. Single stock futures were

    launched on November 9, 2001. The index futures and options contract on NSE

    are based on S&P CNX Trading and settlement in derivative contracts is done in

    accordance with the rules, byelaws, and regulations of the respective exchanges

    and their clearing house/corporation duly approved by SEBI and notified in the

    official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all

    Exchange traded derivative products.

    The following are some observations based on the trading statistics provided in

    the NSE report on the futures and options (F&O):

    Single-stock futures continue to account for a sizable proportion of the

    F&O segment. It constituted 70 per cent of the total turnover during June 2002. A

    primary reason attributed to this phenomenon is that traders are comfortable with

    single-stock futures than equity options, as the former closely resembles the

    erstwhile badla system.

    On relative terms, volumes in the index options segment continue to

    remain poor. This may be due to the low volatility of the spot index. Typically,

    options are considered more valuable when the volatility of the underlying (in this

    case, the index) is high. A related issue is that brokers do not earn high

    commissions by recommending index options to their clients, because low

    volatility leads to higher waiting time for round-trips.


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    Put volumes in the index options and equity options segment have

    increased since January 2002. The call-put volumes in index options have

    decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes

    ratio suggests that the traders are increasingly becoming pessimistic on the


    Farther month futures contracts are still not actively traded. Trading in

    equity options on most stocks for even the next month was non-existent.

    Daily option price variations suggest that traders use the F&O segment as

    a less risky alternative (read substitute) to generate profits from the stock price

    movements. The fact that the option premiums tail intra-day stock prices is

    evidence to this. If calls and puts are not looked as just substitutes for spot

    trading, the intra-day stock price variations should not have a one-to-one impact

    on the option premiums.

    The spot foreign exchange market remains the most important

    segment but the derivative segment has also grown. In the derivative

    market foreign exchange swaps account for the largest share of thetotal turnover of derivatives in India followed by forwards and

    options. Significant milestones in the development of derivatives

    market have been (i) permission to banks to undertake cross

    currency derivative transactions subject to certain conditions (1996) (ii)

    allowing corporates to undertake long term foreign currency swaps

    that contributed to the development of the term currency swap market

    (1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of

    currency futures (2008). I would like to emphasise that currency swaps

    allowed companies wi th ECBs to swap their foreign currency liabili ties

    into rupees. However, since banks could not carry open positions the

    risk was allowed to be transferred to any other resident corporate.

    Normally such risks should be taken by corporates who have natural


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    hedge or have potential foreign exchange earnings. But often

    corporate assume these risks due to interest rate differentials and

    views on currencies.

    This period has also witnessed several relaxations in regulations relating to

    forex markets and also greater liberalisation in capital account regulations

    leading to greater integration with the global economy.

    Cash settled exchange traded currency futures have made foreign

    currency a separate asset class that can be traded without any

    underlying need or exposure a n d on a leveraged basis on the

    recognized stock exchanges with credit risks being assumed by the

    central counterparty

    Since the commencement of trading of currency futures in all the three

    exchanges, the value of the trades has gone up steadily from Rs 17, 429

    crores in October 2008 to Rs 45, 803 crores in December 2008. The average

    daily turnover in all the exchanges has also increased from Rs871 crores to

    Rs 2,181 crores during the same period. The turnover in the currency

    futures market is in line with the international scenario, where I understandthe share of futures market ranges between 2 3 per cent.

    Table 4.1ForexMarketActivity








    Dec08Total turnover (USD billion) 4,404 6,571 12,304 9,621

    Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1

    Spot/Total Turnover (%) 50.5 51.9 49.7 45.9

    Forward/Total Turnover (%) 19.0 17.9 19.3 21.5

    Swap/Total Turnover (%) 30.5 30.1 31.1 32.7

    Source: RBI


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    Derivative markets help investors in many different ways:


    Futures and options contract can be used for altering the risk of investing in spot

    market. For instance, consider an investor who owns an asset. He will always be

    worried that the price may fall before he can sell the asset. He can protect

    himself by selling a futures contract, or by buying a Put option. If the spot price

    falls, the short hedgers will gain in the futures market, as you will see later. This

    will help offset their losses in the spot market. Similarly, if the spot price falls

    below the exercise price, the put option can always be exercised.


    Price discovery refers to the markets ability to determine true equilibrium prices.

    Futures prices are believed to contain information about future spot prices and

    help in disseminating such information. As we have seen, futures markets

    provide a low cost trading mechanism. Thus information pertaining to supply and

    demand easily percolates into such markets. Accurate prices are essential for

    ensuring the correct allocation of resources in a free market economy. Optionsmarkets provide information about the volatility or risk of the underlying asset.


    As opposed to spot markets, derivatives markets involve lower transaction costs.

    Secondly, they offer greater liquidity. Large spot transactions can often lead to

    significant price changes. However, futures markets tend to be more liquid than

    spot markets, because herein you can take large positions by depositing

    relatively small margins. Consequently, a large position in derivatives markets is

    relatively easier to take and has less of a price impact as opposed to a

    transaction of the same magnitude in the spot market. Finally, it is easier to take

    a short position in derivatives markets than it is to sell short in spot markets.


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    The availability of derivatives makes markets more efficient; spot, futures and

    options markets are inextricably linked. Since it is easier and cheaper to trade in

    derivatives, it is possible to exploit arbitrage opportunities quickly and to keep

    prices in alignment. Hence these markets help to ensure that prices reflect true



    Derivative markets provide speculators with a cheaper alternative to engaging in

    spot transactions. Also, the amount of capital required to take a comparable

    position is less in this case. This is important because facilitation of speculation is

    critical for ensuring free and fair markets. Speculators always take calculated

    risks. A speculator will accept a level of risk only if he is convinced that the

    associated expected return is commensurate with the risk that he is taking.

    The derivative market performs a number of economic functions.

    The prices of derivatives converge with the prices of the underlying at the

    expiration of derivative contract. Thus derivatives help in discovery of

    future as well as current prices.

    An important incidental benefit that flows from derivatives trading is that it

    acts as a catalyst for new entrepreneurial activity.

    Derivatives markets help increase savings and investment in the long run.

    Transfer of risk enables market participants to expand their volume of



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    14. National Exchanges

    In enhancing the institutional capabilities for futures trading the idea of

    setting up of National Commodity Exchange(s) has been pursued since 1999.

    Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,

    (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX),

    Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become

    operational. National Status implies that these exchanges would be

    automatically permitted to conduct futures trading in all commodities subject to

    clearance of byelaws and contract specifications by the FMC. While the NMCE,

    Ahmedabad commenced futures trading in November 2002, MCX and NCDEX,

    Mumbai commenced operations in October/ December 2003 respectively.


    MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

    mutulised multi commodity exchange has permanent recognition from

    Government of India for facilitating online trading, clearing and settlement

    operations for commodity futures markets across the country. Key shareholders

    of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank,

    State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBILife Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of

    Baroda, Canera Bank, Corporation Bank

    Headquartered in Mumbai, MCX is led by an expert management team

    with deep domain knowledge of the commodity futures markets. Today MCX is

    offering spectacular growth opportunities and advantages to a large cross section

    of the participants including Producers / Processors, Traders, Corporate,

    Regional Trading Canters, Importers, Exporters, Cooperatives, Industry

    Associations, amongst others MCX being nation-wide commodity exchange,

    offering multiple commodities for trading with wide reach and penetration and

    robust infrastructure.


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    MCX, having a permanent recognition from the Government of India, is

    an independent and demutualised multi commodity Exchange. MCX, a state-of-

    the-art nationwide, digital Exchange, facilitates online trading, clearing and

    settlement operations for a commodities futures trading.


    National Multi Commodity Exchange of India Ltd. (NMCE) was promoted

    by Central Warehousing Corporation (CWC), National Agricultural Cooperative

    Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation

    Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National

    Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).

    While various integral aspects of commodity economy, viz., warehousing,

    cooperatives, private and public sector marketing of agricultural commodities,

    research and training were adequately addressed in structuring the Exchange,

    finance was still a vital missing link. Punjab National Bank (PNB) took equity of

    the Exchange to establish that linkage. Even today, NMCE is the only Exchange

    in India to have such investment and technical support from the commodity

    relevant institutions.

    NMCE facilitates electronic derivatives trading through robust and testedtrading platform, Derivative Trading Settlement System (DTSS), provided by

    CMC. It has robust delivery mechanism making it the most suitable for the

    participants in the physical commodity markets. It has also established fair and

    transparent rule-based procedures and demonstrated total commitment towards

    eliminating any conflicts of interest. It is the only Commodity Exchange in the

    world to have received ISO 9001:2000 certification from British Standard

    Institutions (BSI). NMCE was the first commodity exchange to provide trading

    facility through internet, through Virtual Private Network (VPN).

    NMCE follows best international risk management practices. The

    contracts are marked to market on daily basis. The system of upfront margining

    based on Value at Risk is followed to ensure financial security of the market. In


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    the event of high volatility in the prices, special intra-day clearing and settlement

    is held. NMCE was the first to initiate process of dematerialization and electronic

    transfer of warehoused commodity stocks. The unique strength of NMCE is its

    settlements via a Delivery Backed System, an imperative in the commodity

    trading business. These deliveries are executed through a sound and reliable

    Warehouse Receipt System, leading to guaranteed clearing and settlement.


    National Commodity and Derivatives Exchange Ltd (NCDEX) is a

    technology driven commodity exchange. It is a public limited company

    registered under the Companies Act, 1956 with the Registrar of Companies,

    Maharashtra in Mumbai on April 23,2003. It has an independent Board ofDirectors and professionals not having any vested interest in commodity

    markets. It has been launched to provide a world-class commodity

    exchange platform for market participants to trade in a wide spectrum of

    commodity derivatives driven by best global practices, professionalism and


    Forward Markets Commission regulates NCDEX in respect of futures

    trading in commodities. Besides, NCDEX is subjected to various laws of the land

    like the Companies Act, Stamp Act, Contracts Act, Forward Commission

    (Regulation) Act and various other legislations, which impinge on its working. It is

    located in Mumbai and offers facilities to its members in more than 390 centres

    throughout India. The reach will gradually be expanded to more centres.

    NCDEX currently facilitates trading of thirty six commodities - Cashew,

    Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm

    Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking

    bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard

    Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,


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    Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow

    Peas, Yellow Red Maize & Yellow Soybean Meal.


    From the above analysis it can be concluded that:

    1. Derivative market is growing very fast in the Indian Economy. The

    turnover of Derivative Market is increasing year by year in the Indias

    largest stock exchange NSE. In the case of index future there is a

    phenomenal increase in the number of contracts. But whereas the

    turnover is declined considerably. In the case of stock future there was a

    slow increase observed in the number of contracts whereas a decline was

    also observed in its turnover. In the case of index option there was a huge

    increase observed both in the number of contracts and turnover.

    2. After analyzing data it is clear that the main factors that are driving thegrowth of Derivative Market are Market improvement in communication

    facilities as well as long term saving & investment is also possible through

    entering into Derivative Contract. So these factors encourage the

    Derivative Market in India.

    3. It encourages entrepreneurship in India. It encourages the investor to take

    more risk & earn more return. So in this way it helps the Indian Economy

    by developing entrepreneurship. Derivative Market is more regulated &

    standardized so in this way it provides a more controlled environment. In

    nutshell, we can say that the rule of High risk & High return apply in

    Derivatives. If we are able to take more risk then we can earn more profit

    under Derivatives.

    Commodity derivatives have a crucial role to play in the price risk management

    process for the commodities in which it deals. And it can be extremely beneficial

    in agriculture-dominated economy, like India, as the commodity market also

    involves agricultural produce. Derivatives like forwards, futures, options, swaps

    etc are extensively used in the country. However, the commodity derivatives

    have been utilized in a very limited scale. Only forwards and futures trading are

    permitted in certain commodity items.

    RELIANCE is the most active future contracts on individual

    securities traded with 90090 contracts and RNRL is the next most active futures

    contracts with 63522 contracts being traded.


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    RBI should play a greater role in supporting derivatives.

    Derivatives market should be developed in order to keep it at par with

    other derivative markets in the world.

    Speculation should be discouraged.

    There must be more derivative instruments aimed at individual investors.

    SEBI should conduct seminars regarding the use of derivatives to educate

    individual investors.

    After study it is clear that Derivative influence our Indian Economy up

    to much extent. So, SEBI should take necessary steps for

    improvement in Derivative Market so that more investors can invest in

    Derivative market.

    There is a need of more innovation in Derivative Market because in

    today scenario even educated people also fear for investing in

    Derivative Market Because of high risk involved in Derivatives.


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    Books referred:

    Options Futures, and other Derivatives by John C Hull

    Derivatives FAQ by Ajay Shah

    NSEs Certification in Financial Markets: - Derivatives Core module

    Financial Markets & Services by Gordon & Natarajan


    Report of the RBI-SEBI standard technical committee on exchange tradedCurrency Futures

    Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

    Websites visited: