TARUN JAJU SUMMER PROJECT

8/7/2019 TARUN JAJU SUMMER PROJECT

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PREFACE

It is evident that work experience is an indispensable part of every professional

course. In the same manner practical training in any organization is a must for everyindividual who is undergoing management course. Without practical experience, one

cannot consider oneself as a qualified, potential & capable manager.

The well planned, properly executed and evaluated industrial

training helps a lot in inoculating good work culture. It provides

linkage between the student and the industry in order to develop

the awareness of industrial approach to problem solving based on

broad understanding of plant, process, product and mode of

operations of industrial organization.

EDELWEISS is a broking company which deals in investment banking,

securities broking, and investment management. It is very big organization in

which the new technology is used.

I prepared myself for work in any condition during the training period and

understood the various processed used there. I worked under the department of demat

open at Edelweiss broking limited, New Delhi.

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 2


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ACKNOWLEDGEMENT

First of all it is my privilege to acknowledge with gratitude to Edelweiss broking

limited, New Delhi for granting me to take practical training in this esteemed

organization.

I wish to thank the College Authority for giving me a golden opportunity to take practical

training on

STUDY OF DERIVATIVES IN INDIAN CAPITALMARKET

I am overwhelmed with rejoice to avail this rare opportunity to evince our profound

sense of reference and gratitude to Mr. Praveen kumar, Branch Manager

(Finance), Ms. Sachin arora & Mr. mujeeb ul hasan for providing facilities and

material to carry out this project and for constant encouragement throughout this

project.

I would like to express our sincere gratitude to Dr. Ashok Jeph, Director of

DELHI INSTITUTE OF Management & RESEARCH NEW DELHI, Ms.

NAVDEEP KAUR & SHWETA SIKKA for their support, precious guidance and

constructive encouragement.

No acknowledge would suffice for the support of my family members, my trainingcolleagues, classmates and friends.

TARUN JAJU



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INDEX

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET

S.NO. TOPICSPAGE

NO.

1. Introduction 05

2. Research Objective 11

3. Research Methodology 12

4.

Indian Capital Market

Overview 14

5. Derivative Market 24

6. Pros & Cons of Derivatives 48

7. Indian Derivative Market 59

8. Users of Derivatives 65

9. Conclusion 85

10. Recommendations 8911. Limitations 91

12. Bibliography 92

13. Annexure 93

4


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INTRODUCTION TO DERIVATIVES

The origin of derivative can be traced back to the need of formers to protect

themselves against fluctuation in the price of their crops. From th time it was sown to

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

use of simple derivatives products, it was possible for the farmers to partially or fully

transfer price risk by locking in assets prices. These were simple contracts

developed to meet the needs of farmers and basically a means of reducing risks.

A farmer who sowed his crops in June face uncertainty over the price of he

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

obtain attractive prices. However, during times of over supply, he would have to

dispose off his harvest at a very low price. Clearly this meant that the farmer and his

family were exposing to a high risk of uncertainty.

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

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

favorable prices could be obtained during period of over supply. Under suchcircumstances, it clearly made sense for the farmer and the merchant to come

together and enter in a contract whereby the price of the grain to be delivered in

September could be decided earlier. What they would then negotiate happened to be

a 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

merchant together. A group of traders got together and create the to-arrive contract

that permitted farmers to lock in to price un front and deliver the grain later. These

to-arrive contracts proved useful as a device for hedging and speculation on price

changes. These were eventually standardized, and in 1925 the first futures clearing

house came into existence.



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Today, derivative contract exist on a variety of commodities such as corn, pepper,

cotton, wheat, silver, etc. besides commodities, derivatives contracts also exist on a

lot of financial underlying like, interest rate, exchange rate etc.

Derivatives defined

Derivatives are financial contracts of pre-determined fixed duration, whose values

are derived from the value of an underlying primary financial instrument, commodity

or index, such as: interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce

exposure to changes in foreign exchange rates, interest rates, or stock indexes orcommonly known as risk hedging. Hedging is the most important aspect of

derivatives and also its basic economic purpose. There has to be counter party to

hedgers and they are speculators. Speculators dont look at derivatives as means of

reducing risk but its a business for them. Rather he accepts risks from the hedgers in

pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators

are essential.

Participants in Derivatives Markets

Hedgers

These are market players who wish to protect an existing asset position from

future adverse price movements.

Speculator

A speculator is a one who accepts the risk that hedgers wish to transfer.

Speculators have no position to protect and do not necessarily have the

physical resources to make delivery of the underlying asset nor do they



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necessarily need to take delivery of the underlying asset. They take positions

on their expectations of futures price movements and in order to make a profit.

In general they buy futures contracts when they expect futures prices to rise

and sell futures contract when they expect futures prices to fall.

Arbitrageurs

These are traders and market makers who deal in buying and selling futures

contracts hoping to profit from price differentials between markets and/or

exchanges.

Types of Derivatives

The common derivatives are futures, options, forward contracts, swaps etc. These are described

below.

Futures:

A Future represents the right to buy or sell a standard quantity and quality of

an asset or security at a specified date and price. Futures are similar to Forward

Contracts, but are standardized and traded on an exchange, and settlement of

financial obligation happens at the end of each trading day under the terms of future.

Unlike Forward Contracts, the counterparty to a Futures contract is the clearing

corporation on the appropriate exchange. Futures often are settled in cash or cash

equivalents, rather than requiring physical delivery of the underlying asset.

Options:An Option gives holder the right (but not the obligation) to

buy or sell a security or other asset during a given time for a specified price



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called the 'Strike' price. An Option to buy is known as a Call Option and an

Option to sell is called a Put Option. One can purchase Options (the right to

buy or sell the security) or sell (write) Options. As a seller, one would

become obligated to sell a security to or buy a security from the party that

purchased the Option. In order to acquire the right of option, the option

buyer pays to the option seller (known as "option writer") an Option

Premium. The buyer of an option can lose an amount no more than the

option premium paid but his possible gain in unlimited. On the other hand,

the option writers possible loss is unlimited but his maximum gain is

limited to the option premium charged by him to the holder. Option

premium is calculated using option pricing models like Black Scholes

Model etc.

Forwards:

In a Forward Contract, the purchaser and its counter party are obligated to trade a

security or other asset at a specified date in the future. The price paid for the security

or asset is agreed upon at the time the contract is entered into, or may be determined

at delivery. Forward Contracts generally are traded OTC.

Swaps: A Swap is a simultaneous buying and selling of the same

security or obligation. It can be an agreement in which two partiesexchange interest payments based on an identical principal amount, called

the notional principal amount. This is the most common type of Swap and

also known as plain vanilla swap.



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Warrants: options generally have the life of upto one year, the

majority of options traded on options exchange having a maximum

maturity of nine months. Longer-dated options are called warrants and are

generally traded over the counter.

Leaps: the acronym LEAPS means long term Equity Anticipation

Securities. These are option having a maturity of up to thee years.

Swaptions: Swaptions are options to buy or sell a swap 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 market

has receiver swaption and payer Swaptions. A receiver swaption is an

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

pay fixed and received floating.

Factors driving the growth of financial derivatives

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic

agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and

returns over a large number of financial assets leading to higher returns, reduced risk

as well as transactions costs as compared to individual financial assets.



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RESEARCH OBJECTIVE

Research problem

Study of Derivatives in the India capital market

The main objective of the study is to do the detailed analysis of the trading of

derivatives in the capital market in Indian context and this is also includes the study

of:

Meaning

Type

Trading

Clearing & settlement

Regulatory framework



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RESEARCH METHODOLOGY

Research Design

A research design specifies the methods and procedure for conducting a

particular study. One has to specify the approach he intends to use with respect to the

proposed study. Broadly speaking, research design con be grouped into three

categories.

EXPLORATORY: Focuses on discovery on ideas and generally based on

secondary data.

DISCRIPTIVE:It is undertaken when the research wants to know the characteristicsof certain groups such as age, sex, educational level, income, occupation etc.

CAUSAL: It is undertaken when the researcher is interested in knowing the cause

and effect relationship between two or more variables.

The research design of my study is Exploratory



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DATA SOURCES

Research is based on secondary data that has been collected from

various sources like internet, journals, magazines and books etc. (see

Bibliography also)

Data collection is the heart of all research work. It is an elaborate process

through which the researcher makes a planned search for all relevant data

and gathers the entire data required for the assignment.



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INDIAN CAPITAL MARKET: AN OVERVIEW

Evolution

Indian Stock Markets are one of the oldest in Asia. Its history dates back to

nearly 200 years ago. The earliest records of security dealings in India are meagre

and obscure. The East India Company was the dominant institution in those days and

business in its loan securities used to be transacted towards the close of the

eighteenth century.

By 1830's business on corporate stocks and shares in Bank and Cotton presses took

place in Bombay. Thoh the trading list was broader in 1839, there were only half a

dozen brokers recognized by banks and merchants during 1840 and 1850.

The 1850's witnessed a rapid development of commercial enterprise and brokerage

business attracted many men into the field and by 1860 the number of brokers

increased into 60.

In 1860-61 the American Civil War broke out and cotton supply from United States

of Europe was stopped; thus, the 'Share Mania' in India begun. The number of

brokers increased to about 200 to 250. However, at the end of the American Civil

War, in 1865, a disastrous slump began (for example, Bank of Bombay Share which

had touched Rs 2850 could only be sold at Rs. 87).

At the end of the American Civil War, the brokers who thrived out of Civil War in

1874, found a place in a street (now appropriately called as Dalal Street) where they

would conveniently assemble and transact business. In 1887, they formally



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established in Bombay, the "Native Share and Stock Brokers' Association" (which is

alternatively known as The Stock Exchange "). In 1895, the Stock Exchange

acquired a premise in the same street and it was inaugurated in 1899. Thus, the Stock

Exchange at Bombay was consolidated.

Other leading cities in stock market operations

Ahmedabad gained importance next to Bombay with respect to cotton textile

industry. After 1880, many mills originated from Ahmedabad and rapidly forged

ahead. As new mills were floated, the need for a Stock Exchange at Ahmedabad was

realized and in 1894 the brokers formed "The Ahmedabad Share and Stock Brokers'

Association".

What the cotton textile industry was to Bombay and Ahmedabad, the jute industry

was to Calcutta. Also tea and coal industries were the other major industrial groups

in Calcutta. After the Share Mania in 1861-65, in the 1870's there was a sharp boom

in jute shares, which was followed by a boom in tea shares in the 1880's and 1890's;

and a coal boom between 1904 and 1908. On June 1908, some leading brokersformed "The Calcutta Stock Exchange Association".

In the beginning of the twentieth century, the industrial revolution was on the way in

India with the Swadeshi Movement; and with the inauguration of the Tata Iron and

Steel Company Limited in 1907, an important stage in industrial advancement under

Indian enterprise was reached.

Indian cotton and jute textiles, steel, sugar, paper and flour mills and all companies

generally enjoyed phenomenal prosperity, due to the First World War.

In 1920, the then demure city of Madras had the maiden thrill of a stock exchange

functioning in its midst, under the name and style of "The Madras Stock Exchange"



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with 100 members. However, when boom faded, the number of members stood

reduced from 100 to 3, by 1923, and so it went out of existence.

In 1935, the stock market activity improved, especially in South India where there

was a rapid increase in the number of textile mills and many plantation companies

were floated. In 1937, a stock exchange was once again organized in Madras -

Madras Stock Exchange Association (Pvt) Limited. (In 1957 the name was changed

to Madras Stock Exchange Limited).

Lahore Stock Exchange was formed in 1934 and it had a brief life. It was merged

with the Punjab Stock Exchange Limited, which was incorporated in 1936.

Indian Stock Exchanges - An Umbrella Growth

The Second World War broke out in 1939. It gave a sharp boom which was followed

by a slump. But, in 1943, the situation changed radically, when India was fully

mobilized as a supply base.

On account of the restrictive controls on cotton, bullion, seeds and other

commodities, those dealing in them found in the stock market as the only outlet for

their activities. They were anxious to join the trade and their number was swelled by

numerous others. Many new associations were constituted for the purpose and Stock

Exchanges in all parts of the country were floated.

The Uttar Pradesh Stock Exchange Limited (1940), Nagpur Stock Exchange Limited

(1940) and Hyderabad Stock Exchange Limited (1944) were incorporated.

In Delhi two stock exchanges - Delhi Stock and Share Brokers' Association Limited

and the Delhi Stocks and Shares Exchange Limited - were floated and later in June

1947, amalgamated into the Delhi Stock Exchange Association Limited.



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Post-independence Scenario

Most of the exchanges suffered almost a total eclipse during depression. Lahore

Exchange was closed during partition of the country and later migrated to Delhi and

merged with Delhi Stock Exchange.

Bangalore Stock Exchange Limited was registered in 1957 and recognized in 1963.

Most of the other exchanges languished till 1957 when they applied to the Central

Government for recognition under the Securities Contracts (Regulation) Act, 1956.

Only Bombay, Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore, the well

established exchanges, were recognized under the Act. Some of the members of the

other Associations were required to be admitted by the recognized stock exchanges

on a concessional basis, but acting on the principle of unitary control, all these

pseudo stock exchanges were refused recognition by the Government of India and

they thereupon ceased to function.

Thus, during early sixties there were eight recognized stock exchanges in India

(mentioned above). The number virtually remained unchanged, for nearly two

decades. During eighties, however, many stock exchanges were established: Cochin

Stock Exchange (1980), Uttar Pradesh Stock Exchange Association Limited (at

Kanpur, 1982), and Pune Stock Exchange Limited (1982), Ludhiana Stock Exchange

Association Limited (1983), Gauhati Stock Exchange Limited (1984), Kanara Stock

Exchange Limited (at Mangalore, 1985), Magadh Stock Exchange Association (at

Patna, 1986), Jaipur Stock Exchange Limited (1989), Bhubaneswar Stock Exchange

Association Limited (1989), Saurashtra Kutch Stock Exchange Limited (at Rajkot,

1989), Vadodara Stock Exchange Limited (at Baroda, 1990) and recently established

exchanges - Coimbatore and Meerut. Thus, at present, there are totally twenty one



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recognized stock exchanges in India excluding the Over The Counter Exchange of

India Limited (OTCEI) and the National Stock Exchange of India Limited (NSEIL).

The Table given below portrays the overall growth pattern of Indian stock markets

since independence. It is quite evident from the Table that Indian stock markets have

not only grown just in number of exchanges, but also in number of listed companies

and in capital of listed companies. The remarkable growth after 1985 can be clearly

seen from the Table, and this was due to the favouring government policies towards

security market industry.

Growth Pattern of the Indian Stock Market

Sl.No.As on 31stDecember

1946 1961 1971 1975 1980 1985 1991 1995

1No. ofStock Exchanges

7 7 8 8 9 14 20 22

2No. ofListed Cos.

1125 1203159915522265 4344 6229 8593

3

No. of Stock

Issues ofListed Cos.

1506 2111 2838 3230 3697 6174 8967 11784

4Capital of ListedCos. (Cr. Rs.)

270 753 181226143973 9723 32041 59583

5Market value ofCapital of ListedCos. (Cr. Rs.)

971 12922675 32736750 25302 110279 478121

6Capital perListed Cos. (4/2)

(Lakh Rs.)

24 63 113 168 175 224 514 693

7

Market Value ofCapital per ListedCos. (Lakh Rs.)(5/2)

86 107 167 211 298 582 1770 5564

Trading Pattern of the Indian Stock Market



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Trading in Indian stock exchanges are limited to listed securities of public limited

companies. They are broadly divided into two categories, namely, specified

securities (forward list) and non-specified securities (cash list). Equity shares of

dividend paying, growth-oriented companies with a paid-up capital of atleast Rs.50

million and a market capitalization of atleast Rs.100 million and having more than

20,000 shareholders are, normally, put in the specified group and the balance in non-

specified group.

Two types of transactions can be carried out on the Indian stock exchanges: (a) spot

delivery transactions "for delivery and payment within the time or on the date

stipulated when entering into the contract which shall not be more than 14 daysfollowing the date of the contract" : and (b) forward transactions "delivery and

payment can be extended by further period of 14 days each so that the overall period

does not exceed 90 days from the date of the contract". The latter is permitted only in

the case of specified shares. The brokers who carry over the outstandings pay carry

over charges (cantango or backwardation) which are usually determined by the rates

of interest prevailing.

A member broker in an Indian stock exchange can act as an agent, buy and sell

securities for his clients on a commission basis and also can act as a trader or dealer

as a principal, buy and sell securities on his own account and risk, in contrast with

the practice prevailing on New York and London Stock Exchanges, where a member

can act as a jobber or a broker only.

The nature of trading on Indian Stock Exchanges are that of age old conventional

style of face-to-face trading with bids and offers being made by open outcry.

However, there is a great amount of effort to modernize the Indian stock exchanges

in the very recent times.



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National Stock Exchange (NSE)

With the liberalization of the Indian economy, it was found inevitable to lift the

Indian stock market trading system on par with the international standards. On the

basis of the recommendations of high powered Pherwani Committee, the National

Stock Exchange was incorporated in 1992 by Industrial Development Bank of India,

Industrial Credit and Investment Corporation of India, Industrial Finance

Corporation of India, all Insurance Corporations, selected commercial banks and

others.

Trading at NSE can be classified under two broad categories:

(a) Wholesale debt market and

(b) Capital market.

Wholesale debt market operations are similar to money market operations -

institutions and corporate bodies enter into high value transactions in financial

instruments such as government securities, treasury bills, public sector unit bonds,commercial paper, certificate of deposit, etc.

There are two kinds of players in NSE:

(a) trading members and (b) participants.

Recognized members of NSE are called trading members who trade on behalf of

themselves and their clients. Participants include trading members and large players

like banks who take direct settlement responsibility.

Trading at NSE takes place through a fully automated screen-based trading

mechanism which adopts the principle of an order-driven market. Trading members



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can stay at their offices and execute the trading, since they are linked through a

communication network. The prices at which the buyer and seller are willing to

transact will appear on the screen. When the prices match the transaction will be

completed and a confirmation slip will be printed at the office of the trading member.

NSE has several advantages over the traditional trading exchanges. They are as

follows:

NSE brings an integrated stock market trading network across the nation.

Investors can trade at the same price from anywhere in the country since inter-

market operations are streamlined coupled with the countrywide access to the

securities.

Delays in communication, late payments and the malpractices prevailing in

the traditional trading mechanism can be done away with greater operational

efficiency and informational transparency in the stock market operations, with

the support of total computerized network.

Unless stock markets provide professionalised service, small investors and foreign

investors will not be interested in capital market operations. And capital market

being one of the major source of long-term finance for industrial projects, India

cannot afford to damage the capital market path. In this regard NSE gains vital

importance in the Indian capital market system.



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INTRODUCTION TO FUTURES & OPTIONS

Forward Contracts

A forward contract is a simple derivative It is an agreement to buy or sell an asset

at a certain future time for a certain price. The contract is usually between two

financial institutions or between a financial institution and its corporate client. A

forward contract is not normally traded on an exchange.

One of the parties in a forward contract assumes a long position i.e. agrees to buy the

underlying asset on a specified future date at a specified future price. The other party

assumes a short position i.e. agrees to sell the asset on the same date at the same

price. This specified price is referred to as the delivery price. This delivery price is

chosen so that the value of the forward contract is equal to zero for both transacting



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parties. In other words, it costs nothing to the either party to hold the long or the

short position.

A forward contract is settled at maturity. The holder of the short position delivers the

asset to the holder of the long position in return for cash at the agreed upon rate.

Therefore, a key determinant of the value of the contract is the market price of the

underlying asset. A forward contract can therefore, assume a positive or negative

value depending on the movements of the price of the asset. For example, if the price

of the asset rises sharply after the two parties have entered into the contract, the party

holding the long position stands to benefit, i.e. the value of the contract is positive for

her. Conversely, the value of the contract becomes negative for the party holding theshort position.

The concept of Forward price is also important. The forward price for a certain

contract is defined as that delivery price which would make the value of the contract

zero. To explain further, the forward price and the delivery price are equal on the day

that the contract is entered into. Over the duration of the contract, the forward price is

liable to change while the delivery price remains the same. This is explained in the

following note on payoffs from forward contracts.

Options

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

of the option the right purchase from or sell to the writer a designated instrument for

a specified price within a specified period of time.

The writer grants this right to the buyer for a certain sum of money called the option

premium. An option that grants the buyer the right to buy some instrument is called a

call option. An options that grants the buyer the right to sell an instrument is called a



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put option. The price at which the buyer an exercise his option is called the exercise

price, strike price or the striking price.

Options are available on a large variety of underlying assets like common stock,

currencies, debt instruments and commodities. Also traded are options on stock

indices and futures contracts where the underlying is a futures contract and futures

style options.

Options have proved to be a versatile and flexible tool for risk management by

themselves as well as in combination with other instruments. Options also provide a

way for individual investors with limited capital to speculate on the movements of

stock prices, exchange rates, commodity prices etc. The biggest advantage in this

context is the limited loss feature of options.

Options Terminology

Call Option

A call option gives the holder (buyer/ one who is long call), the right to buy specified

quantity of the underlying asset at the strike price on or before expiration date.

Put Option

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified

quantity of the underlying asset at the strike price on or before a expiry date.

Strike Price (also called exercise price)

The price specified in the option contract at which the option buyer can purchase the

currency (call) or sell the currency (put) Y against X.



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Maturity Date

The date on which the option contract expires is the maturity date. Exchange traded

options have standardized maturity dates.

American Option

An option, call or put, that can be exercised by the buyer on any business day from

initiation to maturity.

European Option

A European option is an option that can be exercised only on maturity date.

Premium (Option price, Option value)

The fee that the option buyer must pay the option writer at the time the contract is

initiated. If the buyer does not exercise the option, he stands to lose this amount.

Intrinsic value of the option

The intrinsic value of an option is the gain to the holder on immediate exercise of the

option. In other words, for a call option, it is defined as Max [(S-X), 0], where s is

the current spot rate and X is the strike rate.

If S is greater than X, the intrinsic value is positive and is S is less than X, the

intrinsic value will be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In

the case of European options, the concept of intrinsic value is notional as these

options are exercised only on maturity.

Time value of the option



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The value of an American option, prior to expiration, must be at least equal to its

intrinsic value. Typically, it will be greater than the intrinsic value. This is because

there is some possibility that the spot price will move further in favor of the option

holder. The difference between the value of an option at any time "t" and its intrinsic

value is called the time value of the option.

At-the-Money, In-the-Money and Out-of-the-Money Options

A call option is said to be at-the-money if S=X i.e. the spot price is equal to the

exercise price. It is in-the-money is S>X and out-of-the-money is S


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Major Features Of Futures Contracts

The principal features of the contract are as follows:

Organized Exchanges Standardization

Clearing House

Marking To Market

Actual Delivery Is Rare

DISTINCTION BETWEEN FORWARD AND FUTURES CONTRACTS

FORWARDS FUTURES

1. Are traded on an exchange 1. Are not traded on an exchange

2. Use a Clearing House which

provides protection for both parties

2. Are private and are negotiated

between the parties with no exchangeguarantee

3. Require a margin to be paid 3. Involve no margin payments

4. Are used for hedging and

speculating

4. Are used for hedging and physical

delivery

5. Are standardised and published 5. Are dependent on the negotiated

contract conditions

6. Are transparent - futures contracts

are reported by the exchange

6. Are not transparent as they are all

private deals

FUTURES & OPTIONS



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An interesting question to ask at this stage is when could one use options

instead of futures? Options are different from future in several interesting senses. At

a practical level, the option buyer faces a interesting situation. He pays for option in

full at the time it is purchased. After this, he only have an upside. There is no

possibility of the options position generating any further losses to him (other than the

fund already paid for option). This is different from futures, which is free to enter

into, but can generate very large losses. This characteristics makes options attractive

to many occasional market participants, who can not put in the time to closely

monitor their futures positions. Buying put options is buying insurance. To buy a put

option on Nifty is to buy insurance, which reimburses the full extent to which Nifty

drops below the strike price of the put option. This is attractive to many people, and

to mutual funds creating guaranteed return product.

Distinction between futures and options

Futures Options

Exchange traded with

novation

Same as futures.

Exchange defines the

product

Same as futures

Price is zero, strike price

moves

Strike price is fixed, price

moves.

Price is zero Price uis always positive.

Linear payoff Nonlinear payoff.



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Both long and short at risk Only short at risk.

PAYOFF FOR DERIVATIVES

CONTRACTS

A pay off is likely profit/loss that would accrue to a market participants with change

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

diagrams, which show the price of the underlying asset on the X-axis and the

profit/loss on the Y-axis. In this section we shall take a look at the payoffs for buyers

and sellers of futures and options.

Payoff for Futures

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

well as profits for the buyer and the sellers of a future contract are unlimited. These



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linear payoffs are fascinating as they can be combined with options and the

underlying to generate various complex payoffs.

Payoff for a Buyer on Nifty FutureThe payoff for a person who sells a futures contract is similar to the payoff for a

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

potentially unlimited downside. Take the case of speculator who sells two-month

Nifty index futures contracts when the Nifty stands at 1220. The underlying asset in

this case is the Nifty portfolio. When the index moves down, the short futures

positions start making profits and when the index moves up, it starts making losses

.the following diagram shows the payoff diagram for the seller of a futures contract.

Profit

1220

0

Nifty

Loss

FIG. PAYOFF FOR A BUYER OF FUTURE

Payoff for a seller on Nifty Futures

The pay off for a person who sells a future contract is similar to the payoff for a

person who shorts an assets. He has a potentially unlimited upsides as well as a



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potentially unlimited downside. Take the case of a speculator who sells thea two-

month Nifty index future 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

positions start making profits, and when the index moves up, it starts making losses.

Profit

1220 Nifty

Loss

Fig. Payoff for a seller on Nifty futures



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Option Payoffs

The optionality characteristics of options results in a non linear payoff for the

options. In simple words, it means that the losses for the buyer of an option are

limited, however the profits are potentially unlimited. For a writer, the payoff is

exactly the opposite. His profits are limited to the options premium, however his

losses are potentially unlimited. These non-linear payoffs are fascinating as they lend

themselves to be used to generate various payoffs by using combination of options

and underlying. We look here at the six basic payoffs.

Payoff profile of buyer of asset: Long assetIn this basic position, an investor buys the underlying asset, Nifty for instance, for

1220, and sells it at a future date at a unknown price. Once it is purchased, the

investor is said to be long the asset. Following figure show the pay off for a long

position of Nifty.

Profit

+60---------------------------------------------------------

1160 1220 1280 Nifty

-60 -----------------------------

Loss



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Fig. Payoff for investor who went long nifty at 1220

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance, for1220 and buys it back at a future date at an unknown price. Once it is sold, the

investor is said to be short the asset. Following figure show the pay off for a long

position of Nifty.

Profit

1160 1220 1280 Nifty

Loss

Fig. Payoff for investor who went short Nifty at 1220



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Payoff profile for buyer of call option: Long run

A call option gives the buyer the right to buy the underlying asset at the strike price

specified in the option. The profit/loss that the buyer makes on the options depends

on the spot price of the underlying. If upon expiration, the spot price exceeds the

strike price, he makes a profit. Higher the spot price, more is the profit he makes. If

the spot price of the underlying is less than the strike price, he lets his option expire

un-exercised. His loss in this case is the premium he paid for buying the option.

Profit

1250 Nifty0

86.60

loss

Fig. Payoff for buyer of a call

Payoff for the buyer of a three-month call option (often referred to as longcall) with a strike of 1250 bought at a premium of 86.60



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Payoff profile for buyer of call option: Short call

Call option gives the buyer the right to buy the underlying at the strike price

specified in the option. For selling the option, the writer of the option charges a

premium. The profit/loss that the buyer make on the option depends upon the spot

price of the underlying. Whatever is the buyers profit/loss? If upon expiration, the

spot price exceeds the strike price, the buyer wills exercise the option on the writer.

Hence as the spot price increase the writer of option starts making losses. Hired the

spot price, more is the loss he makes. If upon expiration the spot price of the

underlying is less than the strike price, the buyer lets his option expire unexercised

and the writer gets to keep the premium. Figure gives the pay off for the writer of

three-month call option (often referred to as short call) with the strike of 1250sold at

premium of 86.60

Profit

86.601250 Nifty

0

Loss

Fig. Payoff for a writer of calls options



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Payoff for buyer of put option: Long put

A put option gives the buyer the right to sell the underlying asset at the strike

price specified in the option. The profit/loss that the buyer makes on the option

depends on the spot price of the underlying. If upon expiration, the spot price is

below the strike price , he makes a profit. Lower the spot price, more is the profit he

makes. If the spot price is higher than the stike price, he let his option expire un-

exercised. His loss in this case is the premium he paid for buying the option.

Profit

1250 Nifty

0

61.70

loss

Fig. Payoff for buyer of put option

Payoff profile for writer of put option: short put

A put option gives the buyer the right to sell the underlying asset at the strike price

specified in the option. For selling the options, the writer of the option charges a



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premium. The profit/loss that the buyer makes on the option depends on the spot

price of the underlying. Whatever is the buyer profit is the seller loss. If upon

expiration, the spot prices happens to be below the strike price, the buyer will

ecercise the option at write. If upon the expiration the pot price of the underlying is

more than the strike price, the buyer lets his option expired un exercised and the

writer gets to keep the premium.

Profit

61.70

0 1250 Nifty

Loss

Fig. Payoff for writer of put option

Fig shows the payoff for the writer of a three-month put option

(often referred as short put) with a strike price of 1250 sold at a premiumof 61.70



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CLEARING AND SETTLEMENT

National Securities Clearing council Limited (NSCCL) undertakes clearing

and settlement of all trades executed on the futures and options (O&P)

segment of the NSE. It also act as legal counter party to all trades on

the F&O segment and guarantees their financial settlement.

Clearing EntitiesClearing and settlement activities in the F&O segment are undertaken by NSCCLwith the help of the following entities:

Clearing Members

A Clearing Member (CM) of NSCCL has the responsibility of clearing and

settlement of all deals executed by Trading Members (TM) on NSE, who clear and

settle such deals through them. Primarily, the CM performs the following functions:

1. Clearing Computing obligations of all his TM's i.e. determining positions

to settle.



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2. Settlement - Performing actual settlement. Only funds settlement is allowed

at present in Index as well as Stock futures and options contracts

3. Risk Management Setting position limits based on upfront deposits /

margins for each TM and monitoring positions on a continuous basis.

Types of Clearing Members

Trading Member Clearing Member (TM-CM)

A Clearing Member who is also a TM. Such CMs may clear and settle their

own proprietary trades, their clients trades as well as trades of other TMs.

Professional Clearing Member (PCM)

A CM who is not a TM. Typically banks or custodians could become a PCM

and clear and settle for TMs.

Self Clearing Member (SCM)

A Clearing Member who is also a TM. Such CMs may clear and settle only

their own proprietary trades and their clients trades but cannot clear and settle

trades of other TMs.

Clearing Banks

NSCCL has empanelled 11 clearing banks namely Canara Bank, HDFC

Bank, IndusInd Bank, ICICI Bank, UTI Bank, Bank of India, IDBI Bank, Hongkong& Shanghai Banking Corporation Ltd., Standard Chartered Bank, Kotak Mahindra

Bank and Union Bank of India.

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Every Clearing Member is required to maintain and operate a clearing account

with any one of the empanelled clearing banks at the designated clearing bank

branches. The clearing account is to be used exclusively for clearing & settlement

operations.

Settlement Mechanism

All futures and options contracts are cash settled, i.e. through exchange of cash. The

underlying for index futures /options of the Nifty index cannot be delivered. These

contracts, therefore, have to be settled in cash. Futures and options on individual

securities can be delivered as in the spot market. However, it has been currently

mandated that stock options and futures would also be cash settled. The settlement

amount for a CM is netted across all their TMs/ clients, with respect to their

obligations on MTM, premium and exercise settlement.

Settlement of future contracts

Futures contracts have two types of settlement, the MTM settlement, which happen

on a continuous basis at the end of each day, and the final settlement, which happens

on the last trading day of the futures contracts.

1. Daily Mark-to-Market Settlement



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The position in the futures contracts for each member is marked-to-market to

the daily settlement price of the futures contracts at the end of each trade day.

The profits/ losses are computed as the difference between the trade price or the

previous days settlement price, as the case may be, and the current days settlement

price. The CMs who have suffered a loss are required to pay the mark-to-market loss

amount to NSCCL which is in turn passed on to the members who have made a

profit. This is known as daily mark-to-market settlement.

Theoretical daily settlement price for unexpired futures contracts, which are not

traded during the last half an hour on a day, is currently the price computed as per the

formula detailed below:

F = S x e rt

where:

F = theoretical futures price

S = value of the underlying index

r = rate of interest (LIBOR)

t = time to expiration

Rate of interest may be the relevant MIBOR rate or such other rate as may be

specified. After daily settlement, all the open positions are reset to the daily

settlement price. CMs are responsible to collect and settle the daily mark to market

profits / losses incurred by the TMs and their clients clearing and settling through

them. The pay-in and payout of the mark-to-market settlement is on T+1 days (T =

Trade day). The mark to market losses or profits are directly debited or credited to



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the CMs clearing bank account.

2. Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM to thefinal settlement price and the resulting profit / loss is settled in cash..The final

settlement of the futures contracts is similar to the daily settlement process except for

the method of computation of final settlement price. The final settlement profit / loss

is computed as the difference between trade price or the previous days settlement

price, as the case may be, and the final settlement price of the relevant futures

contract.

Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing

bank account on T+1 day (T= expiry day).

Open positions in futures contracts cease to exist after their expiration day

SETTLEMENT OF OPTIONS CONTRACTS

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The

premium payable position and premium receivable positions are netted across all

option contracts for each CM at the client level to determine the net premium

payable or receivable amount, at the end of each day.

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The CMs who have a premium payable position are required to pay the premium

amount to NSCCL which is in turn passed on to the members who have a premium

receivable position. This is known as daily premium settlement.

CMs are responsible to collect and settle for the premium amounts from the TMs and

their clients clearing and settling through them.

The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day).

The premium payable amount and premium receivable amount are directly debited or

credited to the CMs clearing bank account.

Interim Exercise Settlement

Interim exercise settlement for Option contracts on Individual Securities is effected

for valid exercised option positions at in-the-money strike prices, at the close of the

trading hours, on the day of exercise. Valid exercised option contracts are assigned to

short positions in option contracts with the same series, on a random basis. The

interim exercise settlement value is the difference between the strike price and the

settlement price of the relevant option contract.

Exercise settlement value is debited/ credited to the relevant CMs clearing bank

account on T+1 day (T= exercise date ).

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike

prices existing at the close of trading hours, on the expiration day of an option

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contract. Long positions at in-the money strike prices are automatically assigned to

short positions in option contracts with the same series, on a random basis.

For index options contracts, exercise style is European style, while for options

contracts on individual securities, exercise style is American style. Final Exercise is

Automatic on expiry of the option contracts.Option contracts, which have been

exercised, shall be assigned and allocated to Clearing Members at the client level.

Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of

the relevant Clearing Members with the respective Clearing Bank.Final settlement

loss/ profit amount for option contracts on Index is debited/ credited to the relevant

CMs clearing bank account on T+1 day (T = expiry day).

Final settlement loss/ profit amount for option contracts on Individual Securities is

debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry

day).

Open positions, in option contracts, cease to exist after their expiration day.

The pay-in / pay-out of funds for a CM on a day is the net amount across settlements

and all TMs/ clients, in F&O Segment.

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PROS & CONS OF DERIVATIVES

Financial innovation that led to the issuance and trading of derivatives products

has been an important boost to the development of financial market. Derivatives

products such as options, futures or swaps contract have become a standard risk

management tool that enable risk sharing and thus facilitate the efficient allocation of

capital to productive investment opportunities. While the benefits stemming from the

economic function performed by derivative securities have been discussed and

proven by academics, there is increasing concern within the financial community that

the growth of the derivative markets-whether standardize or not-destabilize the

economy. In particular, one often hears that the widespread use of derivatives have

been reduced long term investment since it concentrates capital in short term

speculative transactions. In this study, I have tried to look at the various pros andcons that the derivatives trading pose.

BENEFITS OF DERIVATIVES FOR FIRMS,

MARKETS AND THE ECONOMY



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

in the private and public sectors that derivatives provide numerous and substantial

benefits to end users.

Derivatives as means of hedging

Derivatives provide a low cost, effective method for end users to hedge and

manage their exposure to interest rate, commodity price, or exchange rates. Interest

rate future and swaps, for example, help banks for all sizes better manage the re-

pricing mismatches in funding long term assets, such as mortgages, with short term

liabilities, such a certificate of deposits. Agricultural futures and options helps

farmers and processors hedge against commodity price risk. Similarly, multi national

corporations can hedge against currency risk using foreign exchange forwards,

futures and options.

Improves market efficiency and liquidity

Well functioning derivatives improves the efficiency and liquidity of the cash

market. The launch of derivatives has been associated with substantial improvementsin the market quality on the underlying equity market. This happens because of the

law transaction cost involved and arbitrageurs will face low cost when they are

eliminating the mispricings. Traders in individual stock who supply liquidity to these

stock use index futures to offset their exposure and hence able to function at lower

level of risk.

Allows institution to raise capital at lower costs

Corporations, governmental entities, and financial institutions also

benefit from derivatives through lower funding costs and more diversified funding

sources. Currency and interest rate derivatives provide the ability to borrow in the



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cheapest capital market, domestic or foreign, without regard to currency in which the

debt is denominated or the form in which interest is paid. Derivatives can convert the

foreign borrowing into a synthetic domestic currency financing with their fixed or

floating interest rate.

Allows exchange to offer differentiated products

In spot market, the ability for the exchanges to differentiate their

product is limited by the fact that they are trading the same paper. In contrast, in the

case of derivatives, there are numerous avenues for product differentiation. Each

exchange trading index option has to take major decision like choice of index, choice

of contract size, choice of expiration dates, American Vs European options, rules

governing strike price etc.

Assists in capital formation in the Economy

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

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

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

stimulating economic growth. It improves the markets ability to carefully direct

resources toward the projects and the industries where the rate of return is highest.

This improves the allocative efficiency of the market and thus a given stock of

investable funds will be better used in procuring the highest possible GDP growth for

the economy.

The growth in derivatives activities yields substantial benefits to the economy

and by facilitating the access of the domestic companies to international capital

market and enabling them to lower their cost of funds and diversify their funding



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source; derivatives improve the position of domestic firms in an expanding,

competitive, global economy.

Improve ROI for institutions

Derivatives are basically off- balance trading in that no transfer of

principal sum occurs and no posting in the balance sheet will be required.

Consequently, a fund that corresponds to the principal sum in traditional financial

transactions (on balance trading) is unnecessary, thus substantially improving the

return on investment. Looking at the restriction on the ratio of net worth, on the other

hand, the risk ratio of assets that form the basis for calculating the net worth in off

balance trading is assumed to be lower than that in the traditional on balance trading.In practice, it is provided that the credit risk equivalence calculated by multiplying

the assumed amount of principal of an off-balance trading by a risk to value ratio is

to be weighted by the credit worthiness of the other party.

Risk sharing The major economic function of derivatives is typically seen in risk

sharing: derivatives provide a more efficient allocation of economic risks. Examples

of risk management, which have already mentioned are illustrative, but they dont

address the question why derivatives are necessary to attain a better social allocation

of risks.

Information gathering:

In a perfect market with no transaction cost, no friction and no

informational asymmetries, ther would be no benefit stemming from the

use of derivatives instruments. However, in the presence of trading

costs and marketing liquidity, portfolio strategies are often implemented

or supplemented with derivatives at substainial lower cost compare to

cash market transactions. In this respect, the welfare effect of derivative



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instrument result from a reduction in the transaction cost. Ut, this is

only a part of the real economic benefits of the derivatives. If risk

allocation is the major function of these instrument, and because risk is

also related to information, derivatives markets also affect the

information structure of the financial syatem

DISADVANTAGES OF DERIVATIVES

Risk associated with the derivatives

Apart from the explicit risk, which arises from various market risk exposure

stemming from the pure service or position taken in a derivative instrument, otherimplicit risks also associated with derivatives

A credit risk is the risk that a loss will be incurred because a counter party

fails to make payment as due. Concern has been expressed that financial

institutions may have used derivatives to take on an excessive level of

credit risk that is poorly managed.

Market risk is the risk that the value of a position in a contract,financial

instrument, asset,or porflio will decline when market conditions change.

Concern has been expressed that derivatives expose firm to new market

risk while increasing the overall level of exposure.



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Operational risks is the risk that losses will be incurred as a result of

inadequate system and control, inadequate disaster or contingency

planning, human error, or management failure.

Legal risk is the risk of loss because a contract cannot be enforced or

because the contract term fails to achieve the intended goals of the

contracting parties. This risk, of course, is as old as contracting itself. The

legal uncertainty can result in significant unexpected losses.

Implication in global world

Global market for trade and finance has become increasingly integrated andaccessible. Derivatives have both benefited from and contributed to this

development. In this circumstances, however, some observed fear that derivativesmake it possible for shocks in one part of the global finance system to be transmittedfarther and faster than before, being reinforce rather than damped. Concern also have

been expressed that derivatives activity may exacerbated market moves throughpositive feedback trading.

Accounting standard for derivatives

As far as derivatives are concerned, accounting standard is not

homogenized across countries and/or market player thereby suggesting that lack of

precision or ambiguous cross-comparisons may be common. Market values are not

uniformly accepted in accounting rules, and thus their absence prevent marketing-to-

marketing of derivatives positions as well as their proper collateralization.

Accounting practices measure values and not risk exposure and thus remain poor

figure for risk management purpose

Lack of knowledge

Lack of knowledge about derivatives: derivatives are complex. The payoffs

and risks that buyer and seller face, and the economic theory that is used for pricing



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derivatives are considerably more difficult than that seen on the equity market. Thus

at times lack of knowledge on part of traders leads to disaster.

Monetarily Zero sum game

It is impossible for the both the parties in the derivatives transactions to profit

concurrently regardless of the fluctuation of value of underlying assets. Thus one

party has to accept the unprofitable position

Myths behind derivatives

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

become the most important. Today, derivatives have become part of the day-to-day

life for ordinary people in most parts of the world.

Financial derivatives came into the spotlight along with the rise in uncertainty of

post-1970, when the 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. There are still apprehensions about

derivatives. There are also many myths though the reality is different especially for

exchange-traded derivatives which are well regulated with all the safety mechanisms

in place.

What are these myths behind derivatives?



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Derivatives increase speculation and do not serve any economic

purpose.

Numerous studies have led to a broad consensus, both in the private and public

sectors, that derivatives provide substantial benefits to the users. Derivatives are a

low-cost, effective method for users to hedge and manage their exposures to interest

rates, commodity prices, or exchange rates.

The need for derivatives as hedging tool was felt first in the commodities market.

Agricultural futures and options helped farmers and processors hedge against

commodity price-risk. After the collapse of the 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 currencies, increased trading in a variety of derivatives instruments,

and on-line trading in the capital markets.

As the complexity of instruments increased, the accompanying risk factors grew.

This situation led to the development derivatives as effective risk-management tools

for the market participants. Looking at the equity market, derivatives allow

corporations and institutional investors to manage effectively their portfolios of

assets and liabilities through instruments such as 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 part of its equity assets, by using stock index

futures or index options.

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 among global markets,



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increasing market liquidity and efficiency, and facilitating the flow of trade and

finance.

Indian market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indiancapital market is not ready for derivatives trading. Here, we look into the pre-

requisites needed for the introduction of derivatives and how the Indian market fares.

Disasters can happen in any system. The 1992 security scam is a case in

point. Disasters are not necessarily due to dealing in derivatives, but derivatives

make headlines. Careful observation will show that these disasters, such as the

Barings collapse, Metallgesellschaft, Daiwa Bank scandal (not related to derivatives)

and Orange County, occurred due to the lack of internal controls and/or outright

fraud either by employees or promoters.

In essence, these examples suggest that scandals have occurred in the

recent past, not only in derivatives-related instruments, but also in bonds, foreign

exchange trading and commodities trading. Most failures have taken place on the

`over the-counter' deals, except in the case of Barings, where it was a case of internal

fraud, as also with Daiwa Bank, which lost more than $1 billion in debt portfolio.

`Over-the-counter' (OTC) deals lack transparency, sophisticated margining system

and a well-laid-out regulatory framework, which is not the case with the exchange-

traded derivatives.

Many of the failures happened because of the complex nature oftransactions while the exchange-traded derivatives are simple and easy to understand.In that sense, these derivatives have been found to be the most useful in allowing

participants to transfer their risk, without the problems associated with the OTCdeals. Internal controls would be important in any case, for normal equity or debttrading as much as in derivatives trading and the participants need to be more carefulin implementing and operating good back-office and control systems to avoid anyinternal control failures.



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Derivatives are complex and exotic instruments that Indian

investors will have difficulty in understanding

Trading in standard derivatives such as forwards, futures and options is already

prevalent in India and has a long history. The Reserve Bank of India allows forward

trading in rupee-dollar forward contracts, which has become a liquid market. The

RBI also allows cross currency options trading.

Derivatives in commodities markets have a long history. The first

commodity futures exchange was set up in 1875, in Mumbai, under the aegis of

Bombay Cotton Traders Association. A clearing house for clearing and settlement of

these trades was set up in 1918. In oilseeds, a futures market was established in 1900.

Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up

in Calcutta in 1912 and the bullion futures market in Bombay in 1920.

In the equities markets also, derivatives have existed for long. In fact, official history

of the Native Share and Stock Brokers Association, which is now known as the

Bombay Stock Exchange suggests that the concept of options existed from early as in

1898. A quote ascribed to Mr. James P. McAllen, MP, at the time of the inauguration

of BSE's new Brokers Hall in 1898, is: ``...India being the original home of options, a

native broker would give a few points to the brokers of the other nations in the

manipulations of puts and calls.''

This amply proves that the concept of options and futures is well-ingrained in

the Indian equities market and is not as alien as it is made out to be. Even today,

complex strategies of options are traded in many exchanges which are called teji-

mandi, jota-phatak, bhav-bhav at different places. In that sense, the derivatives are

not new to India and are current in various markets including equities markets.

India has a long history of derivatives trading. In fact, in commodities markets,

Indian exchanges are inviting foreigners to participate for which the approvals have

also been granted.



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Is capital market safer than derivatives?

WORLD OVER, the spot market in equities operates on a principle of rolling

settlement. In this kind of trading, if one trades on a particular day (T), one has to

settle these trades on the third working day from the date of trading (T+3).Futures market allows you to trade for a period of, say, one or three months and net

the transaction for the settlement at the end of the period. In India, most stock

exchanges allow the participants to trade over a one-week period for settlement in the

following week. The trades are netted for the settlement for the entire one-week

period. In that sense, the Indian market is already operating on the futures-style

settlement.

In this system, additionally, many exchanges also allow the forward-trading called

badla and contango, which was prevalent in the UK. This system is prevalent in

France, in the monthly settlement market. It allows one to even further increase the

time to settle for almost three months, under the current regulations. But this way, a

curious mix of futures style settlement with the facility to carry the settlement

obligations forward, creates discrepancies.

The more efficient way will be to separate the derivatives from the cash market, that

is, introduce rolling settlement in all exchanges and, simultaneously, allow futures

and options to trade. This way, the regulators will also be able to regulate both the

markets easily and it will provide more flexibility to the market participants.

In addition, the existing system does not ask for any margins from the clients. Given

the volatility of the equities market in India, this system has become quite prone to

systemic collapse.The Indian capital market operates on a account period system which is actually a

seven-day futures market, while internationally, the cash market operates on T+3

rolling settlement basis _ one of the G-30 recommendations for an efficient clearing

and settlement mechanism. In the futures market, there is a daily mark-to-market



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settlement (T+1), leading to faster settlement and risk reduction, unlike the cash

market where settlement takes seven days. Client positions are not segregated from

the trading member's proprietary role and clearing members are not segregated,

affecting the system.



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Derivatives Market in India

Approval For Derivatives trading

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

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



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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 derivatives within the ambit of securities and the regulatory framework was

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(Sensex) index.

This was followed by approval for trading in options based on these two indexes and

options on individual securities.

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



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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.

Exchange-traded vs. OTC (Over The Counter) 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 globalization 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

margining,

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

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

integrity, and for safeguarding the collective interests of market participants, and



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Table 1 growth of options &future trading at NSE

Month &

year

Stock Future Stock Call Option Stock Put Option

No. of

contrac

ts

Turnover

(Rs.Cror

e)

No. of

contract

s

Turnover

(Rs.Crore)

No. of

contract

s

Turnover

(Rs.Crore)

Jul-01 ----- ---- 13082 290 4746 106

Aug-01 ----- ---- 38971 844 12508 263

Sep-01 ----- ---- 64344 1322 33480 690

Oct-01 ----- ----- 85844 1632 43747 801Nov-01 125946 2811 112499 2327 31484 683

Dec-01 309755 7515 84134 1986 28425 674

Jan-02 489793 13261 133947 3836 44498 1253

Feb-02 528947 13939 133630 3635 33055 846

Mar-02 503415 13989 101708 2863 37387 1094

Apr-02 552727 15065 121225 3400 40443 1107

May-02 605284 15981 126867 3490 57984 1643

Jun-02 616461 16178 123493 3325 48919 1317

Jul-02 789290 21205 154089 4341 65530 1837Aug-02 726310 17881 147646 3437 65630 1725



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USERS OF DERIVATIVES

The institutional investor in India could be meaningfully classified

into:

1. Banks

2. All India Financial institution (FIs)

3. Mutual Funds

4. Foreign Institutional Investor

5. Life & General Insurers

The intensity of derivatives usage by any institutional investor

is a function of its ability and willingness to use derivatives

for one or more of the following purposes:

a) Risk containment: Using derivatives for hedging and riskcontainment purpose,

b) Risk Trading /Market Making: Running derivatives

trading book for profits and arbitrage, and / or

c) Covered Intermediation: On-Balance Sheet derivatives

intermediation for client transaction, without retaining any net risk

on the Balance Sheet (except credit risk).



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BANKS

Types of Banks

Based on the differences in governance structure, businesspractices and organizational ethos, it is meaningful to classify theIndian banking sector into the followings:

I. Public Sector Banks(PSBs)

II. Private Sector Banks(Old generation),

III. Private Sector Banks (new generation),

IV. Foreign Banks( with banking and authorized dealer license)

Credit Derivatives

The market of fifth type of derivatives namely, credit derivatives, is

currently nonexistent in India, hence has been dealt with in brief

here. Credit derivatives seek to transfer credit risk and returns of an

asset from one counter party to another without transferring its

ownership. The market for credit derivatives is currently non-

existent in India, though it has the potential to develop.

Equity Derivatives in Banks

Given the highly leveraged nature of banking business, and the

attendant regulatory concerns of their investment in equities, banks

in India can, at best, be turned as marginal investor in equities. Use

of equity derivatives by banks ought to be inherently limited to risk

containment (hedging) and arbitrage trading between the cash



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market and options and futures markets. However, for the following

reasons, banks with direct and indirect equity market exposure are

yet to use exchange traded equity derivatives (viz.., index futures,

index options, security specified futures r options) currently

available on the National Stock Exchange (NSE) or Bombay Stock

Exchange (BSE).

1) RBI guidelines on investment by the banks in capital

market instruments do not authorize banks to use equity

derivatives for any purpose. RBI guidelines also do notauthorized banks to undertake securities lending and/ or

borrowings of equities. This disables also banks

possessing arbitrage trading skills and institutionalized

risk management process for running an arbitrage trading

book to capture risk free pricing mismatch spread

between the equity cash and options and futures market-

an activity banks currently any way undertake in the

fixed income and FX cash and forward markets;

2) Direct and indirect equity exposure of banks is negligible

and does not warrant serious management attention and

resources for hedging purpose;

3) The internal resources and processes in most bank

treasuries are inadequate to mange the risk of equity

market exposure, and monitor use of equity derivatives;

4) Inadequate technological and business process readiness

of their treasuries to run equity arbitrage trading book,

and mange related risks.



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Fixed Income Derivatives in Bank

Scheduled Commercial banks, Primary Dealers (PDs and All India

Financial Institution (FIs have been allowed by RBI since July 0993

to write Interest Rate Swaps(IRS) and Forward Rate

Agreement(FRAs)as product for their own assets liability

management (ALM) or for market making (risk trading)purpose.

The presence of Public Sector Banks major in the rupee IRS market

is marginal. Most PSBs are either unable or unwilling of PSB majors

seemingly stem from the following key are yet to overcome;

1) Inad

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