A STUDY ON DERIVATIVES MARKET

A Project Submitted To

University Of Mumbai For Partial Completion Of The

Degree Of Bachelors Of Financial Markets

Semester-VI

By

ADITI KHOBREKAR

Roll No. 307

Under the Guidance of

Ganashree Kokulla

Smt. Parmeshwaridevi Durgadutt Tibrewala Lions Juhu

College Of Arts, Science & Commerce

J. B. Nagar, Andheri (E), Mumbai-400 059

2018-2019
Smt. Parmeshwaridevi Durgadutt Tibrewala Lions Juhu College

Of Arts, Science & Commerce

J. B. Nagar, Andheri (E), Mumbai-400 059

CERTIFICATE

This is to certify that Miss. Aditi Khobrekar has worked and

duly completed her project work for the degree of bachelors of
financial market and his project is entitled, “A STUDY ON
DERIVATIVES MARKET”, under my supervision. I further
certify that the entire work has been done by the learner under
my guidance and that no part of it has been submitted previously
for any degree or diploma of any university. It is her own work
and facts reported by his personal findings and investigations.

Name and Signature of

Guiding Teacher

Date of submission:
 DECLARATION BY LEARNER

I the undersigned Miss. Aditi Khobrekar here by, declare that the
work embodied in this project work titles “A Study On
Derivatives Market”, forms my own contribution to the research
work carried out under the guidance of Ganashree Kokulla is a
result of my own research work and has not been previously
submitted to any other university for any other Degree to this or
any other University.

Wherever reference has been made to previous works of others,

it has been clearly indicated as such and included in the
webliography.

I here by further declare that all information of this document

has been obtained and presented in accordance with academic
rules and ethical conduct.

Name and Signature

of the learner

Certified by

Name and signature of the Guiding Teacher

 ACKNOWLEDGEMENT

To list who all have helped me is difficult because they are so

numerous and the depth is so enormous.

I would like to acknowledge the following as being idealistic

channels and fresh dimensions in the completion of this project.

I take this opportunity to thank the University of Mumbai for

giving me chance to do this project.

I would like to thank my Principal, Trishla Mehta for

providing the necessary facilities required for completion of this
project.

I take this opportunity to thank our Coordinator Dr. Nanda

Indulkar, for her moral support and guidance.

I would also like to express my sincere gratitude towards my

project guide Prof Pooja Soni, Reshma Khan, & Anita Kedare
whose guidance and care made the project successful.

I would like to thank my College Library, for having provided

various reference books and magazines related to my project.

Lastly, I would like to thank each and every person who directly
or indirectly helped me in the completion of the project
especially my Parents and Peers who supported me throughout
my project.
 EXECUTIVE SUMMARY
Many associate the financial market mostly with the equity market. The
financial market is, of course, far broader, encompassing bonds, foreign exchange,
real estate, commodities, and numerous other asset classes and financial instruments.
A segment of the market has fast become its most important one: derivatives. The
derivatives market has seen the highest growth of all financial market segments in
recent years. It has become a central contributor to the stability of the financial system
and an important factor in the functioning of the real economy. Despite the
importance of the derivatives market, few outsiders have a comprehensive perspective
on its size, structure, role and segments and on how it works. The derivatives market
has recently attracted more attention against the backdrop of the sub prime lending
crisis, financial crisis, fraud cases and the near failure of some market participants.
Although the financial crisis has primarily been caused by structured credit-linked
securities that are not derivatives, policy makers and regulators have started to think
about strengthening regulation to increase transparency and safety both for derivatives
and other financial instruments.
The study is purely based on the secondary data for examining futures
market in terms of relationship, modelling and forecasting volatility in India. The
study period spanned from January 2003 to December 2008 with a sample of 25 stock
futures contracts. For the purpose of evaluating stock futures, we used
ARCH/GARCH family model to draw valid conclusion. Our findings suggest that,
volatility is a part and parcel of capital market and have a major effect in derivative
market fluctuations, it is due to the other key determining factors like inflow of
foreign capital into the country like exchange rate, balance of payment, interest rate
etc. Rise in market capitalization leads to rise in inflation rates, Industrial Production
Index (IIP) and Gross Domestic Product (GDP). Overall, it is clearly desirable to
preserve the environment that has contributed to the impressive development of the
derivatives market and enhances the overall depth, increases market liquidity and
compresses spot market volatility in the Indian economy. However, some aspects of
the futures trading terminal can still be improved further.

CONTENT
SR NO. TOPIC PAGE NO.

1) INTRODUCTION

1.1 Introduction of derivatives 1

1.2 Definition 3

1.3 Why do derivatives matter? 4

1.4 Evolution and growth of derivatives 4

1.5 How do derivatives work 8

1.6 Derivatives market in India 9

1.7 Features of derivatives 15

1.8 Uses of derivatives 17

1.9 Functions of derivatives 18

1.10 Dangers of derivatives 21

1.11 Types of derivatives 23

1.12 Participants of derivatives 50

2) RESEARCH METHODOLOGY

2.1 Research methodology 56

2.2 Objectives of study 58

2.3 Questionnaire for research 59

3) REVIEW OF LITERATURE 61

4) DATA ANALYSIS 64

4.1 Findings 72

5) CONCLUSION &SUGGESTION

5.1 Conclusion 73

5.2 suggestion 74

WEBLOGRAPHY 75

1. INTRODUCTION
1.1 INTRODUCTION OF DERIVATIVES
A derivative is a financial security with a value that is reliant upon, or derived from,
an underlying asset or group of assets. The derivative itself is a contract between two
or more parties, and its price is determined by fluctuations in the underlying asset.
The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market indexes.
These assets are commonly purchased through a variety of brokerages. You can check
out Investopedia's list of the best online brokers to see some of the top places to start
investing. Derivatives can either be traded over-the-counter (OTC) or on an exchange.
OTC derivatives constitute the greater proportion of derivatives and are not
standardized. Meanwhile, derivatives traded on exchanges are standardized and more
heavily regulated. OTC derivatives generally have greater counterparty risk than
standardized derivatives.

Derivatives are securities that derive their value from an underlying asset or
benchmark. Common derivatives include futures contracts, options and swaps. Most
derivatives are not traded on exchanges and are used by institutions to hedge risk or
speculate on price changes in the underlying asset. Exchange-traded derivatives like
futures and stock options are standardized and eliminate or reduce many of the risks
of over-the-counter derivatives like counterparty and liquidity risks. Derivatives are
usually leveraged instruments, which increases the potential risks and rewards of
these securities.

Derivatives, such as options or futures, are financial contracts which derive

their value of a spot price time-series, which is called \the underlying". For examples,
wheat farmers may wish to contract to sell their harvest at a future date to eliminate
the risk of a change in prices by that date. Such a transaction would take place
through a forward or futures market. This market is the \derivative market” and the
prices on this market would be driven by the spot market price of wheat which is
the \underlying". The terms \contracts" or \products" are often applied to denote the
specific traded instrument. The world over, derivatives are a key part of the financial
system. The most important contract types are futures and options, and the most
important underlying markets are equity, treasury bills, commodities, foreign
exchange and real estate.
 The past decade has witnessed an explosive growth in the use of financial
derivatives by a wide range of corporate and financial institutions. This growth has
run in parallel with the increasing direct reliance of companies on the capital markets
as the major source of long-term funding. In this respect, derivatives have a vital role
to play in enhancing shareholder value by ensuring access to the cheapest source of
funds. Furthermore, active use of derivative instruments allows the overall business
risk profile to be modified, thereby providing the potential to improve earnings
quality by offsetting undesired risks.

Despite the clear benefits that the use of derivatives can offer, too often the
public and shareholder perception of these instruments has been coloured by the
intense media coverage of financial disasters where the use of derivatives has been
blamed. The impression is usually given that these losses arose from extreme complex
and difficult to understand financial strategies. The reality is quite different. When the
facts behind the well-reported disasters are analyzed almost invariably it is found that
the true source of losses was a basic organizational weakness or a failure to observe
some simple business controls.

The corollary to this observation is that derivatives can indeed be used safely
and successfully provided that a sensible control and management strategy is
established and executed. Certainly, a degree of quantitative pricing and risk analysis
may be needed, depending on the extent and sophistication of the derivative strategies
employed. However, detailed analytic capabilities are not the key issue. Rather,
successful execution of a derivatives strategy and of business risk management in
general relies much more heavily on having a sound appreciation of qualitative
market and industry trends and on developing a solid organisation, infrastructure and
controls. Within a sound control framework, the choice of a particular quantitative
risk management technique is very much a secondary concern. The objective of this
chapter is to examine the growth of financial derivatives in world markets and to
analyse the impact of these financial derivatives on the monetary policy

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 the profitability and cash flow situation of risk-averse
investors.

1.2 DEFINITION
The word derivative comes from the verb “derive”, which means the action of
having or taking something from an underlying source. A derivative is an instrument
whose value is derived from the value of one or more underlying, which can be
commodities, precious metals, currency, bonds, stocks, stocks indices, etc.

Derivative is easier to understand than to describe it and it is easier to describe

than to define it. Derivative is a generic term used to describe a spectrum of products
that derive their price or have their value linked to some other product. A derivative is
a financial instrument whose value depends on the value of underlying assets
(variables). These variables can be prices of currency, stock, commodity, indices,
interest rates, etc. The term derivative has been defined in securities contracts
(regulations) Act, as: a derivative includes

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

unsecured, risk instrument or contract for differences or any other form of
security;

b) A contract which derives its value from the prices, or index of prices, of
underlying securities.

1.3 WHY DO DERIVATIVES MATTER?

As often is the case in trading, the more risk you undertake the more reward you stand
to gain. Derivatives can be used on both sides of the equation, to either reduce risk or
assume risk with the possibility of a commensurate reward. This is where derivatives
have received such notoriety as of late: in the dark art of speculating through
derivatives. Speculators who enter into a derivative contract are essentially betting
that the future price of the asset will be substantially different from the expected price
held by the other member of the contract. They operate under the assumption that the
party seeking insurance has it wrong in regard to the future market price, and look
to profit from the error
Contrary to popular opinion, though, derivatives are not inherently bad. In fact, they
are a necessity for many companies to ensure profits in volatile markets or provide
mitigated risk for everyday investors looking for investment insurance.

1.4 EVOLUTION AND GROWTH OF DERIVATIVES:

According to some financial scholars, future trading dates back in India to

around 200 B. C. Evolution of trading methods of futures can be traced in the
medieval fairs of France and England as early as the 12th century.

It is difficult to trace out origin of futures trading since it is not clearly

established as to where and when the first forward market came into existence.
Historically, it is evident that futures markets were developed after the development
of forward markets. It is believed that the forward trading was in existence during
12th century in England and France. Forward trading in rice was started in 17th
century in Japan, known as Cho-at-Mai a kind (rice trade-on-book) concentrated
around Dojima in Osaka, later on the trade

As per the records, rice was traded for future delivery in Osaka in the 1730s.
Wheat and corn futures were reportedly traded in the UK and the USA in the 19th
century. The Chicago Board of Trade (CBOT), established in 1848, was an active
exchange for handling commodities, especially corn and wheat.

The history of derivatives has two important milestones. The first was the
establishment of stock options trade in Chicago — initially OTC and subsequently on
the CBOT market in equity derivatives in 1987. The CBOT was set up in 1848 as a
meeting place for farmers and merchants. It standardized the quantities and qualities
of the grains that were to be traded. The first future type contract was known as ‘to
arrive’ contract.
 The CBOT now offers futures contract on various assets like corn, soya bean
meal, soya bean oil, wheat, silver, bonds, treasury notes, stock index, etc.

In 1874, the Chicago Produce Exchange was established to provide a market

for poultry products, butter and other perishable agricultural products. In 1898, the
butter and egg dealers detached themselves from this exchange and formed Chicago
Butter and Egg Board.

In 1919, this was renamed as Chicago Mercantile Exchange and was

reorganized for future trading. In 1972, the International Monetary Market (IMM)
was constituted as a division of the Chicago Mercantile Exchange in 1972 for futures
trading in foreign currencies.

The first traded financial futures were foreign currency contracts which began
trading on the International Commercial Exchange (ICE) in 1970. However, it did not
succeed and had to go out of business. Additional foreign currency contracts
commenced trading on the Chicago Mercantile Exchange in 1974.

In 1975, the commodity futures trading commission (CFTC) officially

designated nine currencies as contract markets on these exchanges, these included
British pound, Canadian dollar, Deutschemarks, Dutch guilders, Japanese Yen, Swiss
traces, Italian Lira and Mexican Pesos. Global futures market currently includes
metals, grains, petroleum products financial instruments and a whole lot of other
products.

Other futures that trade in futures world over include the Chicago Rice and
Cotton Exchange, the New York Future Exchange, the London International Finance
Futures Exchange (LIFFE), the Toronto Futures Exchange (TFE) and the Singapore
International Monetary Exchange (SIMEX), MATIF (France), EOE (Holland),
SOFFEX (Switzerland) and DTB (Germany).

In India, there is no derivative based on interest rate currently. But there is a

future market on selected commodities (Castor seed, hessian, gur, potatoes, turmeric
and pepper). The Forward Markets Commission (FMC) is the controlling body for
these markets.
 India also has a strong currency forward market. Daily volume in this market
is reportedly over US $ 500 million per day. The forward cover is currently available
for a maximum of 6 months. Indian users can also buy derivatives based on foreign
currencies on foreign markets for hedging.

Ever since the “Badla” was banned, there has been a crying need for other
risk-hedging devices. The Bombay Stock Exchange has been glamorizing for the
return of the “Badla” in its old form. But the National Stock Exchange has set into
motion the process of introducing futures and options.

The L. C. Gupta Committee on derivatives was of the view that there was need
for equity-based derivatives, interest rate derivatives and currency derivatives. But it
recommended introduction of equity-based derivatives in the first instance based on
futures only, rather than options or futures/options on individual stocks which are
considered more risky.

The Committee suggested that the other complex type of derivatives should be
introduced at a later stage after the market participants have acquired some degree of
comfort and familiarity with the simpler types. The Securities and Exchange Board of
India (SEBI) has, of late, accepted the recommendation of the Gupta Committee and
allowed phased introduction of derivative trading in the country beginning with a
stock index futures.

Amendments to the Securities Contract Act (SCRA) are on the anvil. This will
facilitate inclusion of derivative contracts based on index of prices of securities and
other derivative contracts in securities trading. The SEBI also approved suggestive
by-laws proposed by the Committee covering operational aspects for regulation and
control on derivative contracts.

The RBI introduced recently, rupee derivative trading in the country. It

formally allowed banks and corporates from July 6, 1999 to hedge against interest rate
risks through the use of interest rate swaps (IRS) and forward rate agreements (FRA).
According to the guidelines, there would be no restriction on the tenure and size of the
IRS and FRA entered into by banks.
 The IRS would allow corporates to hedge their interest rate risks and also
provide an opportunity to swap their old high cost loans with cheaper ones. However,
the RBI has warned that while dealing with corporates, the participants should ensure
that they are undertaking FRAs/IRS only for hedging their own balance sheet
exposures and not for speculative purposes.

Thus, commercial banks, primary dealers, and corporates can now undertake
IRS and FRA as a product for their own balance sheet management and market
making purposes.

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 forward/futures contracts.
However when derivatives trading in securities was introduced in 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 preview of Securities Exchange Board of India (SEBI). We thus have
separate regulatory authorities for securities and commodity derivative markets.

Interest rate fluctuations had not only created instability in bond prices, but
also in other long-term assets such as, company stocks and shares. Share prices are
determined on the basis of expected present values of future dividend payments
discounted at the appropriate discount rate. Discount rates are usually based on long-
term interest rates in the market. So increased instability in the long-term interest rates
caused enhanced fluctuations in the share prices in the stock markets.

1.5 HOW DO DERIVATIVES WORK?

Derivatives are often used as an instrument to hedge risk for one party of a contract,
while offering the potential for high returns for the other party. Derivatives have been
created to mitigate a remarkable number of risks: fluctuations
in stock, bond, commodity, and index prices; changes in foreign exchange rates;
changes in interest rates; and weather events, to name a few.

One of the most commonly used derivatives is the option. Let's look at an example:
Say Company XYZ is involved in the production of pre-packaged foods. They are a
large consumer of flour and other commodities, which are subject to volatile price
movements. In order for the company to assure any kind of consistency with their
product and meet their bottom-line objectives, they need to be able to purchase
commodities at a predictable and market-friendly rate. In order to do this, company
XYZ would enter into an options contract with farmers or wheat producers to buy a
certain amount of their crop at a certain price during an agreed upon period of time. If
the price of wheat, for whatever reason, goes above the threshold, then Company
XYZ can exercise the option and purchase the asset at the strike price. Company XYZ
pays a premium for this privilege, but receives protection in return for one of their
most important input costs. If XYZ decides not to exercise its option, the producer is
free to sell the asset at market value to any buyer. In the end, the partnership acts as a
win-win for both parties: Company XYZ is guaranteed a competitive price for the
commodity, while the producer is assured of a fair value for its goods.

In this example, the value of the option is "derived" from an underlying asset; in this
case, a certain number of bushels of wheat.

Other common derivatives include futures, forwards and swaps.

1.6 DERIVATIVES MARKET IN INDIA

1.6.1 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 withdrew
the prohibition on options in securities. The market for derivatives, however, did not
take off, as there was no regulatory framework to govern trading of derivatives. SEBI
set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on
November 18, 1996 to develop appropriate regulatory framework for derivatives
trading in India. The committee submitted its report on March 17, 1998 prescribing
necessary pre–conditions for introduction of derivatives trading in India. The
committee recommended that derivatives should be declared as ‘securities’ so that
regulatory framework applicable to trading of ‘securities’ could also govern trading of
securities. SEBI also set up a group in June 1998 under the Chairmanship of
Prof.J.R.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 real–time monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within 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 2000. 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 BSE–
30(Sensex) index. This was followed by approval for trading in options based on
these two indexes and options on individual securities. The trading in index options
commenced in June 2001 and the trading in options on individual securities
commenced in July 2001. Futures contracts on individual stocks were launched in
November 2001. 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.

1.6.2 Derivatives market at NSE

The derivatives trading on the exchange 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 Nifty Index. Currently, the futures
contracts have a maximum of 3-month expiration cycles. Three contracts are available
for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced
on the next trading day following the expiry of the near month contract.

1.6.3 Trading mechanism

The futures and options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen–based trading for Nifty futures & options
and stock futures & options on a nationwide basis and an online monitoring and
surveillance mechanism. It supports an anonymous order driven market which
provides complete transparency of trading operations and operates on strict price–time
priority. It is similar to that of trading of equities in the Cash Market (CM) segment.
The NEAT-F&O trading system is accessed by two types of users. The Trading
Members(TM) have access to functions such as order entry, order matching, and order
and trade management. It provides tremendous flexibility to users in terms of kinds of
orders that can be placed on the system. Various conditions like Good-till-Day, Good-
till-Cancelled, Good till-Date, Immediate or Cancel, Limit/Market price, Stop loss,
etc. can be built into an order. The Clearing Members (CM) uses the trader
workstation for the purpose of monitoring the trading member(s) for whom they clear
the trades. Additionally, they can enter and set limits to positions, which a trading
member can take.

1.6.4 Membership criteria

NSE admits members on its derivatives segment in accordance with the rules
and regulations of the exchange and the norms specified by SEBI. NSE follows 2–tier
membership structure stipulated by SEBI to enable wider participation. Those
interested in taking membership on F&O segment are required to take membership of
CM and F&O segment or CM, WDM and F&O segment. Trading and clearing
members are admitted separately. Essentially, a clearing member (CM) does clearing
for all his trading members (TMs), undertakes risk management and performs actual
settlement. There are three types of CMs:
  Self-Clearing Member: A SCM clears and settles trades executed by him
only either on his own account or on account of his clients.

 Trading Member Clearing Member: TM–CM is a CM who is also a

TM. TM–CM may clear and settle his own proprietary trades and client’s
trades as well as clear and settle for other TMs.

 Professional Clearing Member: PCM is a CM who is not a TM.

Typically, banks or custodians could become a PCM and clear and settle for
TM1.

Business growth of futures and options market: Turnover(Rs. Crore)

Month Index futures Stock futures Index futures Stock options Total
Jun-00 35 - - - 35
Jul-00 108 - - - 108
Aug-00 90 - - - 90
Sep-00 119 - - - 119
Oct-00 153 - - - 153
Nov-00 247 - - - 247
Dec-00 237 - - - 237
Jan-01 471 - - - 471
Feb-01 524 - - - 524
Mar-01 381 - - - 381
Apr-01 292 - - - 292
May-01 230 - - - 230
Jun-01 590 - 196 - 785
 Jul-01 1309 - 326 396 2031
Aug-01 1305 - 284 1107 2696
Sep-01 2857 - 559 2012 5281
Oct-01 2485 - 559 2433 5477

Nov-01 2484 2811 455 3010 8760

Dec-01 2339 7515 405 2660 12919
Jan-02 2660 13261 338 5089 21348
Feb-02 2747 13939 430 4499 21616
Mar-02 2185 13989 360 3957 20490
2001-02 21482 51516 3766 25163 101925

Details of the eligibility criteria for membership on the F&O segment are provided in
Tables 12.1 and 12.2(Chapter 12). The TM–CM and the PCM are required to bring in
additional security deposit in respect of every TM whose trades they undertake to
clear and settle. Besides this, trading members are required to have qualified users and
sales persons, who have passed a certification programme approved by SEBI.\

1.6.5 Turnover

The trading volumes on NSE’s derivatives market have seen a steady

increase since the launch of the first derivatives contract, i.e. index futures in
June 2000. Table 1.3 gives the value of contracts traded on the NSE from the
inception of the market to March 2002. The average daily turnover at NSE
now exceeds a 1000 crore. A total of 41,96,873 contracts with a total turnover
of Rs.1,01,926 crore was traded during 2001-2002.

1.6.6 Clearing and settlement

NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O
segment. It acts as legal counterparty to all deals on the F&O segment and guarantees
settlement. We take a brief look at the clearing and settlement mechanism.
  Clearing
The first step in clearing process is working out open positions or obligations
of members. A CM’s open position is arrived at by aggregating the open position of
all the TMs and all custodial participants clearing through him, in the contracts in
which they have traded. A TM’s open position is arrived at as the summation of his
proprietary open position and clients open positions, in the contracts in which they
have traded. While entering orders on the trading system, TMs are required to identify
the orders, whether proprietary (if they are their own trades) or client (if entered on
behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for each
contract. Clients’ positions are arrived at by summing together net (buy-sell) positions
of each individual client for each contract. A TMs open position is the sum of
proprietary open position, client open long position and client open short position.

 Settlement
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.

1.6.7 Risk management system

 The salient features of risk containment measures on the F&O segment are:
Anybody interested in taking membership of F&O segment is required to take
membership of“CM and F&O”or “CM, WDM and F&O”. An existing
member of CM segment can also take membership of F&O segment. The
details of the eligibility criteria for membership of F&O segment are given in
the chapter on regulations in this book.

 NSCCL charges an upfront initial margin for all the open positions of a CM
Upto client level. It follows the VaR based margining system through SPAN
system. NSCCL computes the initial margin percentage for each Nifty index
 futures contract on a daily basis and informs the CMs. The CM in turn collects
the initial margin from the TMs and their respective clients.

 NSCCL’s on-line position monitoring system monitors a CM’s open positions

on a real-time basis. Limits are set for each CM based on his base capital and
additional capital deposited with NSCCL. The on-line position monitoring
system generates alerts whenever a CM reaches a position li 1.7 Derivatives
market in India 17 set up by NSCCL. NSCCL monitors the CMs and TMs for
mark to market value violation and for contract-wise position limit violation.

 CMs are provided with a trading terminal for the purpose of monitoring the
open positions of all the TMs clearing and settling through them. A CM may
set exposure limits for a TM clearing and settling through him. NSCCL assists
the CM to monitor the intra-day exposure limits set up by a CM and whenever
a TM exceeds the limits, it withdraws the trading facility provided to such TM.

 A separate Settlement Guarantee Fund for this segment has been created out
of the capital deposited by the members with NSCC

1.7 FEATURES OF FINANCIAL DERIVATIVES

1. It is a contract:
Derivative is defined as the future contract between two parties. It means there
must be a contract-binding on the underlying parties and the same to be
fulfilled in future. The future period may be short or long depending upon the
nature of contract, for example, short term interest rate futures and long term
interest rate futures contract.

2. Derives value from underlying asset:

Normally, the derivative instruments have the value which is derived from the
values of other underlying assets, such as agricultural commodities, metals,
financial assets, intangible assets, etc. Value of derivatives depends upon the
 value of underlying instrument and which changes as per the changes in the
underlying assets, and sometimes, it may be nil or zero. Hence, they are
closely related.

3. Specified obligation:
In general, the counter parties have specified obligation under the derivative
contract. Obviously, the nature of the obligation would be different as per the
type of the instrument of a derivative. For example, the obligation of the
counter parties, under the different derivatives, such as forward contract,
future contract, option contract and swap contract would be different.

4. Direct or exchange traded:

The derivatives contracts can be undertaken directly between the two parties
or through the particular exchange like financial futures contracts. The
exchange-traded derivatives are quite liquid and have low transaction costs in
comparison to tailor-made contracts. Example of exchange traded derivatives
are Dow Jon’s, S&P 500, Nikki 225, NIFTY option, S&P Junior that are
traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock
Exchange, Bombay Stock Exchange and so on.

5. Related to notional amount:

In general, the financial derivatives are carried off-balance sheet. The size of
the derivative contract depends upon its notional amount. The notional amount
is the amount used to calculate the payoff. For instance, in the option contract,
the potential loss and potential payoff, both may be different from the value of
underlying shares, because the payoff of derivative products differs from the
payoff that their notional amount might suggest.

6. Delivery of underlying asset not involved:

Usually, in derivatives trading, the taking or making of delivery of underlying
assets is not involved; rather underlying transactions are mostly settled by
taking offsetting positions in the derivatives themselves. There is, therefore, no
 effective limit on the quantity of claims, which can be traded in respect of
underlying assets.

7. May be used as deferred delivery:

Derivatives are also known as deferred delivery or deferred payment
instrument. It means that it is easier to take short or long position in
derivatives in comparison to other assets or securities. Further, it is possible to
combine them to match specific, i.e., they are more easily amenable to
financial engineering.

8. Secondary market instruments:

Derivatives are mostly secondary market instruments and have little
usefulness in mobilizing fresh capital by the corporate world; however,
warrants and convertibles are exception in this respect.

9. Exposure to risk:
Although in the market, the standardized, general and exchange-traded
derivatives are being increasingly evolved, however, still there are so many
privately negotiated customized, over-the-counter (OTC) traded derivatives
are in existence. They expose the trading parties to operational risk, counter-
party risk and legal risk. Further, there may also be uncertainty about the
regulatory status of such derivatives.

1.8 USES OF DERIVATIVES

Derivatives are supposed to provide the following services:

1. Risk aversion tools:

One of the most important services provided by the derivatives is to control,
avoid, shift and manage efficiently different types of risks through various strategies
like hedging, arbitraging, spreading, etc. Derivatives assist the holders to shift or
modify suitably the risk characteristics of their portfolios. These are specifically
useful in highly volatile financial market conditions like erratic trading, highly
flexible interest rates, volatile exchange rates and monetary chaos.
2. Prediction of future prices:
Derivatives serve as barometers of the future trends in prices which result in the
discovery of new prices both on the spot and futures markets. Further, they help in
disseminating different information regarding the futures markets trading of various
commodities and securities to the society which enable to discover or form suitable or
correct or true equilibrium prices in the markets. As a result, they assist in appropriate
and superior allocation of resources in the society.

3. Enhance liquidity:
As we see that in derivatives trading no immediate full amount of the transaction
is required since most of them are based on margin trading. As a result, large number
of traders, speculators arbitrageurs operates in such markets. So, derivatives trading
enhance liquidity and reduce transaction costs in the markets for underlying assets

4. Assist investors:
The derivatives assist the investors, traders and managers of large pools of funds
to devise such strategies so that they may make proper asset allocation increase their
yields and achieve other investment goals.

1.9 FUNCTIONS OF DERIVATIVES MARKETS

The following functions are performed by derivative markets:

1. Price Discovery:
Price discovery is expectation of the future cash/spot prices on the basis of prices
of the futures/forward contracts’. Price discovery is a mechanism by which a “fair
value price” is determined by the large number of participants in the derivatives
markets. The markets participants can estimate the prices of underlying at a given
point in time with the help of information currently available in the derivatives
segment/market. Increasing participants of hedgers, speculators and arbitrageurs has
increased the depth of the derivatives markets. The automation of derivatives
exchange and electronic trading systems established by the derivatives exchanges has
led to faster and smoother information dissemination amongst market participants.
Due to which the price discovery mechanism has become more efficient.

2. Risk transfer:
The derivatives market helps to transfer risks from those who have them but may
not like them to those who have an appetite for them.

3. Linked to cash markets:

Derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market witnesses higher
trading volumes because of participation by more players who would not otherwise
participate for lack of an arrangement to transfer risk.

4. Check on speculation:
Speculation traders shift to a more controlled environment of the derivatives
market. In the absence of an organised derivatives market, speculators trade in the
underlying cash markets. Managing, monitoring and surveillance of the activities of
various participants become extremely difficult in these kinds of mixed markets.

5. Encourages entrepreneurship:
An important incidental benefit that flows from derivatives trading is that it acts as
a catalyst for new entrepreneurial activity. Derivatives have a history of attracting
many bright, creative, well-educated people with an entrepreneurial attitude. They
often energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense.

6. Increases savings and investments:

 Derivatives markets help increase savings and investment in the long run. The
transfer of risk enables market participants to expand their volume of activity.

7. Beneficial to banks and financial institutions:

Banks and Financial Institutions can benefit by hedging their risks since they deal
primarily in the underlying on which financial derivatives are based. They can hedge
the risk even if the underlying does not meet their requirements of exact
specifications.

8. Lower transaction cost:

The increasing participation in the derivatives markets by variety of participants,
the transaction costs are showing falling trend.

9. An option for high net worth investors:

With the rapid spread of derivatives trading in commodities, the commodities
route too has become an option for high net worth and savy investors to consider in
their overall asset allocation.

10. High financial leverage:

Leveraged investment is possible in derivatives markets. For example, trading in
Infosys shares need only 4% initial margin. Thus, if one Infosys futures contract (each
futures contract lot size is 100 shares) is valued at Rs. 1,04,000 when futures price is
Rs. 1,040 per share, the investor is expected to deposit an initial margin of only Rs.
4,160 to be able to trade. If the price of Infosys shares goes up by even 2%, the
investor would make profit of Rs. 2,080 (2% of Rs. 1,04,000) on a deposit of Rs.
4,160/- before the expiry of the contract i.e. Return of 50% on deposit on initial
margin amount. This is the benefit of leveraged trading transaction.
11. Derivatives as an asset class for diversification of portfolio risk:
Derivatives provide wider scope to portfolio management in bettering their
investment risk-return trade off. Portfolio managers can diversify their portfolios in a
better way by including derivatives in their investment basket. The risk management
and leveraging function of derivatives helps portfolio managers in efficient portfolio
management. Derivatives have historically an inverse correlation of daily returns as
compared to equities. The skewness of daily returns favours derivatives, thereby
indicating that in a given time period derivatives have a greater probability of
providing positive returns as compared to equities. Another consisting of derivatives
as well as equities. Even with a marginal distribution of funds in a portfolio to include
derivatives, the Sharpe ratio is greatly enhanced, thereby indicating a decrease in risk
for given level of returns. Thus, an investor can effectively minimize the portfolio risk
arising due to price fluctuations in other asset classes by including derivatives in the
portfolio.

1.10 DANGERS OF DERIVATIVES

Derivatives products are primarily used as risk management tool. They are required to
be used appropriately and carefully. If they are used indiscriminately they instead of risk
management tool may become risk prone tools. Indiscriminate use of derivatives can lead to
disasters. Following are selected pitfalls/dangers of derivatives products.

1. Speculative and volatile

2. Restrictive regulation
3. Increased bankruptcy
1.10.1. Speculative and volatile:

The high leveraging capabilities offered by derivatives products attracts

participants with thin capital base. The prospect of high returns induces participants in
taking indiscriminate positions in derivatives markets which leads to excessive
speculation. The speculative tendencies tend to become dominant. This dominance of
speculative forces leads to volatility in the prices of derivatives as well as underlying
assets in the spot market. Indian derivatives markets, especially commodity
derivatives, have quite often experienced extreme volatilities and excessive
speculation. The prices in the spot markets usually get overvalued because of these
excesses. The extreme volatility and excessive speculation leads to demand-supply
mismatch too.

1.10.2. Restrictive regulations:

The extreme volatility and excessive speculation throws the spot market out of
sync. The overvaluation in spot market and demand-supply imbalance prompts the
regulatory authority to suspend trading in derivatives of those underlying whose
prices have become volatile and speculative. This affects the risk management
programs of hedgers who have genuine exposure to risk. Further, in order to
discourage excessive speculation and volatility the regulatory authority world over
have put in place controls measures. Such controls are often not favoured by some
participants. They view such controls as barriers to growth of derivatives market. The
participants at time may feel that derivative markets are over-regulated, thus
inhibiting development of derivatives markets.

1.10.3. Increased Bankruptcy

High leveraging feature of derivatives induces participants in derivatives

markets to builds positions indiscriminately beyond their financial capabilities. The
positions in derivatives markets are sequential thus one default creates chain reaction
and ultimately leading to collapse of entire derivatives market. The recent global
financial crisis is an evidence of indiscriminate trading in derivatives markets, which
created chain reaction and sequentially financial markets across the globe started
failing. The crisis reached such disastrous levels that the monetary authorities of
affected countries had to bail out the affected financial institutions by infusing funds
into these institutions. These bail-out packages are strain on exchequer. The gravity of
crisis is such that it prompted regulatory authorities across the globe to impose more
stringent norms for entire financial markets.

1.11 TYPES OF DERIVATIVES

Derivatives are of two types: financial and commodities.
 One form of classification of derivative instruments is between commodity
derivatives and financial derivatives. The basic difference between these is the nature
of the underlying instrument or asset. In a commodity derivative, the underlying
instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric,
corn, soya beans, crude oil, natural gas, gold, silver, copper and so on. In a financial
derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign
exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted
that financial derivative is fairly standard and there are no quality issues whereas in
commodity derivative, the quality may be the underlying matter. However, despite the
distinction between these two from structure and functioning point of view, both are
almost similar in nature. The most commonly used derivatives contracts are forwards,
futures and options.
1.11.1. FINANCIAL DERIVATIVES
A financial derivative is a financial instrument whose value is based on or
derived from one or more underlying assets or indexes of assets. The underlying
assets in case of financial derivatives are typically equities (stocks), debt (bonds, T-
Bills, and notes), currencies and even indexes of these various financial assets such as
NSE’s S&P Nifty, BSE’s Sensex, Volatility Index, etc. Financial derivatives are kind
of a risk management tool widely used by investors and portfolio managers.
Numerous forms of financial derivatives are available in the financial markets. The
three most fundamental financial derivatives are forward, futures and options.

One important feature of financial derivatives is that these are tools which is
merely a contract and does not help mobilize funds in the primary markets. These are
created by a contractual agreement between two parties based on the price of the
underlying asset. There is usually no limit on the number of contracts that can be
created, except in case of exchange traded financial derivatives wherein the exchange
clearing house imposes limits on number of derivative contracts for particular
underlying asset or class of asset.

Initially derivative products emerged as hedging devices to guard against

fluctuations in commodity prices. For a long time commodity-linked derivatives were
the sole forms of derivatives products available for trading. The growing instability in
the financial markets, post 1970 the financial derivatives gained importance and
became very popular. Two-thirds of the total trade in derivatives products was in the
form of financial derivatives. In the recent years, the market for financial derivatives
has grown in terms of types of instruments available and their complexity
1. Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees
to buy the underlying asset on a certain specified future date for a certain specified
price. The other party assumes a short position and agrees to sell the asset on the same
date for the same price. Other contract details like delivery date, price and quantity are
negotiated bilaterally by the parties to the contract. The forward contracts are
normally traded outside the exchanges.

The salient features of forward contracts are:

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

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

size, expiration date and the asset type and quality.

 The contract price is generally not available in public domain.

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

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

same counterparty, 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 very useful in hedging and speculation. The classic
hedging application would be that of an exporter who expects to receive payment in
dollars three months later. He is exposed to the risk of exchange rate fluctuations. By
using the currency forward market to sell dollars forward, he can lock on to a rate
today and reduce his uncertainty. Similarly an importer who is required to make a
payment in dollars two months hence can reduce his exposure to exchange rate
fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price,

then he can go long on the forward market instead of the cash market. The speculator
would go long on the forward, wait for the price to raise, and then take a reversing
transaction to book profits. Speculators may well be required to deposit a margin
upfront. However, this is generally a relatively small proportion of the value of the
assets underlying the forward contract. The use of forward markets here supplies
leverage to the speculator.

 How it works (Example):

If you plan to grow 500 bushels of wheat next year, you could sell your wheat for
whatever the price is when you harvest it, or you could lock in a price now by selling
a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg
after the harvest for a fixed price. By locking in the price now, you eliminate the risk
of falling wheat prices. On the other hand, if prices rise later, you will get only what
your contract entitles you to.

If you are Kellogg, you might want to purchase a forward contract to lock in
prices and control your costs. However, you might end up overpaying or (hopefully)
underpaying for the wheat depending on the market price when you take delivery of
the wheat.
 Features of Forward Contract

The basic features of a forward contract are given in brief here as under:

 Bilateral:

Forward contracts are bilateral contracts, and hence, they are exposed to counter-
party risk.

 More risky than futures:

There is risk of non-performance of obligation by either of the parties, so these are

riskier than futures contracts.

 Customised contracts:
Each contract is custom designed, and hence, is unique in terms of contract size,
expiration date, the asset type, quality, etc.

 Long and short positions:

In forward contract, one of the parties takes a long position by agreeing to buy the
asset at a certain specified future date. The other party assumes a short position by
agreeing to sell the same asset at the same date for the same specified price. A
party with no obligation offsetting the forward contract is said to have an open
position. A party with a closed position is, sometimes, called a hedger.

 Delivery price:

The specified price in a forward contract is referred to as the delivery price. The
forward price for a particular forward contract at a particular time is the delivery
price that would apply if the contract were entered into at that time. It is important
 to differentiate between the forward price and the delivery price. Both are equal at
the time the contract is entered into. However, as time passes, the forward price is
likely to change whereas the delivery price remains the same.

 Synthetic assets:

In the forward contract, derivative assets can often be contracted from the
combination of underlying assets, such assets are oftenly known as synthetic assets
in the forward market. The forward contract has to be settled by delivery of the
asset on expiration date. In case the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which may dominate and command the
price it wants as being in a monopoly situation.

 Pricing of arbitrage based forward prices:

In the forward contract, covered parity or cost-of-carry relations are relation

between the prices of forward and underlying assets. Such relations further assist in
determining the arbitrage-based forward asset prices.

 Popular in forex market:

Forward contracts are very popular in foreign exchange market as well as interest
rate bearing instruments. Most of the large and international banks quoted the
forward rate through their ‘forward desk’ lying within their foreign exchange
trading room. Forward foreign exchange quotes by these banks are displayed with
the spot rates.
2. Futures contracts

A futures market is an auction market in which participants buy and sell commodity
and futures contracts for delivery on a specified future date. Examples of futures
markets are the New York Mercantile Exchange, the Kansas City Board of Trade, the
Chicago Mercantile Exchange, the Chicago Board Options Exchange and the
Minneapolis Grain Exchange.

Originally, such trading was carried on through open yelling and hand signals in a
trading pit, though in the 21st century, like most other markets, futures exchanges are
mostly electronic. In order to understand fully what a futures market is, it’s important
to understand the basics of futures contracts, the assets traded in these markets.

Futures contracts are made in an attempt by producers and suppliers

of commodities to avoid market volatility. These producers and suppliers negotiate
contracts with an investor who agrees to take on both the risk and reward of
a volatile market. Futures markets or futures exchanges are where these financial
products are bought and sold for delivery at some agreed-upon date in the future with
a price fixed at the time of the deal. Futures markets are for more than simply
agricultural contracts, and now involve the buying, selling and hedging of products
and future values of interest rates. Futures contracts can be made or "created" as long
as open interest is increased, unlike other securities that are issued. The sizes of
futures markets (which usually increase when the stock market outlook is uncertain)
are larger than that of commodity markets, and are a key part of the financial system.

Suppose a farmer produces rice and he expects to have an excellent yield on rice; but
he is worried about the future price fall of that commodity. How can he protect
himself from falling price of rice in future? He may enter into a contract on today with
some party who wants to buy rice at a specified future date on a price determined
today itself. In the whole process the farmer will deliver rice to the party and receive
the agreed price and the other party will take delivery of rice and pay to the farmer. In
this illustration, there is no exchange of money and the contract is binding on both the
parties. Hence future contracts are forward contracts traded only on organised
exchanges and are in standardised contract-size. The farmer has protected himself
against the risk by selling rice futures and this action is called short hedge while on
the other hand, the other party also protects against-risk by buying rice futures is
called long hedge.

 How Do Futures Contracts Work?

The assets often traded in futures contracts include commodities, stocks, and bonds.
Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are
traditional examples of commodities, but foreign currencies, emissions credits,
bandwidth, and certain financial instruments are also part of
today's commodity markets.

There are two kinds of futures traders: hedgers and speculators. Hedgers do not
usually seek a profit by trading commodities futures but rather seek to stabilize
the revenues or costs of their business operations. Their gains or losses are
usually offset to some degree by a corresponding loss or gain in the market for the
underlying physical commodity.

For example, if you plan to grow 500 bushels of wheat next year, you could either
grow the wheat and then sell it for whatever the price is when you harvest it, or you
could lock in a price now by selling a futures contract that obligates you to sell 500
bushels of wheat after the harvest for a fixed price. By locking in the price now, you
eliminate the risk of falling wheat prices. On the other hand, if the season is terrible
and the supply of wheat falls, prices will probably rise later -- but you will get only
what your contract entitled you to. If you are a bread manufacturer, you might want to
purchase wheat futures contract to lock in prices and control your costs. However, you
might end up overpaying or (hopefully) underpaying for the wheat depending on
where prices actually are when you take delivery of the wheat.
 • Features of Futures Contract

 Exchange Traded:

Futures contract are traded on centralized exchange floor, either physical or

electronically networked.

 Standardized Contracts:

The contract size (i.e. lot size), Maturity period, settlement dates are fixed by
derivatives exchange.

 Exchange Regulated:

The trading in futures contract is regulated by the derivatives exchange.

 No Perfect Hedge:

Since futures contract are standardized contracts entered on derivatives exchange,

they do not offer perfect hedge. The buyer / seller of contract will be either over
hedged or under hedged. For example, an importer has a payment obligation of US
$ IS 10,570/- three months from today and if the lot size fixed by derivatives
exchange for futures contract on US $ is 1,000 per contract, then the importer will
have to take either 10 contracts or 11 contracts to hedge his exposure of US $
10,570/-. If importer buys 10 futures contracts then he will be under hedged
(uncovered) by US $ 570 (i.e. US $ 10,570 – US $ 10,000) and if importer buys 11
futures then he will be over hedged by US $ 430 (i.e. US$10,570-US$11,000).
 Exchange as Counter Party:

The futures contracts are written against the clearing house of the derivatives
exchanges thus the clearing house is the counter-party to the contract. That is, for
buyer and seller of futures contract the clearing house of the exchange is the
counter party. In other words, the contract is between the buyer or seller and the
clearing house of the exchange.

 Margin:

The clearing house of the exchange as a part of risk management process keeps
collecting margin from the buyer/seller of the futures contract for the erosion in the
value of the contract.

 Low Or Nil Counter-Party Default:

Since, exchange clearing house collects margin on ongoing basis, the risk of
counter-party default gets eliminated.

 Liquid:

The futures contracts are traded on exchanges hence they offer liquidity to the
buyer/seller of futures contract.
3. OPTION

An option is a contract that gives the buyer the right, but not the obligation, to buy
or sell an underlying asset at a specific price on or before a certain date. An option,
just like a stock or bond, is a security. It is also a binding contract with strictly defined
terms and properties.

Options are a financial derivative sold by an option writer to an option buyer.

They are typically purchased through online or retail brokers. The contract offers the
buyer the right, but not the obligation, to buy (call option) or sell (put option) the
underlying asset at an agreed-upon price during a certain period of time or on a
specific date. The agreed upon price is called the strike price. American options can
be exercised any time before the expiration date of the option, while European options
can only be exercised on the expiration date (exercise date). Exercising means
utilizing the right to buy or the sell the underlying security.

Still confused? The idea behind an option is present in many everyday situations.
Say, for example, that you discover a house that you'd love to purchase.
Unfortunately, you won't have the cash to buy it for another three months. You talk to
the owner and negotiate a deal that gives you an option to buy the house in three
months for a price of $200,000. The owner agrees, but for this option, you pay a price
of $3,000.

Now, consider two theoretical situations that might arise:

1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the
market value of the house skyrockets to $1 million. Because the owner sold you the
option, he is obligated to sell you the house for $200,000. In the end, you stand to
make a profit of $797,000 ($1 million - $200,000 - $3,000).

2. While touring the house, you discover not only that the walls are chock-full of
asbestos, but also that the ghost of Henry VII haunts the master bedroom;
furthermore, a family of super-intelligent rats have built a fortress in the basement.
Though you originally thought you had found the house of your dreams, you now
consider it worthless. On the upside, because you bought an option, you are under no
obligation to go through with the sale. Of course, you still lose the $3,000 price of the
option.

• How it works (Example):

Options are derivative instruments, meaning that their prices are derived from the
price of their underlying security, which could be almost anything: stocks, bonds,
currencies, indexes, commodities, etc. Many options are created in a standardized
form and traded on an options exchange like the Chicago Board Options Exchange
(CBOE), although it is possible for the two parties to an options contract to agree to
create options with completely customized terms.

There are two types of options: call options and put options. A buyer of a call option
has the right to buy the underlying asset for a certain price. The buyer of a put option
has the right to sell the underlying asset for a certain price.

Every option represents a contract between the options writer and the options buyer.

The options writer is the party that "writes," or creates, the options contract, and then
sells it.

• Features of Option Contract

1. Highly flexible: On one hand, option contract are highly standardized and so they
can be traded only in organized exchanges. Such option instruments cannot be made
flexible according to the requirements of the writer as well as the user. On the other
hand, there are also privately arranged options which can be traded ‘over the counter’.
These instruments can be made according to the requirements of the writer and user.
Thus, it combines the features of ‘futures’ as well as ‘forward’ contracts.

2. Down Payment: The option holder must pay a certain amount called ‘premium’ for
holding the right of exercising the option. This is considered to be the consideration
for the contract. If the option holder does not exercise his option, he has to forego this
premium. Otherwise, this premium will be deducted from the total payoff in
calculating the net payoff due to the option holder.
3. Settlement: No money or commodity or share is exchanged when the contract is
written. Generally this option contract terminates either at the time of exercising the
option by the option holder or maturity whichever is earlier. So, settlement is made
only when the option holder exercises his option. Suppose the option is not exercised
till maturity, then the agreement automatically lapses and no settlement is required.

4. Non – Linearity: Unlike futures and forward, an option contract does not possess
the property of linearity. It means that the option holder’s profit, when the value of the
underlying asset moves in one direction is not equal to his loss when its value moves
in the opposite direction by the same amount. In short, profits and losses are not
symmetrical under an option contract. This can be illustrated by means of an
illustration:

5. No Obligation to Buy or Sell: In all option contracts, the option holder has a right
to buy or sell an underlying asset. He can exercise this right at any time during the
currency of the contract. But, in no case, he is under an obligation to buy or sell. If he
does not buy or sell, the contract will be simply lapsed.

• Distinction between futures and options

Though both futures and options are contracts or agreements between two parties, yet
the relies some point of difference between the two. Futures contracts are obligatory
in nature where both parties have to oblige the performance of the contracts, but in
options, the parties have the right and not the obligation to perform the contract. In
option one party has to pay a cash premium (option price) to the other party (seller)
and this amount is not returned to the buyer whether no insists for actual performance
of the contract or not.

In future contract no such cash premium is transferred by either of the two parties. In
futures contract the buyer of contract realizes the gains/profit if price increases and
incurs losses if the price falls and the opposite in case of vice-versa. But the
risk/rewards relationship in options is different. Option price (premium) is the
maximum price that seller of adoption realizes. There is a process of closing out a
position causing causation of contracts but the option contract maybe any number in
existence.

• Valuing an option

The value of option can be determined by taking the difference between two or if it is
not exercised then the value is zero. The valuation of option contract has two
components: intrinsic value and time value of options.

4. Warrants

• Introduction

Warrants are a derivative that give the right, but not the obligation, to buy or sell a
security-most commonly equity—at a certain price before expiration. The price at
which the underlying security can be bought or sold is referred to as the exercise price
or strike price. An American warrant can be exercised at any time on or before the
expiration date, while European warrants can only be exercised on the expiration date.
Warrants that give the right to buy a security are known as call warrants; those that
give the right to sell a security are known as put warrants.

Warrants are a little bit like a living memory of a long-past era of finance. Although
relatively uncommon and out of favour in the United States, warrants have remained
more popular in other areas of the world, such as Hong Kong. However, they do still
appear in the U.S. markets, and investors should know how to assess and value
them. Warrants can be a high-return investment tool. A warrant is like an option. It
gives the holder the right but not the obligation to buy an underlying security at a
certain price, quantity and future time. It is unlike an option in that a warrant is issued
by a company, whereas an option is an instrument of the stock exchange. The security
represented in the warrant (usually share equity) is delivered by the issuing company
instead of by an investor holding the shares.

Companies will often include warrants as part of a new-issue offering to entice

investors into buying the new security. A warrant can also increase a shareholder's
confidence in a stock, provided the underlying value of the security actually does
increase over time. (Warrants are just one type of equity derivative. Find out about the
others in 5 Equity Derivatives And How They Work.)

Warrants are in many ways similar to options, but a few key differences distinguish
them. Warrants are generally issued by the company itself, not a third party, and they
are traded over-the-counter more often than on an exchange. Investors cannot write
warrants like they can options.

Unlike options, warrants are dilutive. When an investor exercises their warrant, they
receive newly issued stock, rather than already-outstanding stock. Warrants tend to
have much longer periods between issue and expiration than options, of years rather
than months.
Warrants do not pay dividends or come with voting rights. Investors are attracted to
warrants as a means of leveraging their positions in a security, hedging against
downside (for example, by combining a put warrant with a long position in the
underlying stock) or exploiting arbitrage opportunities.

Warrants are no longer common in the United States, but are heavily traded in Hong
Kong, Germany and other countries.

• CHARACTERISTICS / FEATURES OF A WARRANT

A warrant is identified by the following characteristics:

ISSUANCE

A warrant can either be issued by a company or a financial institution. A company can

issue these instruments for its own stock while a financial institution issues them for a
variety of underlying assets.

EXERCISE

A warrant can either be exercised at the end of expiry or can be traded independently
of the debt instrument with which it was issued.

LIFE
A warrant usually has a life running from 10 to 15 years. American type warrant can
be exercised anytime during its life while a European type warrant can only be
exercised at the end of its life.

PREMIUM

A warrant is an option like an instrument and hence has a premium attached to it.
Premium is the price that the holder pays for the privilege of exercising the warrant at
a suitable time.

LEVERAGE

A warrant is a derivative instrument and has a leverage attached to it. A holder with
$100 worth of warrants will have more exposure to the underlying stock than a holder
with $100 worth of shares.

5. SWAP

• Introduction

In the recent past, there has been integration of financial markets world-wide which
have led to the emergence of some innovative financial instruments. In a complex
world of variety of financial transactions being taken place every now and then, there
arises a need to understand the risk factors and the mechanism to avoid the risks
involved in these financial transactions. The recent trends in financial markets show
increased volume and size of swaps markets.

Financial swaps are an asset liability management technique which permits a

borrower to access one market and then exchange the liability for another type of
liability. Thus, investors can exchange one asset to another with some return and risk
features in a swap market. In this lesson an attempt has been made to get the students
acquainted with the mechanism of swaps markets and the valuation of the swap
instruments.

• Meaning of swaps

The dictionary meaning of ‘swap’ is to exchange something for another. Like other
financial derivatives, swap is also agreement between two parties to exchange cash
flows. The cash flows may arise due to change in interest Rate or currency or equity
etc. In other words, swap denotes an agreement to exchange payments of two different
kinds in the future. The parties that agree to exchange cash flows are called ‘counter
parties’.

In case of interest rate swap, the exchange may be of cash flows arising from fixed or
floating interest rates, equity swaps involve the exchange of cash flows from returns
of stocks index portfolio. Currency swaps have basis cash flow exchange of foreign
currencies and their fluctuating prices, because of varying rates of interest, pricing of
currencies and stock return among different markets of the world.

• Features of swaps

The following are features of financial swaps:

Counter parties:
Financial swaps involve the agreement between two or more parties to exchange
cash flows or the parties interested in exchanging the liabilities.

Facilitators:
The amount of cash flow exchange between parties are huge and also the process is
complex. Therefore, to facilitate the transaction, an intermediary comes into picture
which brings different parties together for big deal. These may be brokers whose
objective is to initiate the counter parties to finalize the swap deal. While swap
dealers are themselves counter partied who bear risk and provide portfolio
management service.

Cash flows:
 The present values of future cash flows are estimated by the counterparties before
entering into a contract. Both the parties want to get assurance of exchanging same
financial liabilities before the swap deal.

Less documentation
It is required in case of swap deals because the deals are based on the needs of
parties, therefore, less complex and less risk consuming.

Transaction costs:
Generating very less percentage is involved in swap agreement.

Benefit to both parties:

The swap agreement will be attractive only when parties get benefits of these
agreements.

• Types of financial swaps

The swaps agreement provides a mechanism to hedge the risk of the counterparties.
The risk can be- interest rate, currency or equity etc.

Interest rate swaps

It is a financial agreement to exchange interest payments or receipts for a

predetermined period of time traded in the OTC market. The swap may be on the
basis of fixed interest rate for floating interest rate. This is the most common swap
also called ‘plain vanilla coupon swap’ which is simply in agreement between two
parties in which one party payments agrees to the other on a particular date a fixed
amount of money in the future till a specified termination date. This is a standard
fixed-to-floating interest rate swap in which the party (fixed interest payer) make
fixed payments and the other (floating rate payer) will make payments which depend
on the future evolution of a specified interest rate index. The fixed payments are
expressed as percentage of the notional principal according to which fixed or floating
rates are calculated supposing the interest payments on a specified amount borrowed
or lent. The principal is notional because the parties do not exchange this amount at
any time but is used for computing the sequence of periodic payments. The rate used
for computing the size of the fixed payment, which the financial institution or bank
are willing to pay if they are fixed rate payers (bid) and interested to receive if they
are floating rate payers in a swap (ask) is called fixed rate. A US dollar floating to
fixed 9-year swap rate will be quoted as:

Currency swaps

In these types of swaps, currencies are exchanged at specific exchange rates

and at specified intervals. The two payments streams being exchanged are dominated
in two different currencies. There is an exchange of principal amount at the beginning
and a re-exchange at termination in a currency swap. Basic purpose of currency swaps
is to lock in the rates (exchange rates). As intermediaries large banks agree to take
position in currency swap agreements. In a fixed to fixed currency rate, one party
raises funds in currency suppose ‘pounds’ and the other party raises the funds at fixed
rate in currency suppose US dollars. The principal amount are equivalent at the spot
market exchange rate. In the beginning of the swap contract, the principal amount is
exchanged with the first party handing over British Pound to the second, and
subsequently receives US dollars as return. The first party pays periodic dollar
payment to the second and the interest is calculated on the dollar principal while it
receives from the second party payment in pound again computed as interest on the
pound principal. At maturity the British pound and dollar principals are re-exchanged
on a fixed-to-floating currency swaps or cross-currency-coupon swaps, the following
possibilities may occur:

(a) One payment is calculated at a fixed interest rate while the other in floating rate.

(b) Both payments on floating rates but in different currencies.

(c) There may be contracts without and with exchange and re-exchange of principals.
6. Exotic Option

An exotic option is an option that differs in structure from the more

common American options or European options in terms of the underlying asset or
the calculation of how or when the investor receives a certain payoff. Exotic options
are generally more complex than plain vanilla call and put options.

Despite their embedded complexities, exotic options have certain advantages over
regular options, which include:

 Being more adaptable to specific risk-management needs of individuals or

entities

 Trading and management of unique risk dimensions

 A greater range of investment products to meet investors' portfolio needs

 In some cases, they are cheaper than regular options

Exotic options have unique underlying conditions that make them a good fit for high-
level active portfolio management and situation-specific solutions. Complex pricing
of these derivatives may give rise to arbitrage, which can provide great opportunities
for sophisticated quantitative investors.

In many cases an exotic option can be purchased for a smaller premium than a
comparable vanilla option. This is because often exotic options contain additional
features that increase the chances of the option expiring worthless. This is not the case
with chooser options, for example, since the "choice" actually increases the chances
of the option finishing in the money. In this case, the chooser may be more expensive
than a single vanilla option, but could be cheaper than buying both a vanilla
call and put if a big move is expected but the trader is unsure on the direction.

Exotic options may also be suitable for business that need to hedge up to or down to
specific price levels in the underlying asset. In these cases, barrier options may be
effective because they come into existence or go out of existence at specific/barrier
price levels.
 • Exotic Option Examples

There are many types of exotic options available. Below we will run through some of
them.

Chooser Options
Chooser options are an instrument that allows an investor to choose whether the
option is a put or call at a certain point during the option's life. Because this type of
option can change over the holding period, it is not found on regular exchanges.

Compound Options
Compound options are options that give the owner the right, but not the obligation, to
purchase another option at a specific price on or by a specific date. Typically, the
underlying asset of a call or put option is an equity security, but the underlying asset
of a compound option is always another option. Compound options come in four
types: call on call, call on put, put on put, and put on call. These types of options are
commonly used in foreign exchange and fixed-income markets.

Barrier Options
Barrier options are similar to plain vanilla calls and puts, but only become activated or
extinguished when the underlying asset hits certain price levels. In this sense, the
value of barrier options jumps up or down in leaps, instead of changing in price in
small increments. These options are commonly traded in the foreign exchange and
equity markets. They come in four types: up-and-out, down-and-out, up-and-in,
and down-and-in.

As an example, a barrier option with a knock-out price of $100 and a strike price of
$90 may be written on a stock that is currently trading at $80. The option will behave
like normal when the underlying is below $99.99, but once the underlying stock's
price hits $100, the option gets knocked-out and becomes worthless. A knock-in
would be the opposite. If the underlying is below $99.99, the option doesn't exist, but
once the underlying hits $100 the option comes into existence and is $10 in the
money.
Binary Options
A binary option, or digital option, is defined by its unique payout method. Unlike
traditional call options, in which final payouts increase incrementally with each rise in
the underlying asset's price above the strike, this option provides the buyer with a
finite lump sum at that point and beyond. Inversely, with the buyer of a binary put
option, the finite lump-sum payout is received by the buyer if the asset closes below
the stated strike price.

For example, if a trader buys a binary call option with a stated payout of $10 at the
strike price of $50 and the underlying asset is above the strike at expiration, the holder
will receive a lump-sum payout of $10 (irrespective of how deep in the money the
option is). If the underlying asset is below the strike at expiration, the trader will not
receive anything.

Most traded binary options are based on the outcomes of events rather than equities.
Things like the level of the Consumer Price Index or the value of Gross Domestic
Product on a specific date are usually the underlyings of the option. As such, early
exercise is impossible because the underlying conditions will not have been met.

Bermuda Options
Bermuda options can be exercised at the expiry date, as well as certain specified dates
in between the creation and expiration of the option's life. This style of option may
provide the writer with more control over when the option is exercised and provides
the buyer with a slightly less expensive alternative to an American option without the
restrictions of a European option (American options demand a slightly larger
premium due to their "anytime" exercise feature).

Quantity-Adjusting Options
Quantity-adjusting options, called quanto options for short, expose the buyer to
foreign assets but provide the safety of a fixed exchange rate in the buyer's home
currency. This option is great for an investor looking to gain exposure in foreign
markets, but who may be worried about how exchange rates will settle when it comes
time to settle the option.
For example, a French investor looking at Brazil may find a favourable economic
situation on the horizon and decide to put some portion of allocated capital in the
BOVESPA Index, which represents Brazil's largest stock exchange. The problem is,
the French investor is a little worried about how the exchange rate for the euro and
Brazilian real might settle in the interim. The solution for this French investor is to
buy a quantity-adjusting call option on the BOVESPA denominated in euros. This
solution provides the investor with exposure to the BOVESPA and lets the payout
remain denominated in euros.

As a two-in-one package, this option will inherently demand an additional premium

that is above and beyond what a traditional call option would require. This provides
quantity-adjusting option writers with additional premium if they are willing to take
on the additional risk of currency

Look-Back Options
Look-back options do not have a fixed exercise price at the beginning. The holder of
such an option can choose the most favourable exercise price retrospectively for the
time period of the option. These options eliminate the risk associated with
timing market entry and are, therefore, more expensive than plain vanilla options.

Let’s say an investor buys a one-month look-back call option on a stock at the
beginning of month. The exercise price is decided at maturity by taking the lowest
price achieved during the life of the option. If the underlying is at $106 at expiration
and the lowest price achieved was $71, the payoff is $35 ($106-$71).

Asian Options
Asian options have a payoff based on the average price of the underlying on a few
specific dates. If the average price based on those dates is less than the exercise price,
the option expires out of the money.

Basket Options
Basket options are similar to plain vanilla options except that they are based on more
than one underlying. For example, an option that pays off based on the price
movement of not one but three underlying assets is a type of basket option. The
underlying assets can have equal weights in the basket or different weights, based on
the characteristics of the option.

Extendible Options
Extendible options allow the investor to extend the expiration date of the option.
There are two types:

 Holder-extendible: The buyer of the option (call or put) has the right to extend
the option by a pre-specified amount of time if the option is out of the money
at the original expiration date.

 Writer-extendible: The writer of the option (call or put) has the right to extend
the option by a pre-specified amount of time if the option is out of the money
at the original expiration date.

Spread Options
The underlying asset for spread options is the spread or difference between the prices
of two underlying assets. Let’s say a one-month spread call option has a strike price of
$3 and the price difference between stocks ABC and XYZ as the underlying. At
expiry, if stocks ABC and XYZ are trading at $106 and $98, respectively, the option
will pay $106 - $98 - $3 = $5.

Shout Options
A shout option allows the holder to lock in a certain amount in profit while retaining
future upside potential on the position.

If a trader buys a shout call option with a strike price of $100 on stock ABC for a one-
month period, when the stock price goes to $118, the holder of the shout option can
lock in this price and have a guaranteed profit of $18. At expiry, if the underlying
stock goes to $125, the option pays $25. Meanwhile, if the stock ends at $106 at
expiry, the holder still receives $18 on the position.
1.11.2. COMMODITY DERIVATIVE

Commodity derivatives are financial instruments whose value is based on underlying

commodities, such as oil, gas, metals, agricultural products and minerals. Other
assets such as emissions trading credits, freight rates and even the weather can also
underlie commodity derivatives.

Although the market has been around for centuries, commodity derivatives remain a
vital and increasingly sophisticated product today. Airlines continue to hedge
themselves against volatility in fuel prices, mining corporations against declines in
metal values and power companies against rises in the price of natural gas.

This accessible title explains each type of transaction, together with the
documentation involved. In particular, the book analyses and guides the reader
through the full suite of over-the-counter, exchange-traded and structured commodity
derivative documentation, and provides a detailed guide to International Swaps and
Derivatives Association and other leading documentation platforms. The book further
contains detailed analysis of the regulatory and tax issues affecting commodity
derivative products in the United Kingdom and United States.
1.12. PARTICIPANTS OF DERIVATIVES MARKET

The participants of the derivatives markets can be classified as under:

A. On the basis of motives

B. On the basis of constitution of participants

C. On the basis of nature of roles performed

1.12.1. On the basis of motives

Depending on the motives of participation in the derivatives markets the

participants can be broadly classified into following three types:

1. Hedgers:

Risk is inherent in all activities that we perform in our day to day life. Risk is a
basic element of any business and investment activities. All of us are concerned
about the risk. Risk can be defined as a deviation of the actual outcomes from the
expected results. Elimination of risk is something which each one of us are
interested, however, complete elimination of risk is not possible. Alternatively,
risk can be mitigated to a considerable extent. Derivative is one of the tools that
can be effectively used to hedge against the risk of fluctuation in the prices of
underlying assets, which either we own or intend to own at future date. Hedgers
are those who enter into a derivative contract with the objectives of covering risk
arising out of price fluctuation. An importer having a deferred liability (payables
in foreign currency) faces uncertainty about the exchange rate at the time of
payable becoming due. A forward/futures contract would eliminate the price risk
(foreign exchange rate fluctuation in this case). A foreign currency forward/futures
contract is entered into with objective of hedging against the risk of exchange rate
fluctuation.

The hedger (importer in this case) would settle the contract by taking delivery of
agreed quantity of foreign currency at the pre-agreed price on future pre-decided
 delivery date by paying the pre-agreed price or offset the contract by settling it in
cash.

2. Speculator

A trader, who trades or takes position without having exposure in the cash/spot
market, with the sole intention of earning profit from price movements is a speculator.
Speculators are those who may not have an interest in the ready contracts, etc. but see
an opportunity of price movement favourable to them. They are prepared to assume
the risks, which the hedgers are trying to cover in the futures market. They provide
depth and liquidity to the market. It would not be wrong to say that in absence of
speculators the market will not be liquid and may at time collapse.

Although one can argue that all investment is speculation, an acknowledged

speculator will buy or sell a security solely to reap a typically short-term profit from
the price movement of that security. This motivation differs significantly from those
of more traditional investors or hedgers.

For example, consider the purchase of corn futures. A hedger may purchase these
securities in order to offset any negative movements in the price of corn and thus
stabilize his or her portfolio (these people might be corn growers or cereal companies,
for instance). A speculator, however, may buy the very same security simply because
he or she has reason to believe the position will increase in value. He or she simply
bets on which way the market is going to go.

Speculation can sometimes drive securities prices away from their intrinsic value,
either becoming overpriced during a buying frenzy or becoming underpriced during a
huge sell-off. Although speculators sometimes get a bad rap in the press for this
reason, they are a crucial lubricant to the markets, particularly the commodities
markets. Although they don't want to physically possess any of the commodities
they're trading (that is, they don't really want a truckload of rice delivered to their
door), their trading activity brings liquidity to the market, which in turn provides
stability and efficiency to those markets.
It is important to note, however, that speculators are generally bigger risk takers than
other investors. They are more likely than other investors to use leverage, and as such
can suffer huge losses alongside huge gains.

3. Arbitrageurs

The process of simultaneously buying of securities or derivatives in one

market/segment at lower price and sale thereof inn another market/segment at higher
prices is known as arbitrage.

The markets for derivatives and underlying are separate. The spot market or cash
segment, on Indian exchanges, is a market where securities (underlying) are sold for
cash and delivered as per the settlement period i.e. on T+2 day basis. While,
derivatives products for those underlying (securities) are traded on futures & options
segment. It is possible that there may be price mismatches and earn riskless profits.

For example on maturity if the Infosys futures contract is priced at Rs. 1,040 per share
and the spot price is Rs. 950 per share, then the arbitrageur will buy Infosys @ Rs.
950 in the spot segment and short sell futures in F & 0 segment @ Rs. 1040, thereby
making riskless profit of Rs. 90 per share. Thus, riskless profit making is the prime
goal of arbitrageurs.

The hedgers attempt to eliminate risk and speculator assumes the risk of hedgers,
whereas arbitrageurs take riskless position and yet make profits. Arbitrageurs
constantly monitor the prices of different assets on these two segments/markets and
capture the mispricing of the products to earn arbitrage profits. Such arbitrage gain
arises due to imperfections in the markets/segments. However, it may be noted that
market imperfections do not last long. In the selling market/segment the prices fall
because of increased supply and in the buying market prices rise due increasing
demand. This results in the convergence of prices in two different segments/markets
and they operate in tandem. Thus, the price equilibrium is achieved through demand-
supply forces. The arbitrageurs encashes on these short-lived market imperfections. In
fact, arbitrageurs restore the balance and consistency in different segment through the
arbitrage process. Arbitrageurs arrests the overbidding or underbidding of prices by
speculators in F&O segment as compared to cash segment.
1.12.2. On the basis of constitution of participants

1. Mutual funds

2. Corporate treasury

3. Banks/financial institution

4. High net worth individuals

1. Mutual funds house

Mutual fund can be defined as a trust that pools the savings of a number of investors
who share a common financial goal. The money thus collected is then invested by the
fund manager on behalf of the investors in different types of securities. As already
discussed the securities are in general subject to price risk fluctuation. The fluctuation
in the prices of securities held by mutual funds may erode the asset value of the fund.
Thus, the fund managers make use of derivatives products to manage/hedge the price
risk of the securities held under various schemes. Fund managers may also take
speculative view based on its understanding of market wide factors. Fund managers
are specialists, who track the prices of securities continuously, thus making it possible
for them to identifying arbitrage opportunities and make riskless gains. It may
therefore be noted that mutual fund houses may participate in the derivatives markets
as hedger or speculator or even as an arbitrageur.

7. Corporate treasury

The companies into regular exports or imports of goods or services are exposed to risk
of fluctuation in foreign exchange rates. Such exchange rates fluctuation in foreign
exchange rates. Such exchange rates fluctuations may affect the viability of imports or
exports. These companies usually have separate treasury and risk management
department (or a manager), who employ risk management tools to hedge the risk
arising out of foreign exchange rate fluctuations. Foreign Currency forwards and
futures and options are popular risk management products sought after by these
treasury managers.

Similarly, companies having borrowing in foreign currency are also exposed to risk of
fluctuation in foreign exchange rates, since the debt servicing i.e. interest and
principal repayments obligations are in foreign currency. The treasury manager or
department of such companies may participate in the derivatives markets as hedger, to
guard against the probable losses due to foreign exchange rate fluctuation.

A manufacturing company is also exposed to risk of fluctuation in the prices of

commodities which are its principal raw material/input. For example, Finolex cables,
manufacturer of electrical wires and cables is exposed to risk of fluctuation in the
prices of copper, since copper is its principal input. Such companies may participate
in the commodities futures and options markets to guard itself against the risk of
fluctuation in the prices of its input.

8. Banks and financial institutions

Banks and financial institutions have exposures in the form of lending to its
customers. They face the risk of credit default as well as changes in interest rates.
Bank and financial institutions use derivatives products such as credit default swaps
and interest rates futures to hedge the risk of credit default and interest rates changes.
Banks may also have exposures in foreign exchange towards its customers involved in
import and export trade. These merchant transactions make bank vulnerable to losses
due to fluctuation in foreign exchange rates. Banks covers its exposure arising out of
such merchant transactions with the help of suitable derivatives products by patriating
in derivatives market.

9. High net worth individuals

High net worth individuals are those who have large scale investments in various
classes of investment assets. The investment assets such as stocks, bonds, etc. are
prone to risk of price fluctuations. The high net worth investors participate in the
derivatives markets to manage the price risk element of their portfolio of investments.
The high net-worth individuals usually have high risk appetite, so they also tend to
speculate in the derivatives markets. High net-worth investors may also participate as
arbitrageur in the derivatives market.

1.12.3. On the basis of nature of roles performed:

The participants of derivatives market perform various roles SEBI taking into account
the nature of roles performed has categorized derivatives market participants as under:

1. Trading member:

A trading member is a registered member of a SEBI recognized financial derivatives

exchange. A trading member executes trade on behalf of its clients and on its own
behalf. They cannot clear and settle the trades executed by them. Clearing and
settlement of trade is done by clearing member.

10.Trading cum clearing member:

Trading cum clearing member besides trading on its own behalf and on behalf of its
clients, also clear and settle the trades executed by them (own and its client) as well as
trades of other trading members.

11.Self-clearing member:

Self-clearing members clear and settle trades executed by them only. They do not
clear and settle trades of other trading members.

Professional clearing member

Professional clearing members performs only clearing function. They clear and settle
the trades executed by trading members. They do not execute trade either on their own
behalf or for any clients.
 2) RESEARCH METHODOLOGY

2.1 Introduction
Research methodology is a way to solve the research problem systematically.
It involves the various steps to find out the solution of an identified problem. It also
clarifies the logic behind the study of the problem. When we talk about research
methodology we not only talk of the research method but also consider the logic
behind the method we use in the context of our research study and explain why we are
using a particular method or techniques and why we are not using other so the result
are capable of being evaluated.

1. Research design:
A descriptive study tries to discover answers to the questions who, what, when,
where, and sometimes, how. The researcher attempts to describe or define a subject,
often by creating a profile of a group of problems, people or events. Such studies may
involve the collection of data and the creation of a distribution of the number of times
the researcher observes a single event or characteristic (the research variable), or they
may involve relating the interaction of two or more variables. Organizations that
maintain databases of their employees, customers and suppliers already have
significant data to conduct descriptive studies using internal information. Yet many
firms that have such data files do not mine them regularly for the decision-making
insight they might provide. This descriptive study is popular in business research of
its versatility across disciplines. In for-profit, not-for-profit and government
organizations, descriptive investigations have broad appeal to the administrator and
policy analyst for planning, monitoring and evaluating. In this context, how questions
address issues such as quantity cost, efficiency, effectiveness and adequacy.
Descriptive studies may or may not have the potential for drawing powerful
inferences.

12.Sample method
Convenience sampling method is used for the survey of this project. It is a non-
probability sample. This Is the least reliable design but normally the cheapest and
easiest to conduct. In this method researcher have the freedom to choose whomever
they find, thus the name convenience. Example includes informal pools of friends and
neighbour or people responding to a newspaper’s invitation for readers to state their
position on some public issue.

13.Sample size
Sample size denotes the number of elements selected for the study. For the present
study, 50 respondents were selected at random.

14.Sampling method
A sample is a representative part of the population. In sampling technique,
information is collected only from a representative part of the universe and the
conclusions are drawn on that basis for the entire universe.

15.Types of data
Every decision poses unique needs for information, and relevant strategies can be
developed based on the information gathered through research. Research is the
systematic objective and exhaustive search for and study of facts relevant to the
problem.

Research design means the framework of study that leads to the collection and
analysis of data. It is a conceptual structure with in which research as effective as
possible.
Primary data:
Primary data are those collected by the investigator himself for the first time and thus
they are original in character, they are collected for a particular purpose. A well-
structured questionnaire was personally administered to the selected sample to collect
the primary data.

Secondary data:
Secondary data are those, which have already been collected by some other persons
for their purpose and published. Secondary data are usually in the shape of finished
products.

2.2 Objectives of study

1) To analyze the perception of investors towards investment in derivative instrument

and market

2) To know different types of financial derivatives.

3) To study the awareness about derivative market.

2.3 QUESTIONNAIRE FOR RESEARCH

Instructor Name

Results Age

Gender

Annual income

1. Are you trading in derivative market?

Yes

No

2. If No is the reply in the Q1 question, reasons for not investing in derivative

market?

Lack of knowledge

Lack of awareness

Very risky / counter party risk

Huge amount of investment

Other
3. Which of the following derivative instruments do you deal in?

Stock Future

Stock Index Futures

Stock Options

Stock Index Options

Swaps

Currency

4. How much percentage of your income you trade in Derivative market?

Don’t trade

Less than 5%

5%-10%

11%-15%

16%-20%

More than 20%

5. You participate in Derivative market as?

Hedger
 Speculator

Arbitrageur

Others

6. For what purpose do you invest in derivative market ?

Regular income

Meet future obligations

Capital appreciation

Others

7. What is the rate of return expected by you from derivative market?

Do not trade

Less than 5%

5%-10%

14%-17%

18%-23%

More than 23%

8. Are you satisfied with the current performance of the derivative market?

Do not trade

Strongly disagree

Disagree
 Neutral

Agree

Strongly agree

3) REVIEW OF LITERATURE
Abdulla Yameen (2001) delivered massage, investors will need to be alert to any
new development in capital market and take advantage of the Investor Education
and Awareness Campaign program which to be undertaken by the Capital Market
Section to acquaint of the risks and rewards of investing on the Capital market.
Speech was also focused on to create a new breed of financial intermediaries,
which will deal on the market for their clients. These intermediaries have to be
professionals with quite advanced knowledge on stock exchange operations,
techniques, law and companies valuation. Investors depend to a large extent on
their professional advice when investing on the market. Furthermore, these
intermediaries must be men of integrity and honesty as they would deal with
clients‟ money Confidence of investors in these professionals is a key to the
success of the capital market.

Warren Buffet (2002) argued that derivatives as time bombs, both for the parties
that deal in them and the economic system. He also argued that those who trade
derivatives are usually paid, in whole or part, on “earnings” calculated by mark-
to-market accounting. But often there is no real market, and “mark-to-model” is
utilized. This substitution can bring on largescale mischief. In extreme cases,
mark-to-model degenerates into mark-to-myth. Many people argue that
derivatives reduce systemic problems, in that participant who can’t bear certain
risks are able to transfer them to stronger hands. He said that the derivatives genie
is now well out of the bottle, and these instruments will almost certainly multiply
in variety and number until some event makes their toxicity clear.
G.N.Bajpai (2006) showed that continuously monitors performance through
movements of share prices in the market and the threats of takeover improves
efficiency of resource utilisation and thereby significantly increases returns on
investment. As a result, savers and investors are not constrained by their
individual abilities, but fascinated by the economy’s capability to invest and save,
which inevitably enhances savings and investment in the economy. Thus, the
capital market converts a given stock of investible resources into a larger flow of
goods and services and augments economic growth. The study concluded the
investors and issuers can take comfort and undertake transactions with confidence
if the intermediaries as well as their employees (i.) follow a code of conduct and
deal with probity and (ii) are capable of providing professional services.

K. Ravichandran (2007) argued the younger generation investors are willing to

invest in capital market instruments and that too very highly in Derivatives
segment. Even though the knowledge to the investors in the Derivative segment is
not adequate, they tend to take decisions with the help of the brokers or through
their friends and were trying to invest in this market. He also argued majority the
investors want to invest in short-term funds instead of long-term funds that prefer
wealth maximization instruments followed by steady growth instruments.
Empirical study also shows that market risk and credit risk are the two major risks
perceived by the investors, and for minimizing that risk they take the help of
newspaper and financial experts. Derivatives acts as a major tool for reducing the
risk involved in investing in stock markets for getting the best results out of it. The
investors should be aware of the various hedging and speculation strategies, which
can be used for reducing their risk. Awareness about the various uses of
derivatives can help investors to reduce risk and increase profits. Though the stock
market is subjected to high risk, by using derivatives the loss can be minimized to
an extent.

Rajiv Gupta (2010) argued in Capital Market 2009-10 IPO-QIP Report there have
been several noticeable trends over the past five years. First, the size of offerings
by Indian issuers has been growing and there are more and larger size global
offerings reflecting the maturing and increasing depth of the Indian capital
markets. Second, India has become a destination and region in its own right for 13
 raising capital - previously companies could not raise more than a few hundred
million, but now have capital issues like Reliance Power, in excess of Rs. 13,200
crore ($ 3 billion). While the ADR/GDR markets remain attractive, fewer
companies are using that route as Indian markets have become strong and have the
appetite for large transactions. Third, Indian capital markets now attract
companies across sectors, rather than in any single sector.

4) DATA ANALYSIS

1. Are you trading in derivative market?

ANSWER PERCENTAGE

Yes 38%

No 62%

70

60

50

40

30

20

10

0
Yes No
 Interpretation:

From the above graph out of 50 investor, only 38% investors means 19
respondent are trading in derivative market and 62% means 31 respondents are
not trading in derivative market.

16.If No is the reply in the Q1 question, reasons for not investing in

derivative market?

REASONS PERCENTAGE

Lack Of Knowledge 20%

Lack Of Awareness 15%

High Risky 49%

Huge Amount Of Investment 13%

Other 3%

50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
ge ss ky t r
en he
l ed ene ri s tm ot
ow ar gh ve
s
f kn f aw hi in
f
ko ko nto
l ac l ac ou
am
ge
hu
Interpretation

From the above graphical representation you can see that 20% of the investors don’t
have knowledge about derivatives. 15% of investors are not aware of derivative
market. 49% investors think that the derivatives are high risky whereas 3% investors
don’t have specify their reasons for not trading in derivative market.

17.Which of the following derivative instruments do you deal in?

PREFERNCES SALES

Stock Futures 26%

Stock Index Futures 10%

Stock Options 20%

Stock Index Options 25%

SWAPS 19%

Sales
19 26
stock futures

stock index futures

stock options

stock index options

25 10
swaps

20

Interpretation
 From the above graph you can see that 26% of investors invest in stock
futures, 10% in stock index futures, 20% in stock options, 25% in stock index
options and 19% of investors invest in SWAPS.

18.How much percentage of your income you trade in Derivative

market?

PREFERNCES PERCENTAGE

Don't Trade 62%

Less Than 5% 4%

5%-10% 14%

11%-15% 13%

16%20% 6%

More Than 20% 1%

 70%
62%
60%

50%

40%

30%

20%

10% 14%
13%
4%
0%
don't trade 6%
less than 5%
5%-10% 1%
11%-15%
16%20%
more than 20%

Interpretation:

From the above graph we can see that 62% investors don’t invest in
derivatives market. 4% of investors invest less than 5% of their income. 14%
investors invest 5%-10%of their income. 13% of investors invest 11%-15% of
their income. 6% of investors invest 16%-20% of their income. 1% of
investors invest more than 20% of their income.

19.You participate in Derivative market as?

PARTICPANTS PERCENTAGE
Arbitrageurs 16%
Speculator 47%
Hedger 27%
Others 10%
 50%

45%

40%

35%

30%

25%

20%

15%

10%

5%

0%
arbitrageurs speculator hedger others

Interpretation:

From the above graph we can see that 16% of investors are in the form of
arbitrageurs and 47% of investors are in the form of speculators while 27% of
investors are in the form of hedger and others are of only 10%.

20.For what purpose do you invest in derivative market?

PURPOSE OF INVESTMENT PERCENTAGE

Regular Income 43%

Meet Future Obligations 54%

Capital Appreciation 2%

Others 1%

60%

50%

40%

30%

20%

10%

0%
regular income
meet future obligations
capital appreciation
others

Interpretation

From the above graph we can see that 43% investors invest their money in derivatives
to earn their regular income. 54% of investors invest for the purpose to meet future
obligations. 2% of investors invest for capital appreciation while 1% of investors
invest for other purpose.
21.What is the rate of return expected by you from derivative
market?
EXPECTATION RATE PERCENTAGE
Do Not Trade 62%
5%-9% 10%
10%-13% 12%
14%-17% 11%
18%-23% 5%

5000%

4500%

4000%

3500%

3000%

2500%

2000%

1500%

1000%

500%

0%
do not trade 5%-9% 10%-13% 14%-17% 18%-23%

Interpretation

From the above graph we can see that 62% do not trade in derivatives so they don’t
expect anything from derivative market but remaining 38% investor expect some
range of returns from derivative market i.e. 10% expect 5%-9% returns, 12% expect
10%-13%returns, 11% investor expect 14%-17% and 5% investors expect 18%-23%
of returns.
22.Are you satisfied with the current performance of the derivative
market?
PREFERENCES PERCENTAGE
Do Not Trade 62%
Strongly Disagree 4%
Disagree 8%
Neutral 10%
Agree 12%
Strongly Agree 4%

4.00%
12.00%

do not trade
10.00% strongly disagree
disagree
neutral
agree
8.00% strongly agree
62.00%

4.00%

Interpretation

From the above graph we can see that 62% of investors don’t trade in derivative
market. 4% are strongly disagree with current performance of the derivative market
but at the same time 4% of investors are strongly agree with the current performance.
8% are disagreeing but 12% are agreeing with the performance and remaining 10%
has no answer they are neither satisfied nor dissatisfied.
3.1 Findings

1. Here we found that out of 50 investors only 38% investors means 19

respondent are trading in derivative market and 62% means 31 respondents are
not trading in derivative market.

2. Reasons for not investing in derivative market is because lack of awareness

and knowledge, high risky, need huge amount of investment.

3. The main objective of trading in derivative market of the investors is getting

high return.

4. 14% of respondents save 11%-15% of their income for investments and only
1% of respondents save more than 25% of their income for investments.

5. 54% of respondents investing to meet future obligations and 43% respondents

are looking for regular income.

6. 62% of respondents are not willing to invest in derivatives, 49% of

respondents are felt that derivatives are highly risky. 15% of respondents not
aware of derivatives, so derivatives are highly risky and expected profit or loss
is also high

7. 47% of investors are speculators in derivatives market, 27% of investors are

hedging for their investments, followed by 16% of investors are arbitrageurs.

8. 25% of investors are more often invest in index options. And 10% are more
often invest in index futures.
 5) CONCLUSION & SUGGESTIONS

5.1 Conclusion

Now a days the investors know about the derivative market, so they are aware
as derivative market offers more return, with the hedging of interest rate risk and
exchange rate risk with maximum profits and minimum loss. Indian derivative
markets have had a very good performance till date, to continue with this same
growth individual investors have to be encouraged to enter into trades more often so
that they help to drive the economy. In the study, it was found that derivatives are
used as risk Hedging tool and the trend of the spot market affects the trading of
Derivatives. It has been noticed that there has been awareness about derivatives
trading amongst the derivatives in India since last few years. SEBI and government
should take responsibility to create awareness among investors and need to educate
individual investors through different seminars or training programs regarding the
advantages and risk factors associated with derivative instruments. Respondents
perceived that Market Risk and Credit risk are the two major risk observed in capital
markets. Exchange traded derivatives market helps investors in many different ways
in planning the finances, hedging/mitigating various risks, appropriate price
discovery, arbitrage opportunities, ease of speculations etc. There are various strategic
applications, uses and benefits of the equity derivatives market in the Indian Markets
in today’s economic scenario such as providing efficiency to capital markets, helping
investors in mitigating risks, providing equitable price discovery, comforting foreign
investors, creating jobs and developing human capital, preserving value of assets
during stressed market scenario and many more ways.

Equity derivatives turnover has surpassed its underlying turnover in the

financial year 2003-04 and today stands far taller than its underlying turnover. The
equity derivatives turnover was 12.66% of its underlying equity market turnover in
the year 2001-02. Today, in 2011-12, the equity derivatives turnover is 924.51% of its
underlying equity market turnover.
5.2 Suggestions

There is a need to introduce more equity derivatives products in India and has
long strides to take in terms of providing larger liquidity and depth to the bigger
market players. Many respondents felt that it is right time to introduce the other
complex products like exotic derivatives. In this study Derivatives market is risk and
return game that‘s why the investor get risk. Due to absence of delivery based
settlement, many investors may not be participating in the derivatives market. Also,
this could bring one more type of product in the basket to be offered to the market at
large. Hence, NSE may look at starting the physical delivery derivatives contracts to
give further fillip to volume on its exchange in particular and the Indian equity
derivatives market at large. Investors are more often invest in index options because
of derivatives are highly risky. The study suggests that Government should look
forward to setting up a super regulator who can take care of these various regulatory
arbitrage/risk issues or there should be joint committee of all the regulatory bodies to
look into such concerns of the market from overall perspective. This study can be
used by the regulating authorities and broker houses to increase awareness among the
investors about derivatives. Only 38% investors are trading whereas 62% are not
trading so attract them for trading. The investors who are not aware of derivatives
make them aware that will increase the customers. Some investors don’t have
knowledge about derivatives so provide them knowledge for trading in derivatives
market. Those who are not satisfied with the derivative by knowing their behaviour of
investment make them satisfied because negative word mouth of the customers fall
down the business and good word of mouth builds the business.
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