DERIVATIVE MARKET- INDIA’’

GHAZIABAD

INSTITUTE OF TECHNOLOGY AND SCIENCE, MOHAN NAGAR, GHAZIABAD SUMMER INTERNSHIP PROJECT REPORT ON TITLE

“DERIVATIVE MARKET- INDIA’’ BY MUKTA DHEER Enrollment No : PG2K8 181 E mail id [email protected]

IL&FS INVESTSMART SECURITIES LIMITED (A group company of HSBC)

I

INDIA’S FINANCIAL MULTIPLEX

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I

A REPORT ON “DERIVATIVE MARKET”

_____________________________________________________________ A report submitted in complete fulfillment of the requirements of PGDM program of INSTITUTE OF TECHNOLOGY AND SCIENCE GHAZIABAD

SUBMITTED TO: PROF. PRIYA FACULTY I.T.S GHAZIABAD RAHUL KUMAR AGARWAL ASM IL&FS INVESTSMART SECURITIES LIMITED E MAIL [email protected]

ACKNOWLEDGEMENT 2

The beatitude, bliss and euphoria that accompany the successful completion of any task would not be complete without the expression of appreciation of simple virtues to the people who made it possible. The final project report is submitted to institute of technology and science, Ghaziabad for partial fulfilment of diploma, post graduate diploma in management (PGDM). This project is an attempt to study “DERIVATIVE MARKET-INDIA” At IL&FS INVESTSMART SECURITIES LTD.(HSBC Group). I would like to thanks to the Management of IL&FS INVESTSMART SECURITIES LTD. (HSBC Group) for giving me the opportunity to do my two-month project training in their esteemed organization. I am highly obliged to Mr. RAHUL KUMAR AGARWAL (AREA SALES MANAGER) for granting me to undertake my training at RDC RAJ NAGAR branch. I express my thanks to all Sales Managers and other relationship managers under whose guidance and direction, I gave a good shape to my training. Their constant review and excellent suggestions throughout the project are highly commendable. My heartfelt thanks go to all the executives who helped me to gain knowledge about the actual working and the processes involved in various departments.

I would also like to

sincerely thank my faculty guide PROF. PRIYA whose guidance has helped me to Understand and complete my project in a timely and proper manner

MUKTA DHEER

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DECLARATION I do hereby declare that the project report is submitted as partial fulfilment of the requirement of PGDM Program of INSTITUTE OF TECHNOLOGY AND SCIENCE, GHAZIABAD. The Project has been done under the guidance of Mr. RAHUL KUMAR AGARAWAL, in Raj nagar branch ,Ghaziabad and PROF. PRIYA Faculty guide, INSTITUTE OF TECHNOLOGY AND SCIENCE, Ghaziabad No part of this report has not been published or submitted elsewhere for the fulfilment of any degree or diploma for any institute or university.

MUKTA DHEER

EXECUTIVE SUMMARY

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New ideas and innovations have always been the hallmark of progress made by mankind. At every stage of development, there have been two core factors that drives man to ideas and innovation. These are increasing returns and reducing risk, in all facets of life. The financial markets are no different. The endeavour has always been to maximize returns and minimize risk. A lot of innovation goes into developing financial products centred on these two factors. It has spawned a whole new area called financial engineering. Derivatives are among the forefront of the innovations in the financial markets and aim to increase returns and reduce risk. They provide an outlet for investors to protect themselves from the vagaries of the financial markets. These instruments have been very popular with investors all over the world. Indian financial markets have been on the ascension and catching up with global standards in financial markets. The advent of screen based trading, dematerialization, rolling settlement have put our markets on par with international markets. As a logical step to the above progress, derivative trading was introduced in the country in June 2000. Starting with index futures, we have made rapid strides and have four types of derivative products- Index future, index option, stock future and stock options. Today, there are 30 stocks on which one can have futures and options, apart from the index futures and options. This market presents a tremendous opportunity for individual investors .The markets have performed smoothly over the last two years and has stabilized. The time is ripe for investors to make full use of the advantage offered by this market. We have tried to present in a lucid and simple manner, the derivatives market, so that the individual investor is educated and equipped to become a dominant player in the market

CONTENTS

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PAGE NO. INTRODUCTION TO PROJECT

7

COMPANY PROFILE

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DERIVATIVES a) Derivative defined b) Types of market c) History of derivatives d) Indian derivative market e) Need for derivatives in India today f) Myths and realities about derivatives g) Comparison of new system with existing system h) Factor contributing to the growth of derivatives i) Benefits of derivatives

13 15 25 27 28 28 31 36 39

DEVELOPMENT OF DERIVATIVE MARKET IN INDIA

41

NATIONAL EXCHANGES

45

RESEARCH OBJECTIVE

48

RESEARCH METHODOLOGY

48

ANALYSIS & INTERPRETATION

51

RECOMMENDATION & LIMITATION

62

BIBLIOGRAPHY

63

ANNEXURE a) Questionnaire b) Abbreviations

64 68

INTRODUCTION 6

A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly important in the field of finance, Options and Futures are traded actively on many exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as over-the-counter markets – in other words, there is no single market place organized exchanges. Interpretation

NEED OF THE STUDY The study has been done to know the different types of derivatives and also to know the derivative market in India. This study also covers the recent developments in the derivative market taking into account the trading in past years. Through this study I came to know the trading done in derivatives and their use in the stock markets.

SCOPE OF THE PROJECT The project covers the derivatives market and its instruments. For better understanding various strategies with different situations and actions have been given. It includes the data collected in the recent years and also the market in the derivatives in the recent years. This study extends to the trading of derivatives done in the National Stock Markets.

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2. COMPANY PROFILE IL&FS Investsmart securities Limited (IISL) is one of India’s leading financial services organizations providing individuals and corporate with customized financial management solutions. IL&FS investsmart limited( IIL) through its subsidiaries in India and Singapore provide a wide range of investment products to its retail and institutional client including equity broking investment banking, insurance broking and distribution, mutual fund distribution and related financial services. IIL’s 2000 employees provide a complete range of investment solution to over 138000 customers in India through its 88 branches and 190 franchised outlets from 133 cities. Company is having a market capitalization of approximately US $260 million. Investsmart is listed on the national stock exchange (NSE) and the Bombay stock exchange (BSE) and its global depository share are listed on the LUXEMBURG STOCK EXCHANGE At IISL, we believe in "Realizing your goals together". You will find in us - a trusted investment partner to help you work towards achieving your financial goals. Our institutional expertise, combined with a thorough understanding of the financial markets results in appropriate investment solutions for you. Our strong team of all your investment needs through a office near you. All you need to do is drop in at the nearest branch or call us and we’ll be happy to do the rest! Investsmart recognized as “National Relationship Managers, Customer Service Executives, Advisory Managers and Research Analysts, offers efficient execution backed by in-depth research, knowledge and expertise to customers across the country. With a pan-India presence of over 300 offices, IISL is geared to meet “Best Performing Financial Advisor-Retail” for two tear in a row (2006-07 and 2007-08) by CNBC TV18.

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Vision To become a long term preferred long term financial to a wide base of customer whilst optimizing Stake holder value. Mission To establish a base of 1 million satisfied customer by 2010 We will create this by being a responsible trustworthy partner. Corporate action An approach to business that reflects responsibility, transparency and ethical behaviour Respect for employee client and stake holder group.

PROMOTER OF THE COMPANY IL&FS Investsmart securities Limited (IISL) is one of India’s leading companies in the Financial Services industry. It was promoted in 1997 by Infrastructure Leasing & Financial Services (IL&FS), one of India's leading infrastructure development and finance companies.

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The company is now held by HSBC, one of the world’s largest banking and financial services organizations. In India, The HSBC Group offers a range of financial services including corporate, commercial, retail and private banking, insurance, asset management, investment banking, equities and capital markets, institutional brokerage, custodial services. It also provides software development expertise and global services facilities for the HSBC Group’s operations worldwide.

HSBC ACQUIRED 93.86 % OF IL&FS INVESTSMART IN INDIA

HSBC has completed the acquisition of 93.86 % of IL&FS investsmart limited (investsmart). A leading retail brokerage in India for a total consideration of INR 1311 crore (approx. US $296.4 million) Sandy flockhart Group managing director and CEO of HSBC Asia pacific said “investsmart gives HSBC access to the world’s third-largest investor base with over 20 million retail investors. In fact ,the business already has 1,43,000 customers and operates in 128 cities with Indian GDP expected to grow by 7.8% in 2009. The opportunity here is obvious and underlines why HSBC has a stated strategic aim of focusing on high-growth economics” Under the transaction agreement, HSBC acquired 43.85% of Investsmart from E*TRADE Mauritius Limited, an indirectly wholly-owned subsidiary of E*TRADE Financial Corporation, and 29.36 per cent from Infrastructure Leasing and Financial Services Limited (IL&FS). The decision to acquire a controlling stake in Investsmart triggered an open offer to public shareholders, through which HSBC has accepted shares equivalent to 20.65 per cent of Investsmart's capital. E*TRADE Mauritius Limited, IL&FS and those that tendered shares through the open offer received INR200 per share for their Investsmart shares. In addition, IL&FS was paid, as part of a three-year non-compete agreement, INR82.0 crore (approximately US$17.9 million). In accordance with local regulations, HSBC paid interest of INR2.3

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per share to the public shareholders who tendered their shares. This amounted to INR3.31 crore approximately US$0.72 million).

Naina Lal Kidwai, Group General Manager and Chief Executive Officer, HSBC in India, added: "Investsmart is a great addition to our current operations, which already constitute the second largest foreign banking network in India. We look forward to working with Investsmart's management team and growing this business." HSBC was advised on the acquisition by the investment banking division of HSBC Global Banking and Markets. The HSBC Group in India is represented by several entities including The Hongkong and Shanghai Banking Corporation Limited which offers a full range of banking and financial services to its over 2.8 million customers in India through its 47 branches and 170 ATMs across 26 cities. HSBC is one of India's leading financial services groups, with over 34,000 employees in its banking, investment banking and capital markets, asset management, insurance broking, two global IT development centres and six global resourcing operations in the country. The Bank is the founding and a principal member of the HSBC Group which, with over 9,500 offices in 85 countries and territories and assets of US$2,547 billion at 30 June 2008, is one of the world's largest banking and financial services organizations. In September 2008, HSBC Securities & Capital Markets (HSCI) and HSBC Violet Investments (Mauritius) had acquired 29.35% and 43.85% stakes held by IL&FS and E Trade in IL&FS Investsmart. Post the stake acquisition, HSCI’s total holding in IL&FS Investsmart increased to 50.01%, taking the total stake held by HSBC and HSCI together in the company to 93.86% HSBC Securities & capital markets (India) private limited

34,922,751

50.01 %

HSBC Violet investment (Mauritius) limited

30,625,692

43.85 %

Others

4,287,830

6.14 %

Total

69836273

100 %

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Currently HSBC group is having 93.86% of share in IL&FS investsmart securities limited. HSBC securities and capital markets (INDIA) private limited has 50.01% HSBC violet investment (maturities) limited has 43.85% in investsmart. Now the company is running under the management of HSBC group.

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3. INTRODUCTION TO DERIVATIVES The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favorable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the ‘to-arrive’ contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence.

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Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

3.1DERIVATIVES DEFINED A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying” in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was 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 purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines “derivative” to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities

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Figure.1 Types of Derivatives Market

3.2 TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

National Stock Exchange

Over The Counter Derivatives

Bombay Stock Exchange

National Commodity & Derivative exchange

Index Future

Index option

Stock option

Stock future

Interest rate Futures

3.3 TYPES OF DERIVATIVES

Derivatives

Future

Option

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Forward

Swaps

Figure.2 Types of Derivatives 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 n o r m a l l y 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 counter-party, which often results in high prices being charged.

However forward contracts in certain

markets have become very standardized,

as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially th e same

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economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. FUTURE CONTRACT In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT 1. Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: •

The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate.

•

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

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•

The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

•

The currency in which the futures contract is quoted.

•

The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.

•

The last trading date.

•

Other details such as the tick, the minimum permissible price fluctuation. 2. Margin:

Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its

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present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. 3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: •

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).

•

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. Pricing of future contract In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the future/forward, value

at time to maturity

, will be found by discounting the present

by the rate of risk-free return .

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This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher: 1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower: 1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds. 2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. 3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.

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TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURES

FORWARD CONTRACT

FUTURE CONTRACT

Operational

Traded directly between two

Traded on the exchanges.

Mechanism

parties (not traded on the exchanges).

Contract

Differ from trade to trade.

Contracts are standardized contracts.

Exists.

Exists. However, assumed by the clearing

Specifications Counter-party risk

corp., which becomes the counter party to all the trades or unconditionally guarantees their settlement.

Liquidation

Low, as contracts are tailor High,

as

contracts

are

Profile

made contracts catering to the exchange traded contracts.

standardized

needs of the needs of the parties. Price discovery

Not efficient, as markets are Efficient, as markets are centralized and all scattered.

buyers and sellers come to a common platform to discover the price.

Examples

Currency market in India.

Commodities, futures, Index Futures and Individual stock Futures in India.

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OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the ‘strike price’. There are two types of options i.e., CALL OPTION AND PUT OPTION. CALL OPTION: A contract that gives its owner the right but not the obligation to buy an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a ‘Call option’. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. b. PUT OPTION: A contract that gives its owner the right but not the obligation to sell an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as a ‘Put option’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

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4. SWAPS Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are: INTEREST RATE SWAPS: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract. CURRENCY SWAPS: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. FINANCIAL SWAP: Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

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The other kind of derivatives, which are not, much popular are as follows: 5. BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets. 6. LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities. 7. WARRANTS Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. 8. SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

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3.1 HISTORY OF DERIVATIVES:

The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700’s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of ‘credit risk’ and to provide centralised location to negotiate forward contracts. From ‘forward’ trading in commodities emerged the commodity ‘futures’. The first type of futures contract was called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of ‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984. 25

Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealer’s Association was set up in early 1900’s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with

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the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange. 3.5 INDIAN

DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India Table Chronology of instruments 1991 Liberalisation process initiated 14 December 1995 NSE asked SEBI for permission to trade index futures. 18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework for 11 May 1998 7 July 1999

index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and

24 May 2000

interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian

index. 25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading. 9 June 2000 Trading of BSE Sensex futures commenced at BSE. 12 June 2000 Trading of Nifty futures commenced at NSE. 25 September 2000 Nifty futures trading commenced at SGX. 2 June 2001 Individual Stock Options & Derivatives

3.6 Need for derivatives in India today

27

In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors’ aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India’s financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of India’s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.

3.7 Myths and realities about derivatives In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? •

Derivatives increase speculation and do not serve any economic purpose

•

Indian Market is not ready for derivative trading

•

Disasters prove that derivatives are very risky and highly leveraged instruments

•

Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding

•

Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economic purpose

28

Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity Prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets increasing market liquidity and efficiency and facilitating the flow of trade and finance.

29

Indian Market is not ready for derivative trading Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives, and how Indian market fares: PRE-REQUISITES Large market Capitalisation

INDIAN SCENARIO India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores.

High

Liquidity

in

underlying

the The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in

Trade guarantee

the underlying. The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities

Clearing

Corporation

(NSCCL).

NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does A Strong Depository

the clearing. National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised

A Good legal guardian

the security settlement in our country. In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

30

What kind of people will use derivatives? Derivatives will find use for the following set of people: • Speculators: People who buy or sell in the market to make profits. For example, if you will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits • Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$ • Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will examine this in detail when we look at futures in a separate chapter. Basically, every investor assumes one or more of the above roles and derivatives are a very good option for him.

3.8 Comparison of New System with Existing System Many people and brokers in India think that the new system of Futures & Options and banning of Badla is disadvantageous and introduced early, but I feel that this new system is very useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI. The figure 3.3a –3.3d shows how advantages of new system (implemented from June 20001) v/s the old system i.e. before June 2001 New System Vs Existing System for Market Players

31

Figure 3.3a

Speculators

Existing

SYSTEM

Approach

Peril &Prize

New

Approach

Peril

&Prize 1) Deliver based

1) Both profit &

1)Buy &Sell stocks

1)Maximum

Trading, margin

loss to extent of

on delivery basis

loss possible

trading& carry

price change.

2) Buy Call &Put

to premium

forward transactions.

by paying

paid

2) Buy Index Futures

premium

hold till expiry.

Advantages •

Greater Leverage as to pay only the premium.

•

Greater variety of strike price options at a given time.

Figure 3.3b

Arbitrageurs

32

Existing

SYSTEM

Approach

New

Peril &Prize

Approach

Peril

&Prize 1) Buying Stocks in

1) Make money

1) B Group more

one and selling in

whichever way the

promising as still

another exchange.

Market moves.

in weekly settlement

forward transactions.

1) Risk free game.

2) Cash &Carry

2) If Future Contract

arbitrage continues

more or less than Fair price •

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing

Approach

SYSTEM

Peril &Prize

New

Approach

Peril

&Prize 1) Difficult to

1) No Leverage

1)Fix price today to buy

1) Additional

offload holding

available risk

latter by paying premium.

cost is only

during adverse

reward dependant

2)For Long, buy ATM Put

premium.

33

market conditions

on market prices

Option. If market goes up,

as circuit filters

long position benefit else

limit to curtail losses.

exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages •

Availability of Leverage

Figure 3.3d

Small Investors

Existing

SYSTEM

Approach

Peril &Prize

New

Approach

Peril

&Prize 1) If Bullish buy stocks else sell it.

1) Plain Buy/Sell

1) Buy Call/Put options

implies unlimited

based on market outlook

profit/loss.

Losses Protected.

34

remains

2) Hedge position if

protected &

holding underlying

upside

stock

unlimited.

Advantages •

1) Downside

Exchange-traded vs. OTC derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability.

35

The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter-party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal. 3.9 FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES: Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the markets, technological developments and advances in the financial theories. A.} PRICE VOLATILITY – A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. The concept of price is clear to

36

almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have ‘demand’ and producers or suppliers have ‘supply’, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as ‘price volatility’. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. These price volatility risks pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds. B.} GLOBALISATION OF MARKETS –

37

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalisation has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent. C.} TECHNOLOGICAL ADVANCES – A significant growth of derivative instruments has been driven by technological break through.

Advances in this area include the development of high speed processors,

network systems and enhanced method of data entry. Closely related to advances in computer

technology

are

advances

in

telecommunications.

Improvement

in

communications allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the

38

technological developments increase volatility, derivatives and risk management products become that much more important.

39

D.} ADVANCES IN FINANCIAL THEORIES – Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970’s, work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. The above factors in combination of lot many factors led to growth of derivatives instruments

3.10 BENEFITS OF DERIVATIVES Derivative markets help investors in many different ways: 1.] RISK MANAGEMENT – Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. 2.]

PRICE DISCOVERY –

Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset. 3.]

OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant

40

price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets. 4.]

MARKET EFFICIENCY –

The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values. 5.]

EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions. •

The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices.

•

An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.

•

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

41

4.1 DEVELOPMENT OF DERIVATIVES MARKET IN INDIA 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 Securities Contract Regulation Act (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 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30 (Sense) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.

42

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): •

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

segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. •

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

This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. •

Put volumes in the index options and equity options segment have increased since

January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.

43

•

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

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

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

risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums. •

The spot foreign exchange market remains the most important segment but the derivative segment has also grown. In the derivative market foreign exchange swaps account for the largest share of the total turnover of derivatives

in

India

followed

milestones

in the development

by

forwards

of derivatives

and

options. Significant

market

have been (i)

permission to banks to undertake cross currency derivative transactions subject to certain conditions (1996) (ii) allowing corporates to undertake long term foreign currency swaps that contributed to the development of the term currency swap market (1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of currency futures (2008). I would like to emphasise that currency swaps allowed companies with ECBs to swap their foreign currency liabilities into rupees. However, since banks could not carry open positions the risk was allowed to be transferred to any other resident corporate. Normally such risks should be taken by corporates who have natural hedge or have potential foreign exchange earnings.

But often corporate assume these

risks due to interest rate differentials and views on currencies. This period has also witnessed several relaxations in regulations relating to forex markets and also greater liberalisation in capital account regulations leading to greater integration with the global economy.

44

•

Cash settled exchange traded currency futures have made foreign currency a separate asset class that can be traded without any underlying need or exposure a n d on a leveraged basis on the recognized stock exchanges with credit risks being assumed by the central counterparty

Since the commencement of trading of currency futures in all the three exchanges, the value of the trades has gone up steadily from Rs 17, 429 crores in October 2008 to Rs 45, 803 crores in December 2008. The average daily turnover in all the exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same period. The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between 2 – 3 per cent.

Table 4.1ForexMarketActivity April’05-

April’06-

April’07-

April’08-

Total turnover (USD billion)

Mar’06 4,404

Mar’07 6,571

Mar’08 12,304

Mar’09 9,621

Inter-bank to Merchant ratio

2.6:1

2.7:1

2.37: 1

2.66:1

Spot/Total Turnover (%)

50.5

51.9

49.7

54.9

Forward/Total Turnover (%)

19.0

17.9

19.3

21.5

Swap/Total Turnover (%)

30.5

30.1

31.1

32.7

Source: RBI

45

5. National Exchanges In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational. “National Status” implies that these exchanges would be automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively. MCX MCX (Multi Commodity Exchange of India Ltd.) an independent and demutulised multi commodity exchange has permanent recognition from Government of India for facilitating online trading, clearing and settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank of

India, Bank of

Baroda,

Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Traders, Corporate, Regional Trading Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others MCX

46

being nation-wide commodity exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure.

MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of-the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading.

NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz., warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN).

47

NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement. NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice,

48

Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize & Yellow soyabean meal.

OBJECTIVES OF THE STUDY  To understand the concept of the Derivatives and Derivative Trading.  To know different types of Financial Derivatives.  To know the role of derivatives trading in India.  To analyse the performance of Derivatives Trading since 2001with special reference to Futures & Options  To know the investors perception towards investment in derivative market

RESARCH METHODOLOGY Method of data collection:Secondary sources:It is the data which has already been collected by some one or an organization for some other purpose or research study .The data for study has been collected from various sources: 

Books



Journals



Magazines 49



Internet sources

Second Phase is Collection of Primary Data and Analysis: After collecting the Secondary data the next phase will be collection of primary data using Questionnaires. The questionnaire will be filled by around 50 people who will be mainly from Delhi/NCR region. The sample will consist of people who are employed or work as free lancers dealing in derivative market to know their perception towards investment in derivative market. The data collected will be then entered into MS Excel for analysis of the data collected from the questionnaire.

RESEARCH DESIGN Non probability The non –probability respondents have been researched by selecting the persons who do the trading in derivative market. Those persons who do not trade in derivative market have not been interviewed. Exploratory and descriptive research The research is primarily both exploratory and descriptive in nature. The sources of information are both primary and secondary. The secondary data has been taken by referring to various magazines, newspapers, internal sources and internet to get the figures required for the research purposes. The objective of the exploratory research is to gain insights and ideas. The objective of the descriptive research study is typically concerned with determining the frequency with which something occurs. A well structured questionnaire was prepared for the primary

50

research and personal interviews were conducted to collect the responses of the target population.

SAMPLING METHODOLOGY Sampling Technique Initially, a rough draft was prepared a pilot study was done to check the accuracy of the Questionnaire and certain changes were done to prepare the final questionnaire to make it more judgmental. Sampling Unit The respondents who were asked to fill out the questionnaire in the National Capital Region are the sampling units. These respondents comprise of the persons dealing in derivative market. The people have been interviewed in the open market, in front of the companies, telephonic interviews and through other sources also Sample Size The sample size was restricted to only 50 respondents. Sampling Area The area of the research was National Capital Region (NCR).

Time: 2 months Statistical Tools Used: Simple tools like bar graphs, tabulation, line diagrams have been used.

51

ANALYSIS Q. Education qualification of investors who investing in derivative market.

Education Under graduate Graduate Post graduate Professional

No. of result 6 10 23 11

Q. Income range of investors who investing in derivative market.

Income range below 1,50,000 1,50,000-3,00,000

No. of Result 1 9

52

3,00,000-5,00,000 above 5,00,000

14 26

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

Investment Between 5% to 10% Between 11% to 15% Between 16% to 20% Between 21% to 25% More than 25%

No. of result 2 6 13 18 11

53

Q. What is your primary investment purpose?

Q. What kind of risk do you perceive while investing in the stock market?

54

Risk in stock market Uncertainty of returns Slump in stock market Fear of windup of company Others

No.of result 19 22 6 3

Q. Why people do not invest in derivative market?

Reasons Lack of knowledge & understanding Increase speculation Risky & highly leveraged Counter party risk

No.of result 27 2 17 4

55

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

Purpose of investment Hedge their fund Risk control More stable Direct investment without buying & holding assets

Q. You participate in derivative market as

56

No. of Result 27 9 1 13

Participation as investor Speculator Broker/Dealer Hedger

No. of Result 23 2 8 17

Q. From where you prefer to take advice before investing in derivative market?

Advice From Brokerage houses Research analyst Websites News Networks Others

No. of Result 15 7 2 23 3

57

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

Participate in Stock index futures Stock index Options Future on individual stock Currency futures Options on individual stock

No. of Result 19 13 6 9 3

58

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

Q. How often do you invest in derivative market?

59

Q. What was the result of your investment? Result of

No.of

investment Great results Moderate but

result

acceptable Disappointed

4 24 22

60

Q. What is best describes the overall approach to invest as a mean of achieving investors goals.

OPTIONS Relative level of stability in overall investment portfolio increasing investment value while minimizing potential for loss of principal Investment growth with moderate high levels of risk Maximum long term returns with high risk

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NO. of Result 17 19 4 10

INTERPRETATION  Most of the investors who invest in derivatives market are post graduate.  Investors who invest in derivative market have a income of above 5,00,000  Investors generally perceive slump in stock market kind of risk while investing in derivative market.  People are generally not investing in derivative market due to lack of knowledge and difficulty in understanding and it is very risky also.  Most of investor purpose of investing in derivative market is to hedge their fund.  People generally participate in derivative market as a investor or hedger.  People generally prefer to take advice from news network before investing in derivative market.  Most of investors participate in stock index futures.  From this survey we come to know that most of investors make a contract of 3 month maturity period.  Investors invest regularly in derivative market.  The result of investment in derivative market is generally moderate but acceptable.

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RECOMMENDATIONS & SUGGESTIONS



A knowledge need to be spread concerning the risk and return of the derivative market.



More variation in stock index future need to be made looking a demand side of investors.



RBI should play a greater role in supporting derivatives



There must be more derivative instruments aimed at individual investors.



SEBI should conduct seminars regarding the use of derivatives to educate individual investors.

LIMITAITONS OF STUDY 1. LIMITED TIME: The time available to conduct the study was only 2 months. It being a wide topic, had a limited time.. 2. LIMITED RESOURCES: Limited resources are available to collect the information about the commodity trading 3. VOLATALITY: Share market is so much volatile and it is difficult to forecast anything about it whether you trade through online or offline 4. ASPECTS COVERAGE: Some of the aspects may not be covered in my study.

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BIBLIOGRAPHY Books referred:  Options Futures, and other Derivatives by John C Hull  Derivatives FAQ by Ajay Shah  NSE’s Certification in Financial Markets: - Derivatives Core module  Financial Markets & Services by Gordon & Natarajan

Reports:  Report of the RBI-SEBI standard technical committee on exchange traded Currency Futures  Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA Websites visited:  www.nse-india.com  www.bseindia.com  www.sebi.gov.in  www.ncdex.com  www.google.com  www.derivativesindia.com

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ANNEXURE

SURVEY QUESTIONNAIRE OF INVESTORS FOR PERCEPTION TOWARDS INVESTMENT IN DERIVATIVE MARKET Sir/Ma’am, This questionnaire is meant for educational purposes only. The information provided by you will be kept secure and confidential. NAME- __________________________________________________ CONTACT- ______________________________________________ GENDER-________________________________________________ OCCUPATION-___________________________________________ 1. Educational Qualification MACROBUTTON HTMLDirect Undergraduate MACROBUTTON HTMLDirect Graduate MACROBUTTON HTMLDirect Post Graduate MACROBUTTON HTMLDirect Professional Degree Holder 2. Income Range: MACROBUTTON HTMLDirect Below 1,50,000 MACROBUTTON HTMLDirect 1,50,000 – 3,00,000 MACROBUTTON HTMLDirect 3,00,000 – 5,00,000 MACROBUTTON HTMLDirect Above 5,00,000 3. Normally what percentage of your monthly household income could be available for investment?

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MACROBUTTON HTMLDirect Between 5% to 10% MACROBUTTON HTMLDirect Between 11% to 15% MACROBUTTON HTMLDirect Between 16% to 20% MACROBUTTON HTMLDirect Between 21% to 25% MACROBUTTON HTMLDirect More than 25% 4. What is your primary investment purpose? MACROBUTTON HTMLDirect Retirement Planning MACROBUTTON HTMLDirect Building up a corpus for charity donations MACROBUTTON HTMLDirect Supporting future education of your children MACROBUTTON HTMLDirect Other (Specify) _____________________ 5. What kind of risk do you perceive while investing in the stock market? MACROBUTTON HTMLDirect Uncertainty of returns MACROBUTTON HTMLDirect Slump in stock market MACROBUTTON HTMLDirect Fear of being windup of company

MACROBUTTON HTMLDirect Other

(Specify) _________________

6. Why people do not invest in derivative market? (Rank your preference 1-4) MACROBUTTON HTMLDirect Lack of knowledge and difficulty in understanding MACROBUTTON HTMLDirect Increase speculation

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MACROBUTTON HTMLDirect Very risky and highly leveraged instrument MACROBUTTON HTMLDirect Counter party risk

7. What is the purpose of investing in derivative market? MACROBUTTON HTMLDirect To hedge their fund MACROBUTTON HTMLDirect Risk control MACROBUTTON HTMLDirect More stable MACROBUTTON HTMLDirect Direct investment without buying and holding assets 8. You participate in derivative market as: MACROBUTTON HTMLDirect Investor MACROBUTTON HTMLDirect Speculator MACROBUTTON HTMLDirect Broker/Dealer MACROBUTTON HTMLDirect Hedger 9. From where you prefer to take advice before investing in derivative market? MACROBUTTON HTMLDirect Brokerage houses MACROBUTTON HTMLDirect Research analyst MACROBUTTON HTMLDirect Websites MACROBUTTON HTMLDirect News Networks MACROBUTTON HTMLDirect Other (Specify) _________________ 10. In which of the following would you like to participate? MACROBUTTON HTMLDirect Stock Index Futures MACROBUTTON HTMLDirect Stock Index Options

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MACROBUTTON HTMLDirect Future on individual stock MACROBUTTON HTMLDirect Options on individual stock MACROBUTTON HTMLDirect Currency futures 11. What contract maturity period would interest you for trading in? MACROBUTTON HTMLDirect 1 month MACROBUTTON HTMLDirect 2 month MACROBUTTON HTMLDirect 3 month MACROBUTTON HTMLDirect 6 month MACROBUTTON HTMLDirect 9 month MACROBUTTON HTMLDirect 12 month 12. How often do you invest in derivative market? MACROBUTTON HTMLDirect 1-10 times in a year MACROBUTTON HTMLDirect 11-50 times MACROBUTTON HTMLDirect More than 50 times MACROBUTTON HTMLDirect Regularly

13. Which of the following statements best describes your overall approach to invest as a mean of achieving your goals? MACROBUTTON HTMLDirect Having a relative level of stability in my overall investment portfolio. MACROBUTTON HTMLDirect Moderately increasing my investment value while minimizing potential for loss of principal. MACROBUTTON HTMLDirect Pursue investment growth, accepting moderate to high levels of risk and principal fluctuation.

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MACROBUTTON HTMLDirect Seek maximum long-term returns, accepting maximum risk with principal fluctuation. 14. What was the result of your investment? MACROBUTTON HTMLDirect Great results MACROBUTTON HTMLDirect Moderate but acceptable MACROBUTTON HTMLDirect Disappointed

ABBREVATIONS A AMEX- America Stock Exchange B BSE- Bombay Stock Exchange

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BSI- British Standard Institute C CBOE - Chicago Board options Exchange CBOT - Chicago Board of Trade CEBB - Chicago Egg and Butter Board CME - Chicago Mercantile Exchange CNX- Crisil Nse 50 Index CPE - Chicago Produce Exchange CWC- Central Warehousing Corporation D DTSS- Derivative Trading Settlement System F FIIs- Foreign Institutional Investors F & O – Future and Options FMC- Forward Markets Commission FRAs- Forward Rate Agreements

G GAICL-Gujarat Agro Industries Corporation Limited GSAMB- Gujarat State Agricultural Marketing Board I IMM - International Monetary Market IPSTA- India Pepper & Spice Trade Association

M MCX – Multi Commodity Exchange N NAFED-National Agricultural Co-Operative Marketing Federation Of India NCDEX – National Commodities and Derivatives Exchange NIAM- National Institute Of Agricultural Marketing NMSE- National Multi Commodity Exchange

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NOL- Neptune Overseas Limited NSCCL- National Securities Clearing Corporation NSDL- National Securities Depositories Limited NSE - National Stock Exchange O OTC- Over The Counter P PHLX - Philadelphia Stock Exchange PNB- Punjab National Bank R RBI- Reserve Bank Of India S SC(R) A - Securities Contracts (Regulation) Act, 1956 SEBI- Securities Exchange Board Of India SGX- Singapore Stock Exchange SIMEX - Singapore International Monetary Exchange V VPN- Virtual Private Network

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