Introduction

Derivatives are one of the most complex instruments. The word derivative comes from the word ‘to derive’.
It indicates that it has no independent value. A derivative is a contract whose value is derived from the value
of another asset, known as the underlying asset, which could be a share, a stock market index, an interest
rate, commodity, or a currency. The underlying is the identification tag for a derivative contract. When the
price of the underlying changes, the value of the derivative also changes. Without an underlying asset,
derivatives do not have any meaning. For example, the value of a gold futures contract derives from the
value of the underlying asset i.e., gold. The prices in the derivatives market are driven by the spot or cash
market price of the underlying asset, which is gold in this example.

Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft
and so on. Derivatives on the other hand, take care of market risks - volatility in interest rates, currency rates,
commodity prices, and share prices. Derivatives offer a sound mechanism for insuring against various kinds
of risks arising in the world of finance. They offer a range of mechanisms to improve redistribution of risk,
which can be extended to every product existing, from coffee to cotton and live cattle to debt instruments.

In this era of globalisation, the world is a riskier place and exposure to risk is growing. Risk cannot be
avoided or ignored. Man, however is risk averse. The risk averse characteristic of human beings has brought
about growth in derivatives. Derivatives help the risk averse individuals by offering a mechanism for
hedging risks.

Derivative products, several centuries ago, emerged as hedging devices against fluctuations in commodity
prices. Commodity futures and options have had lively existence for several centuries. Financial derivatives
came into the limelight in the post-1970 period; today they account for 75 percent of the financial market
activity in Europe, North America, and East Asia. The basic difference between commodity and financial
derivatives lies in the nature of the underlying instrument.
Presently, most major institutional borrowers and investors use derivatives. Similarly, many act as
intermediaries dealing in derivative transactions. Derivatives are responsible for not only increasing the
range of financial products available but also fostering more precise ways of understanding, quantifying and
managing financial risk.
Definition:

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values
and definitions of the underlying variables, the parties' contractual obligations, and the notional amount)
under which payments are to be made between the parties The assets include commodities, stocks, bonds,
interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity
to proper valuation. The components of a firm's capital structure, e.g., bonds and stock, can also be
considered derivatives, more precisely options, with the underlying being the firm's assets, but this is
unusual outside of technical contexts.

From the economic point of view, financial derivatives are cash flows that are conditioned stochastically and
discounted to present value. The market risk inherent in the underlying asset is attached to the financial
derivative through contractual agreements and hence can be traded separately. The underlying asset does not
have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the market
value of an asset. This also provides a considerable amount of freedom regarding the contract design. That
contractual freedom allows derivative designers to modify the participation in the performance of the
underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be
effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market
price risk of the underlying asset can be controlled in almost every situation.

There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivatives such
as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD)
that are traded through specialized derivatives exchanges or other exchanges.

Derivatives are more common in the modern era, but their origins trace back several centuries. One of the
oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth
century. Derivatives are broadly categorized by the relationship between the underlying asset and the
derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign
exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in
which they trade (such as exchange-traded or over-the-counter); and their pay-off profile.
Derivatives may broadly be categorized as "lock" or "option" products. Lock products (such
as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the
contract. Option products (such as interest rate swaps) provide the buyer the right, but not the obligation to
enter the contract under the terms specified.

Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in
case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). This
distinction is important because the former is a prudent aspect of operations and financial management for
many firms across many industries; the latter offers managers and investors a risky opportunity to increase
profit, which may not be properly disclosed to stakeholders.

Along with many other financial products and services, derivatives reform is an element of the Dodd–Frank
Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many rule-making details of
regulatory oversight to the Commodity Futures Trading Commission (CFTC) and those details are not
finalized nor fully implemented as of late 2012.
History of Derivatives:

In finance, a derivative is an agreement based on an underlying asset. Instead of exchanging the actual asset,
agreements are made to exchange cash or other assets for the underlying asset within a specified timeframe.
As the value of the underlying asset changes, so does the value of the derivative. Following the definition,
we find that our lives are filled with derivatives. Credit cards, service agreements, and many other everyday
contracts promise a service now in exchange for cash within the billing period - the specified period. Rather
than being the boogey man of financial destruction, derivatives are financial tools that if used properly make
our lives easier. History shows that these financial instruments were developed to solve real world issues that
needed to be solved for business.

Ancient History

Although generally thought of as a high tech trading tool, derivatives have been around for a quite a while.
Over 100,000 years ago, it is known that people bartered for goods and services. The problem with bartering
is that it is hard to trade between items that are harvested at different times of year. Items that perished
quickly are difficult to trade. The solution was to begin utilizing a less or non-perishable commodity such as
wine, grains, or other objects as an intermediary. For instance, we could trade a perishable item for wine,
which we could then use to exchange for another crop harvested later in the year - our currency being
effectively wine. These types of trades eventually led to the development of commodity money, an
intermediate store of value that expanded the number of trading opportunities. Almost every civilization
would develop a commodity money basis for trading.

Around 8,000 B.C. writing and mathematics had developed in Sumer, located in the Tigris and Euphrates
river region, to a point they developed a unique method for accounting. Clay tokens were used to represent
the different commodities and quantities. To keep people from tampering with the tokens, they baked them
into a hollow vessel. Pressed into the exterior of the vessel - prior to baking - would be markings similar to
the tokens inside and a witness mark to make it official. The beauty of this system is the way it resolves
disputes. If there were any disagreement of the values on the exterior of the vessel, they would break it open
to count the tokens inside.
Eventually the tokens and vessels would become a promise to deliver a quantity of goods by a certain date -
all baked on the vessel. Now instead of wine, we would accept a vessel and give the other party
(counterparty) our product. Then based on the quantity and time of delivery pressed into the vessel, we
would receive the counterparty's goods. By 3,500 B.C., new forms of writing and math enabled the
Sumerians to replace the vessels with clay tablets. These trades are similar in behaviour to forward contracts.

A forward contract is an agreement where a seller agrees to deliver an item by a certain date to a buyer at an
agreed price. Typically, forward contracts are settled upon the delivery of the item at the expiration date.
Profits are only realized if the buyer had purchased the item at a reasonable price. If the buyer overpaid they
would lose money.

In ancient Greece, the Athenians used shipping contracts for trading which resemble forward contracts, with
a twist. The buyer would borrow the money up front. Prior to a trading voyage, an entrepreneur (buyer)
looking to profit on a trade of commodities would make an agreement with a merchant who would finance
the voyage. They would draw up a contract. The contract would state the amount of money loaned and
required interest the entrepreneur would pay the merchant upon return. Since these voyages were risky, the
merchants demanded a high return in the rage of 30%. After all, there were many ways a ship could
disappear; pirates, unfriendly nations, and storms to name but a few. Further stipulations would name the
commodity to be purchased, state where it was to be purchased, the ships route, and a time limit for the
voyage. To make sure the entrepreneurs' would not cheat them, the merchants had a trustworthy
acquaintance or employee accompany the voyage. Upon reaching the agreed upon port of call, our
entrepreneurs' would purchase the commodity - or sell in the case of exports. In either event, the merchant
now had an effective ownership of the commodities until they were paid back. The similarity to a forward
contract can be seen since the factors of price, commodity, and time are stipulated in the shipping contract.
Profits for the entrepreneurs' would only be realized if they could sell the commodity at a high enough price
to cover the merchant's loan and interest. If they could not cover the loan, they would end up in court and
may find much of their collateral, and perhaps their freedom, in jeopardy. Because trade was so important,
laws and regulations would develop to ensure each party would be justly treated in disputes.
Medieval Europe

Around 1100 European merchants developed the "fair letter" that acted like a letter of credit between the
buyer and seller. These letters would then be settled at regional trade fairs such as the Fairs of Champagne;
an annual cycle of trading fairs held in town located in the Champagne and Brie regions of France, which
were the main markets for Northern Europe. The seller would have the merchandise ready for pickup at a
fair, and the buyer would give a "fair letter" for payment. The Fairs of Champagne started out as mainly
agricultural events, but evolved into major trading markets for many commodities. Italian moneychangers at
the fair would settle the letters for the merchants. The Fairs of Champagne became international
clearinghouses for paper debt and credit. The seller would receive another "fair letter" or letter of credit that
could be settled in or near their hometown with a local goldsmith. Back in these times, the local goldsmith is
where merchants held their money. The goldsmiths would eventually evolve into banks. Over time, the fairs
began to lose their dominance in trade. Many of the trade routes to the fairs were over land. War and
political issues would cause over land routes to fall from favour - traders turned to sea routes. The fairs
would move from the Champagne region to the port city of Burges.

Bruges is interesting because of the impact natural changes in the environment had on the city and its
economy. Bruges is located near the North Sea in modern day Belgium. Prior to 1134, the natural water
channels that provided access to the sea had silted up. That year a large storm hit the coast and reopened the
natural channels near the city. Soon, because of the over land trade issues for the Fairs of Champagne,
merchants started using the port city as their main trading location. Ships would begin to arrive from as far
away as the Mediterranean. By 1309 Bruges became one of the most sophisticated money markets and
trading cities in Europe. Growth and prosperity seemed abundant until around 1500. The channels that had
been the reason for Bruges success began to silt in. Trade would move to another port city - Antwerp.
Bruges would decline.

In1515, the city of Antwerp opens the Bourse, a dedicated building where local and international traders
could gather to conduct business. Before the Bourse, traders generally met at a specified place and time to
conduct their affairs. Now there was a dedicated marketplace year round. Soon, the town of Antwerp grew
dramatically as the Bourse became the preferred place of trade in Northern Europe. Textiles from England,
spices from the Portuguese, and metals from Germany all were traded in Antwerp.
Due to its success, by 1531 a new and larger Bourse was built outside the city in a planned development
specifically with trade in mind. Away from the port and warehouses, the new facility is where contracts and
other financial instruments were traded. Traders were not purchasing commodities directly; they were
buying and selling rights to commodities - intangibles. A true financial market had been established.

Antwerp was generally prosperous until 1648. Antwerp is located on the Scheldt River. The river provided
access to the ocean and allowed the city to become an international trading post. Recall that the region was
in the middle of the Eighty Years War, which ended in 1648. Antwerp was located in the southern provinces
of the Netherlands that remained under control of Spain - the Spanish Netherlands. As part of the Treaty of
Munster, the peace treaty between Spain and the United Provinces (Dutch Republic), the Scheldt River
would be closed to navigation. Antwerp's trading activities were effectively shut down. Amsterdam would
become the new leading trading hub for Northern Europe.

For the next two hundred years the trading of commodities in the western world will utilized agreements that
are similar to forward contracts. Several civilizations would have similar type of agreements or arrangements
for trading not only for ship voyages, but for caravans as well. However, the agreements are still generally
between parties that must deal with each other directly, sort of an ancient over-the-counter (OTC). Each
party must trust the other party in order to trade. The next revolution in trading would occur in the East.
A Major Step Forward

In Feudal Japan around 1700, many rulers in agricultural regions taxed their subjects in rice. For currency,
they would bring the rice to cities such as Osaka where it was stored and sold at auction. Only authorized
wholesalers were allowed to bid on the rice at auction. The winning bidder would receive a rice voucher that
would be settled shortly thereafter for cash. The vouchers eventually became transferable; a new market in
the buying and selling of vouchers would develop among the merchants.

Around 1730, the Dojima Rice Exchange is established with the full support of the government. At the
exchange, there are two types of rice markets; the shomai and choaimai. The shomai market is where actual
rice trading takes place. Here traders buy and sell different grades of rice based on the spot price. Rice
vouchers are issued for each transaction and would be settled within four days. At the choaimai the first
future market was operating. Choaimai roughly translates to rice trading on books. In the spring, summer,
and fall different grades of rice were contracted with standardized agreements. No cash or vouchers were
exchanged; all relevant information was recorded in a book at a clearinghouse. The contract period was
limited to four months at a time. All contracts had to be settled prior to the closing of the contract period, and
no contract was allowed to carry over to another period. Settlement of the differences in value between the
current rice spot price and the contract had to be done with cash or an opposing contract position. With a few
interruptions and updates, the rice exchanges would operate until 1937.

To be able to participate in the exchange, traders were required to establish lines of credit with a
clearinghouse. Trades were done through the clearinghouse, and if the trader defaulted on a trade, the
clearinghouse was responsible for payment. Similar to today, the clearinghouse acts as the intermediary and
guarantees payment on trades. Hence, the Dojima Rice Exchange is considered by many to be the first
futures market. The final metamorphosis in commodities trading and derivatives would be over a century
after the establishment of the rice exchange in the New World.
The New World

Receiving its city charter in 1837, Chicago had grown to over 4,000 inhabitants. Soon four events would lay
the groundwork for this small city to become one of the world's largest. The year is 1848 and the Illinois and
Michigan Canal has just been finished to connect the Great Lakes to the Mississippi River and ultimately the
Gulf of Mexico. That same year the telegraph is introduced - within two years Chicago would be connected
to most major East Coast cities. Also in 1848, railroad companies install lines for commerce; the city will
become a large railroad hub. Lastly, the Chicago Board of Trade (CBOT) was founded.

Prior to the exchange, commodity trading operated similar to earlier centuries. Buyers and sellers would
need to locate each other then make an agreement - similar to a forward contract. The problem was if the
prices fluctuated too much the other party would back out of the deal, there was significant counter-party
risk. As earlier fairs and markets, the CBOT was founded to make it easier to trade and bring order to the
process. Initially the CBOT was a voluntary association with little active trading activity. By 1850, the
exchange had developed rules and product standards, which allowed the grain market to operate more
efficiently, but forward contracts were still in use. Since contracts were assignable, speculators began to play
the commodities markets looking to cash in on price movements. In 1855, France moved its grain
purchasing from New York to Chicago; CBOT had become a very popular place to trade in grains. The
Illinois State Legislature incorporated the exchange in 1859. The true revolution in commodity trading for
the CBOT would not take place until 1865. That year standardized agreements were introduced with the
exchange as the counter party - futures agreements. This is similar in nature to what the Japanese were doing
130 years earlier.

1898, The Chicago Board of Trade spun off the Chicago Butter and Egg Board, which would evolve into the
Chicago Mercantile Exchange by 1919. Over time, each exchange would begin trading a broad range of
product types from agricultural commodities to metals. Major advances in trading derivatives would not
come until 1970's. Perhaps not so coincidentally, this period also gives birth to the microprocessor and
personal computers. It is the beginning of the Computer Age.
The Computer Age

The 1970's is when derivatives gained widespread use. Several factors were at play to propel derivative
markets. First, many governments began to deregulate pricing and controls in markets introducing higher
volatility. Tedious calculations were required utilizing probability theories to help predict future price
movements. Luckily, at this time the computer becomes more wide spread allowing the complex models and
computations to be solved quickly and efficiently. Then in 1973, Fischer Black and Myron Scholes would
publish their paper, "The Pricing of Options and Corporate Liabilities", which established methodologies to
help determine option prices. The paper also shows using options on equities that it is possible to create a
hedged position - something fairly well known in agricultural commodities. That same year and
coincidentally, the Chicago Board of Trade opens the Chicago Board Options Exchange. With a
methodology to price options, computers to crunch the numbers, and a market to trade- things boomed. Over
the next few decades, there would be derivatives on almost anything with a market willing to trade.

The next big development for derivatives would be electronic trading. Launched initially by the Chicago
Mercantile Exchange in 1992, electronic trading has gained wide acceptance. Benefits have been greater
liquidity, reduced transaction cost, and higher transparency. Today, trading in virtually any derivative,
commodity, or security can be done from one's living room.
Property Derivatives

The tools we utilize for synthetic real estate are property derivatives (aka. real estate derivatives ). Similar to
forward agreements in concept, property derivatives have been around for millennia. In fact, a simple
contract to buy a home is a forward agreement - buyer and seller agree upon the price and period for delivery
(due diligence period). The due diligence period could be equated to determining if the property's
"grade/quality" meets your contract requirements. As we sometimes learn most painfully, the price we pay
may not be what the true value of the real estate is. Real estate, unlike many other commodities, comes in
many prices, sizes, and locations. Before efficient markets develop, there would need to be a reasonable
"standardization" of property values - an index. Looking to fill the information gap, several institutions,
businesses, and academia worked on developing indices for their interests. The results of these efforts would
yield indices for commercial and residential real estate with the first indices appearing around 1980.

With the development of reliable property value indexes, the first early attempt of a property derivative
market began in London around 1994. Focusing on commercial real estate, the market for property
derivatives never really caught on with investors. In 2005, property derivatives came back to life in the U.K.
with trades on commercial property. Although many various derivative types were available, the most
common type of transaction would be in swaps and eventually forward agreements.

The United States would not really get started in property derivatives until around 2005. Very similar to
practices in London, the market is for the most part an over the counter affair although a market for pricing
does exist. Different derivative types, but mostly forwards on the index, are available for residential and
commercial indices. A bright spot for residential investment came in 2006 with CME/Chicago Board of
Trade establishing a market for housing futures based on the S&P/ Case-Shiller Index - although trading is
light, it is really the only market where real estate futures can be electronically traded.
Most recently, June 2009, equities (stocks) had been developed to allow traders to effortlessly invest or
hedge real estate risk - allowing even greater access to property derivatives for small investors since equity-
trading accounts have smaller deposit requirements. Known as MacroShares, they had great potential.
Unfortunately, they suspended trading in January 2010. Trading did not take off as expected. Perhaps they
were an unfortunate victim of timing; trying to launch a real estate investment product in the middle of a
depression.
History of Derivatives Market in India:

Interestingly, derivatives have been existed in India since long time in one form or the other. But, they were
not liberalised nor efforts were put to enlighten the public. The area of existence of derivatives was in
commodities, it was association by traders in Bombay which was named as Bombay Cotton Trade
Association (BCTA) in 1875 and started dealing with the futures contracts. By the starting of 19th century
derivatives in India crawled to top making India one of the worlds largest in futures industry. But, in the
early 1952 Government banned trade in cash-settlements and option contracts.

As a result derivatives’ trading was shifted to informal forward contracts which were a normal practice.
Trading at that time was restricted to only few brokers, and their trading practice was typical located under
the banyan tree in front of the town hall in Bombay. This practise was followed for long time unofficially
and finally The Bombay Stock Exchange (BSE) was formed in May 1927 under the supervision of Bombay
Securities Control Act (BSCA, 1925).

Indian markets took so long to get accustomed with the financial instruments innovations, it was due to the
financial markets were not organised well as it was under the British rule where they showed no interest in
the growth of the Indian Economy. After the Independence, government took initiatives and started
liberating people about the stock market and always kept a close eye on the market making several changes
when necessary, like banned the trading of forward contracts called “Badla” in 1993.

Later on, after much of lobbying in the government Badla was opened to markets again. Badla was similar to
forward contracts it was invented by the BSE to overcome the liquidity problems in the secondary market.
But unfortunately, this indigenous instrument could not last long as it was led with no. of undesirable
practices and was put to an end by SEBI in 2001 for good in all the 23 exchanges.
SEBI was established on April 12th 1992, with the motive “…..to protect the interests of investors in
securities and to promote the development of, and to regulate the securities market and for matters connected
therewith or incidental thereto”. Thus, SEBI started reforming the Indian market after its very constitution
and led to the development of exchange traded derivatives market in India. As derivative market was lacking
of the proper regulatory framework, SEBI formed a 24 member committee under the Chairmanship of
L.C.Gupta on Nov 18th 1996, to form the regulatory framework on derivatives market in India. The
committee then came up with the report on March 17th, 1998 with the idea of derivatives to be treated as
securities, so that it need not form a new board and access it under the securities board and the same
regulatory frameworks applies to derivatives.

And a second board was setup in June 1998 under the leadership of Prof.J.R.Varma to discover the length
and breadth of risk content in the Indian derivative market, soon the committee was back by Oct 1998 with
the critical issues solutions like margining system, methodology for charging initial margins, broker net
worth, deposit requirement and real time monitoring requirements. Thus, Securities Contract Act treated
derivatives as legal since 1999 as long as they are traded in the exchanges. Finally, 30 year ban was lifted on
the forward contracts. After the smooth and acceptable results of derivatives Badla was banned forever in
2001.

In June 2001 trading commenced in the BSE Sensex options, trading of options in individual securities
started in July 2001 and futures contracts on individual stocks was commenced in the same year
November.NSE was a head compared to BSE as its derivative trading opened up with S&P CNX Nifty
Futures Index in June 2000, the trading in Index Futures and Options contracts on NSE are based on S&P
CNX. Trading in index options was started in June 2001 and trading on individual securities commenced in
July 2001. While, single stock futures were started in Nov 2001.
Types of Derivatives:

Derivatives are a kind of financial instruments, which obtain their values from other assets. If you want to
buy a derivatives contract, the number of derivatives available in the market will flabbergast you. You will
be completely spoilt for choices in the derivatives market, but at the same time, you will be confused too.
However, the fact is these derivatives are variations of four main types of derivatives. There are four main
kinds of derivatives primarily available in the markets, which include forwards, futures, options, and swaps.

Below is a detailed explanation that will help you to understand the major types of derivatives that are
available in the Indian share market:

Forward

Forward contracts are the oldest and the most basic kind of derivatives contract available in the market. As
the name suggests, a forward contract is an agreement to buy or sell an asset in the future; the price of the
transaction is also decided in the present. The stock exchange is not a party to the contract as it is an
agreement between two private parties. Since a forward contract is a customized contract between two
parties, there is a higher risk of counterparty credit default risk. The terms of the contract may also vary
across contracts. Since the stock exchange is not involved in this, the forward contract is traded over-the-
counter. Earlier, finding an interested party was also tough, however, in today’s digital age, this problem has
been resolved.

The assets traded as a part of a forward contract are commodities such as pulses, grains, oil, electricity,
natural gas, and precious metals. Apart from this, global currencies and financial instruments are also a part
of the forward market.
Futures

A futures contract has many similarities to a forward contract. The similarity lies in the fact that it also
involves the sale of an asset or commodity at a future date; the price of this contract is also pre-decided.
However, there are many differences between the two.

A futures contract is a standardized contract listed on the exchange. Since the exchange is a party to the
futures contract, the terms of the contract cannot be modified, and the risk element is limited. In order to
further minimize the risk, all the parties are required to maintain the daily margin requirement at all times.

As the futures contract is traded on the exchange, they are mandated to follow a daily settlement process,
which means that any profit/loss realized on a contract on a particular day will have to be settled on that very
date itself. This is the most effective way to limit the counterparty risk.

The major point of difference between the two is that both the parties do not need to enter into an agreement
with each other, but rather with the exchange.

Options

This is the third most important kind of derivatives contract that is popular amongst the traders. Unlike the
forward and futures contracts, there is an obligation between parties to discharge a contract at a future date.
Options, on the other hand, gives one of the parties a right to buy/sell the underlying assets but there is no
compulsion or obligation. The other party is bound by obligation to carry out the trade. Options can be
traded in the exchange-traded markets, as well as, the over-the-counter markets. Since one party has the
privilege to make a choice to buy/sell, it has to pay a privilege or premium to the other party.

Options can be of two types: call and put. Call options give the right but not the compulsion to purchase
something at a future date, which is pre-decided. On the other hand, the put option allows you the right but
not compulsion to sell something at a pre-determined rate.
Swaps

A swap is a rather complex kind of derivative in the market. As the name suggests, Swap allows the parties
to exchange their stream of cash flows. You can say that an uncertain stream of cash flow can be exchanged
for a more certain one. Two of the most popular types of Swaps are ‘Interest Rate Swaps’ and ‘Currency
Swaps.’ It is a prevalent practice to exchange a fixed rate interest for a floating one. These derivatives are
traded between financial institutions and not retail investors. Investment bankers sometimes act as
intermediaries to these contracts. Swaps are known to be exposed to a great extent of exchange rate risks.

These are the four main types of derivatives contract that are most widely used. These days, the derivative
contracts involve many combinations of these four basic types, which lead to the formation of complex kinds
of contracts. Out of all four derivatives contract, Futures & Options are known to be the most effective
hedging instruments, as these can be instrumental in speculating future movement of prices and deriving
maximum profit out of the situation.
 Research Methodology

Research:

Research is the systematic process of collecting and analyzing information to increase our understanding of
the phenomenon under study. It is the function of the researcher to contribute to the understanding of the
phenomenon and to communicate that understanding to others.

Definition:

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values
and definitions of the underlying variables, the parties' contractual obligations, and the notional amount)
under which payments are to be made between the parties.

Types of Research:

There are two types of researches:

 Primary Research.
 Secondary Research.

Primary Research:

Primary data is collected for a particular purpose and is new information. This is conducted using some

means of questioning usually via a survey or interviews, or the information can be gathered through

observation.

Secondary Research:

Secondary research gathers information which has already been collected from Journals, books, internet,

etc. were used.

Advantage of Derivatives:

Hedging or Mitigating Risk

Since the value of the contract is intrinsically linked to the underlying asset price, it can be used to insure
against losses caused by unexpected price drops or hikes. It allows risk related to the price of the underlying
asset to be transferred from one party to another. For instance, a miller and wheat farmer sign a futures
contract to exchange a particular amount of wheat for a set price in the future. This reduces the price
uncertainty of wheat for the farmer, while reducing the risk related to availability of wheat for the miller.

Many businesses borrow large sums of money at a particular interest rate through forward rate agreements,
which stabilises earnings and reduces the risk of interest rate hikes in the future.

Determining the Price of Underlying Assets

Derivatives are often used to determine the price of the assets. For example, spot prices of futures contracts
give an idea of the approximate price of a commodity.

Speculation and Arbitrage

Derivatives can be used to hedge risk as well as acquire risk. Speculators can buy an asset at a low price in
the future, based on a derivatives contract, even when the price rises in the future. They can also sell assets at
a high price in the future, when market prices are actually going down. Riskless profits can also be enabled
by entering into simultaneous transactions in two or more markets.

Increasing Market Efficiency

A trader can replicate the payoff of the assets using derivatives contracts. Prices of the underlying assets and
the contract tend to remain in equilibrium, negating arbitrage opportunities. This helps increase the
efficiency of the financial markets.
Access to Different Markets and Assets

Individuals and organisations can gain access to unavailable or otherwise hard-to-trade assets and markets.
Companies can borrow money at favourable interest rates, rather than higher rates in the current market.

Tax Benefits

There are derivatives like equity swaps, where an investor can get steady payments based on the LIBOR
rate, while avoiding capital gains tax.

Derivatives are an important part of the global financial markets. The gross market value of OTC derivatives
alone stood at $10 trillion at the end of June 2018. But they do have counterparty, price and systemic risks
associated with them, which are important to consider before entering into any agreement.
Disadvantage of Derivatives:

High volatility:

Since the value of derivatives is based on certain underlying things such as commodities, metals and stocks
etc., they are exposed to high risk. Most of the derivatives are traded on open market. And the prices of these
commodities metals and stocks will be continuously changing in nature. So the risk that one may lose their
value is very high.

Requires expertise:

In case of mutual funds or shares one can manage with even a limited knowledge pertaining to his sector of
trading. But in case of derivatives it is very difficult to sustain in the market without expert knowledge in the
field.

Contract life:

The main problem with the derivative contracts is their limited life. As the time passes the value of the
derivatives will decline and so on. So one may even have chances of losing completely within that agreed
time frame.

Counter-party risk

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some
of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a
possibility of counter-party default.
Futures Contract:

Futures are contracts that derive value from an underlying asset such as a traditional stock, a bond or stock
index. Futures are standardized contracts traded on a centralized exchange. They are an agreement between
two parties to buy or sell something at a future date for a certain price called "the future price of
the underlying asset." The party who agrees to buy is said to be long, and the party agreeing to sell is short.
The parties are matched for quantity and price. The parties entering a futures contract do not need to
exchange a physical asset but only the difference in the future price of the asset price at maturity.

Both parties need to pay an initial margin amount (a fraction of the total exposure) with the exchange. The
contracts are marked to market; that is, the difference between the base price (the price the contract was
entered at) and the settlement price (usually an average of the prices of last few trades) are deducted from or
added to the account of the respective parties. The next day the settlement price is used as the base price.
The parties need to post additional funds into their accounts if the new base price falls below a maintenance
margin (pre-determined level). The investor can close out the position at any time before maturity but has to
be responsible for any profit or loss made from the position.

Futures are an important vehicle to hedge or manage different kinds of risks. Companies engaged in foreign
trade use futures to manage foreign exchange risk, interest rate risk if they have an investment to make, and
lock in an interest rate in anticipation of a drop in rates, and price risk to lock in prices of commodities such
as oil, crops, and metals that serve as inputs.

Futures and derivatives help increase the efficiency of the underlying market because they lower the
unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go
long in the S&P 500 futures than to replicate the index by purchasing every stock. Studies have also shown
that the introduction of futures into markets increase the trading volumes in underlying as a whole.
Consequently, futures help reduce transaction costs and increase liquidity as they are viewed as an insurance
or risk management vehicle.
Option Contract:

In finance, an option is a contract which gives the buyer (the owner or holder of the option) the right, but not
the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a
specified date, depending on the form of the option. The strike price may be set by reference to the spot
price (market price) of the underlying security or commodity on the day an option is taken out, or it may be
fixed at a discount or at a premium. The seller has the corresponding obligation to fulfil the transaction – to
sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy
at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific
price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.

The seller may grant an option to a buyer as part of another transaction, such as a share issue or as part of an
employee incentive scheme, otherwise a buyer would pay a premium to the seller for the option. A call
option would normally be exercised only when the strike price is below the market value of the underlying
asset, while a put option would normally be exercised only when the strike price is above the market value.
When an option is exercised, the cost to the buyer of the asset acquired is the strike price plus the premium,
if any. When the option expiration date passes without the option being exercised, the option expires and the
buyer would forfeit the premium to the seller. In any case, the premium is income to the seller, and normally
a capital loss to the buyer.

The owner of an option may on-sell the option to a third party in a secondary market, in either an over-the-
counter transaction or on an options exchange, depending on the option. The market price of an American-
style option normally closely follows that of the underlying stock being the difference between the market
price of the stock and the strike price of the option. The actual market price of the option may vary
depending on a number of factors, such as a significant option holder may need to sell the option as the
expiry date is approaching and does not have the financial resources to exercise the option, or a buyer in the
market is trying to amass a large option holding. The ownership of an option does not generally entitle the
holder to any rights associated with the underlying asset, such as voting rights or any income from the
underlying asset, such as a dividend.
Features of Futures Contract:

Futures contracts are similar to forward contracts, where two parties agree to buy or sell an underlying asset
at a predetermined price on a pre-specified date.

The key difference between the two is that unlike a forward contract, which is traded over-the-counter, a
futures contract is traded on an organized exchange.

Just like a forward contract, a futures contract can also be deliverable or cash settled. Because a futures
contract is traded on an exchange, it gives rise to a few more differences between futures and forwards.

The following is a list of key differences:

1. Futures contracts are traded on an exchange while forward contracts are privately traded.

2. Since they are traded on exchange, futures contracts are highly standardized. Forward contracts, on
the other hand, are customized as per the requirements of the counterparties.

3. A single clearinghouse acts as the counterparty for all futures contracts. This means that the
clearinghouse is the buyer for every seller and seller for every buyer. This eliminates the risk of
default, and also allows traders to reverse their positions at a future date.

4. Futures contracts require a margin to be posted at the contract initiation, which fluctuates as the
futures prices fluctuate. There is no such margin requirement in a forward contract.

5. The government regulates futures market while the forward market is not regulated.

In a futures contract, the buyer of the contract is said to have a long position and the seller is said to have a
short position. The long is required to buy the underlying asset as per the specified time and price and the
short is required to deliver this underlying asset.
In terms of standardization, the futures markets have specifications for various things such as the quality of
the underlying asset, quantity, delivery dates, price movements, etc. For example, 100 shares of a company
may form one futures contract.

Futures contracts are used by both speculators to gain market exposure, and hedgers to mitigate their risks or
reduce their exposure to price changes.
Features of Option Contract:

Options are a type of derivative, and hence their value depends on the value of an underlying instrument.
The underlying instrument can be a stock, but it can also be an index, a currency, a commodity or any other
security.

Now that we have understood what options are, we will look at what an options contract is. An option
contract is a financial contract which gives an investor a right to either buy sell an asset at a pre-determined
price by a specific date. However, it also entails a right to buy, but not an obligation.

When understanding option contract meaning, one needs to understand that there are two parties involved, a
buyer (also called the holder), and a seller who is referred to as the writer.

Features of an option contract:

1. Premium or down payment: The holder of this type of contract must pay a certain amount called
the ‘premium’ for having the right to exercise an options trade. In case the holder does not exercise
it, s/he loses the premium amount. Usually, the premium is deducted from the total payoff, and the
investor receives the balance.

2. Strike price: This refers to the rate at which the owner of the option can buy or sell the underlying
security if s/he decides to exercise the contract. The strike price is fixed and does not change during
the entire period of the validity of the contract. It is important to remember that the strike price is
different from the market price. The latter changes during the life of the contract.

3. Contract size: The contract size is the deliverable quantity of an underlying asset in an options
contract. These quantities are fixed for an asset. If the contract is for 100 shares, then when a holder
exercises one option contract, there will be a buying or selling of 100 shares.
4. Expiration date: Every contract comes with a defined expiry date. This remains unchanged until the
validity of the contract. If the option is not exercised within this date, it expires.

5. Intrinsic value: An intrinsic value is the strike price minus the current price of the underlying
security. Money call options have an intrinsic value.

6. Settlement of an option: There is no buying, selling or exchange of securities when an options

contract is written. The contract is settled when the holder exercises his/her right to trade. In case the
holder does not exercise his/her right till maturity, the contract will lapse on its own, and no
settlement will be required.

7. No obligation to buy or sell: In case of option contracts, the investor has the option to buy or sell the
underlying asset by the expiration date. But he is under no obligation to purchase or sell. If an option
holder does not buy or sell, the option lapses.
Difference between Option and Future:

A market much bigger than equities is the equity derivatives market in India. Derivatives basically consist of
2 key products in India viz Options and Futures. The difference between future and options is that while
futures are linear, options are not linear. Derivatives mean that they do not have any value of their own but
their value is derived from an underlying asset. For example, options and futures on Reliance Industries will
be linked to the stock price of Reliance Industries and will derive their value from the same. Options and
Futures trading constitute an important part of the Indian equity markets. Let us understand the differences
between Options and Futures and how equity futures and the options market form an integral part of the
overall equity market.

What are futures and options?

A future is a right and an obligation to buy or sell an underlying stock (or other assets) at a predetermined
price and deliverable at a predetermined time. Options are a right without an obligation to buy or sell equity
or index. A call option is a right to buy while a put option is a right to sell.

So, how do I benefit from options and futures?

Let us look at futures first. Assume that you want to buy 1500 shares of Tata Motors at a price of Rs.400.
That will entail an investment of Rs.6 lakhs. Alternatively, you can also buy 1 lot (consisting of 1500 shares)
of Tata Motors. The advantage is that when you buy futures, you only pay the margin which (let us say) is
around 20% of the full value. That means your profits will be five-fold that of when you are invested in
equities. But, the losses could also be five-fold and that is the risk of leveraged trades.

An option is a right without an obligation. So, you can buy a Tata Motors 400 call option at a price of Rs.10.
Since the lot size is 1500 shares, your maximum loss will be Rs.15,000 only. On the downside, even if Tata
Motors goes to Rs.300, your loss will only be Rs.15,000. On the upside, above Rs.410 your profits will be
unlimited.
How to trade in Options and Futures?

Options and Futures are traded in contracts of 1 month, 2 months and 3 months. All F&O contracts will
expire on the last Thursday of the month. Futures will trade at a futures price which is normally at a
premium to the spot price due to the time value. There will only be one futures price for a stock for one
contract. Like in Jan 2018, one can trade in Jan Futures, Feb futures and March futures of Tata Motors.
Trading in options is slightly more complicated as you actually trade the premiums. So, there will be
different strikes traded for the same stock for call options and for put options. So, in the case of Tata Motors,
the call options premium of 400 call will be Rs.10 while these option prices will be progressively lower as
your strikes go higher.

Understanding some Options and Futures basics

Futures offer the advantage of trading equities with a margin. But the risks are unlimited on the opposite side
irrespective of whether you are long or short on the futures. When it comes to options, the buyer can limit
losses to the extent of the premium paid only. Since options are non-linear, they are more amenable to
complex Options and Futures strategies. When you buy are sell futures you are required to pay upfront
margin and mark-to-market (MTM) margins. When you sell an option also you are required to pay initial
margins and MTM margins. However, when you buy options you are only required to pay the premium
margins.
Understanding the quadrants of Options and Futures

When it comes to futures the periphery is quite simple. If you expect the stock price to go up then you buy
futures on the stock and if you expect the stock price to go down then you sell futures on the stock or the
index. Options will have 4 possibilities. Let us understand each one of them with a Options and Futures
trading example. Let us assume that Infosys is currently quoting at Rs.1000. Let us understand how different
traders will use different kinds of options based on their outlook.

1. Investor A expects Infosys to go up to Rs.1150 over the next 2 months. The best strategy for him will
be buying a call option on Infosys of 1050 strike. He will get to participate in the upside by paying a
much lower premium.

2. Investor B expects Infosys to go down to Rs.900 over the next 1 month. The best approach for him
will be to buy put options on Infosys of 980 strikes. He can easily participate in the downside
movement and make profits after his premium cost is covered.

3. Investor C is not sure of the downside in Infosys. However, he is certain that with the pressure on the
stock from global markets, Infosys will not cross 1080. He can sell Infosys 1100 call option and take
home the entire premium.

4. Investor D is not sure of the upside potential of Infosys. However, he is certain that considering its
recent management changes, the stock should not dip below Rs.920. A good strategy for him will be
too sell the 900 put option and take the entire premium.
Participant of Derivatives Market:

Hedgers are the least risk lover in the derivatives market

Hedging is an act, whereby an investor seeks to protect a position or anticipated position in the spot
market. It is done by using an opposite position in derivatives. This means that if you have a buy position,
you have to create a sell position and vice-versa. The parties who perform hedging are known as hedgers. In
the process of hedging, parties such as individuals or companies owning or planning to own a cash
commodity like corn, pepper, wheat, treasury, bonds, notes or bills, etc. are concerned that the cost of the
commodity may change before either buying it in the cash market.

They want to reduce or limit the impact of such movements, which, if not covered, would incur a loss. In
such a situation, the hedger achieves protection against changing prices by purchasing or selling futures
contracts of the same type and quantity. You can achieve, such similar objectives by exercising options. In a
situation when the prices of any of your underlying stock are intended to fall you can buy put options.
Similarly, in situations with price rise, a call option is preferred.

Speculators in the derivatives market provide depth to the market

Speculators are basically traders. They enter the futures and options contract, with a view to making the
profit from the subsequent price movements. They do not have any risk to hedge. In fact, they operate at a
high level of risk in anticipation of profits. Speculation provides liquidity in the market.

The speculators also perform a valuable economic function of feeding information. These pieces of
information are not readily available elsewhere. They also help others in analyzing the derivatives markets.
Arbitragers as a derivatives market participants

Some traders participate in the market for obtaining risk-free profits. They do so by simultaneously buying
and selling financial instruments like stocks futures in different markets. This process is known as
‘arbitrage’. Thus, ‘arbitrageurs’ are the person who does such kind of trading. For example, one can always
sell a stock on the National Stock Exchange exchange and buy simultaneously back on the Bombay Stock
Exchange platform.

The arbitrageurs continuously monitor various markets. And wherever there is a chance of arbitraging, they
buy from one market and sell in the other market. In this way, they make a riskless profit. They keep the
prices of derivatives and current underlying assets closely consistent and perform a valuable economic
function.

Arbitragers and speculators perform almost a similar function. Since they both do not possess any risk to
hedge for. They help in identifying inefficiencies that exist among the markets. It is also a fact that
arbitragers help in price discovery of stocks. Further, this leads to market efficiency. On the other hand,
speculators help in enhancing liquidity in the market.
Role of derivative markets:

What is a ‘derivative’? A derivative is a financial contract whose value is derived from or depends on the
price of some underlying asset. Equivalently the value of a derivative changes when there is a change in the
price of an underlying related asset.

In the markets for assets, purchases and sales require that the underlying goods or security be delivered
either immediately or shortly thereafter. A payment is usually made immediately in these markets as cash
markets or spot markets. The sale is made, the security is remitted, and the good or security is delivered.

In other situations, the goods or security is to be delivered at a later date. Still other types of arrangements let
the buyer or seller choose whether or not to go through with the sale. These types of arrangements are
conducted in derivative markets. In contrast to the market assets, derivative markets are the markets for
contractual instruments whose performance is determined by how another instruments or asset performs.

In this article I referred to derivatives as a contract. Like all other contracts they are agreements between two
parties, a buyer and seller, in which each party does something for the other.

These contracts have a price, and buyers try to buy as cheaply as possible, while sellers try to sell as dearly
as possible. The term ‘derivative’ is simply a new name for a tried and trusted set of risk management
instruments. Unfortunately some financial market players or participants, not only the end users, but also
some of the firms who provide a service in these instruments, have used these derivative products to
speculative widely.

But it is better to understand the following statement when using the derivative products for different reasons
by the market participants.

It says: “Derivatives have been linked to Aspirin: taken as prescribed for a headache, they will make the pain
go away. If you take the whole bottle at once, you may kill yourself.”
There are various types of derivative products/contracts such as options, forwards contracts, futures contracts
and swaps. It is interesting to understand the role of derivative markets. Following are few key roles of the
derivative markets.

Role of derivative markets

1. Risk Management

2. Price discovery.

3. Operational advantages

4. Market efficiency

Risk Management

As derivative prices are related to the underlying spot market goods (assets), they can be used to reduce or
increase the risk of owing the spot items. For example, buying the spot item and selling a futures contract or
call option reduces the investor’s risk. If the goods price falls, the price of the futures or options contract will
also fall. The investor can then repurchase the contract at the lower price, affecting a gain that can at least
partially offset the loss on the spot item. All investors however want/need to keep their investments at an
acceptable risk level. Derivative markets enable those wishing to reduce their risk to transfer it to those
wishing to increase it, which we call speculators.

Because these markets are so effective at re-allocating risk among investors, no one need to assume an
uncomfortable level of risk. Consequently investors are willing to supply more funds to the financial
markets. This benefits the economy, because it enables more firms to raise capital and keeps the cost of that
capital as low as possible.

Many investors prefer to speculate with derivatives rather than with the underlying securities. The ease with
which speculation can be done using derivatives in turn makes it easier and less costly for hedgers. (hedge- a
transaction in which an investors seeks to protect a position or anticipated position in the spot market by
using an opposite position in derivatives.)
Price discovery

Forward and futures markets are an important source of information about prices. Futures markets in
particular are considered a primary means for determining the spot price of an asset. Futures and forwards
prices also contain information about what people expect future spot prices to be. In most cases the futures
price is more active hence, information taken from it is considered more reliable than spot market
information.

Therefore futures and forward market are said to provide price discovery. Option markets do not directly
provide forecasts of future spot prices. They do, however provide valuable information about the volatility
and hence the risk of the underlying spot asset.

Operational advantages

Derivative markets offer several operational advantages, such as:

1. They entail lower transaction costs. This means that commission and other trading costs lower for traders
in these markets.

2. Derivative markets, particularly the futures and exchanges have greater liquidity than the spot markets.

3. The derivative markets allow investors to sell short more easily. Securities markets impose several
restrictions designed to limit or discourage short if not applied to derivative transactions. Consequently
many investors sell short in these markets in lieu of selling short the underlying securities.
Market efficiently

Spot markets for securities probably would be efficient even if there were no derivative markets. There are
important linkages among spot and derivative prices. The ease and low cost of transacting in these markets
facilitate the arbitrage trading and rapid price adjustments that quickly eradicate these opportunities. Society
benefits because the prices of the underlying goods more accurately reflect the goods true economic value.

Therefore the derivative markets provide a means of managing risk, discovering prices, reducing costs,
improving liquidity, selling short and making the market more efficient.
Need of Derivatives:

The truth is that derivatives were created out of the need of financial markets. They can and do serve a wide
variety of purposes and that is the reason that they exist. Some of the purposes that they serve are ethical
whereas others are not. In this article we will list down the 4 most common reasons behind the usage of
derivatives.

1: To Hedge

Derivatives were originally created as tools for hedging. Businesses face a lot of risks related to commodity
prices in their day to day operations.

 For instance, the operations of an airline firm are largely affected by the prices of jet fuel. The prices
of jet fuel fluctuate on a daily basis. Hence, businesses cannot earn a stable income. Organizations
usually prefer stability and hence there is a need for a financial instrument which can ensure stable
prices regardless of the rise and fall in commodity prices

 Exporters face a lot of risk related to foreign exchange. Their goods are invoiced in foreign currency.
However, they have to pay their expenses in local currency. The exchange rates between the foreign
and local currency change every second. Hence, the profitability of such an export oriented firm is hit
by these changes in the commodity prices. They too feel that there is a need for a financial instrument
which can provide them a stable exchange rate regardless of the ups and downs in the market so that
they can plan their operations based on this stable platform.

 Lastly, a farmer faces the risk of the variability in the price of his produce. If there is excess produce
in a given year, then the prices are low or else the prices are high. The farmer wants to get rid of this
price variability and hence feels that there is a need for a financial instrument that can help him fix
the prices.

Hedging is the legitimate reason for the existence of derivatives. Hedging happens when the people buying
or selling derivatives contract use the underlying asset in the day to day operations of their firm.
2: To Speculate

The second most common reason behind the usage of derivatives is speculation. Now, this may not seem
like a legitimate reason. However, speculators are necessary participants in any market as they provide
liquidity.

Hedging happens when the parties to a contract have genuine business interests in the underlying asset.
Speculation is the exact opposite. Speculators have no interest in the underlying asset and take part in the
contract because they believe that they can make a gain out of the price movements. For instance if you
believe that the US dollar will depreciate significantly against the Euro in the next month, derivatives
contracts enable you to take a position on this in the market. Since derivative contracts are extremely
leveraged, speculation in the derivative market is a highly risky business. However, there are people who
specialize in doing so.

3: Circumventing Regulations

The third reason why derivatives are used in the marketplace is to circumvent regulation. Certain institutions
like pension funds are prohibited from making investments in any kind of risky securities. Hence, derivatives
help in superficially de-risking the securities and making it legal for the pension funds to purchase them.

Consider the case of mortgage backed securities. Pension funds were not allowed to invest money in real
estate since it was considered a risky bet. However, investment bankers created de-risked mortgage backed
securities which were backed by agencies like Freddie Mac and Fannie Mae. These securities appeared to be
risk free and hence pension funds could legally trade in them.

There are many such instances wherein derivatives have been used to circumvent regulations and change the
very nature of the investment being made.
4: Minimizing Trade Costs

Investors all over the world do not like transaction costs. Derivatives provide a great way to avoid and evade
them. This can be best explained with the help of an example.

Consider the case of a company that has taken a fixed rate loan from a bank. However, now they believe that
the interest rates will go down. Hence, they feel like they should take a floating rate loan. However, closing
the loan before its due date would attract prepayment penalty. Also, taking a new loan would generally
attract processing charges. Hence to avoid these transaction costs on both sides, a firm can simply structure a
swap wherein they can switch over to floating interest rates without bearing any of the above mentioned
transaction charges.

Hence, derivatives are extremely useful financial instruments. This usefulness adds tremendously to their
popularity and explains why ever Multinational Corporation, major bank or investment bank in the world is
highly involved in derivative trading.
 Review Literature

Avadhani (2000)

Stated that a derivative, an innovative financial instrument, emerged to protect against the risks generated in
the past, as the history of financial markets is replete with crises. Events like the collapse of the fixed
exchange rate system in 1971, the Black Monday of October 1987, the steep fall in the Nikkei in 1989, the
US bond debacle of 1994, occurred because of very high degree of volatility of financial markets and their
unpredictability. Such disasters have become more frequent with increased global integration of markets.

Marlowe (2000)

Argues that the emergence of the derivative market 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. It is generally stated that regulation has an important and critical
role to ensure the efficient and smooth functioning of the markets.

Kumar R. & Chandra A. (2000)

Critically examined arbitrage opportunities in derivative market. They concluded that individuals often
invest in securities based on approximate rule of thumb, not strictly in tune with market conditions. Their
emotions drive their trading behaviour, which in turn drives asset (stock) prices. Investors fall prey to their
own mistakes and sometimes other’s mistakes, referred to as herd behaviour. Markets are efficient,
increasingly proving a theoretical concept as in practice they hardly move efficiently. The purely rational
approach is being subsumed by a broader approach based upon the trading sentiments of investors.

Bose Suchismita (2006),

In their study “The Indian Derivatives Market Revisited” examined derivative as a risk management tool. It
was found that Derivatives products provide certain important economic benefits such as risk management
or redistribution of risk away from risk-averse investors towards those more willing and able to bear risk.
Derivatives also help price discovery, i.e. the process of determining the price level for any asset based on
supply and demand.
These functions of derivatives help in efficient capital allocation in the economy; at the same time their
misuse also poses a threat to the stability of the financial sector and the overall economy.

Ravichandran, (2008)

Studied investors preferences towards various investment avenues in Capital Market with special reference
to Derivatives. The study shows that in the current scenario, investing in stock markets is a major challenge
even for professionals. Derivatives act as a major tool for reducing the risk involved in investing in the stock
markets for getting the best results out of it. The study also focuses that investors should be aware of the
various hedging and speculation strategies, which can be used for reducing their risk. Awareness regarding
various uses of derivatives can help investors to reduce risk and increase profits.

Lovric M. et al., (2008)

Presented a description model of individual investor behaviour in which investment decisions are seen as an
iterative process of interactions between the investor and the investment environment. The investment
process was influenced by a number of interdependent variables. They suggested that this conceptual model
can be used to build stylized representations of individual investors and further studied using the paradigm
of agent-based artificial financial markets.

Devi. S and Renuga Bharathi, N (2008)

Found that the following factors namely advertisement, risk factor, investor grievances, investment pattern,
change in life style, stock broker service, investment knowledge, investment information, personal savings,
size of investment, economic condition and decreasing level of sensex influences the perception of investors
on investment.
Talati and Sanghvi (2010)

Made an attempt to identify the awareness and perception of the investors’ towards hedge funds as an
investment avenue with special reference to Gujarat state. It was found that the awareness level regarding
hedge funds was very less in the area covered for study. The investors were not aware of the advantage that
they could get by investing in hedge funds nor were they aware of the basic functioning of hedge funds.
Investors in Gujarat preferred to invest in government securities and fixed deposits of nationalize banks
where they had a complete safety of their funds, though they got less returns.

Mark fenton, Emma Soane, Nigel Nicolson and Paul Williame(2011)

Document a quantitative investigation to find difference between high and low performing traders and
studied the role of intuition in the decision making process. The emotional regulation strategies adopted by
experts reveals that high performing traders are qualitatively different from low performing traders as former
are inclined to cope up with negative feelings and formulate effective strategies to regulate their emotions.

Varadharajan.P and Vikkraman.P (2011)

In their study has stated that an investor decides on an investment after getting opinion from family, friends
and colleagues, Broker’s recommendation and also other professional advice. The investor also takes into
consideration the market situations like financial results of the companies, bonus issue, price earnings ratio
and the reputation of the company.

Shanmnga Sundaram V (2011)

Examined the impact of behavioural dimensions of investors in Capital market and found that investor
decisions are influenced by psychological factors as well as behavioural dimensions and this psychological
effect is created by the fear of losing money, sudden decline in stock indices, greed and lack of confidence
about their decision making capability.
Sahoo (2012)

Opines “Derivatives products initially emerged, as hedging devices against fluctuation in commodity prices
and the commodity-linked derivatives remained the sole form of such products for many years”. According
to him the legal framework for derivatives trading is a critical part of overall regulatory framework of
derivative markets. The purpose of regulation is to encourage the efficiency and competition rather than
impeding it.

Kousalya P R and Gurusamy P (2012)

In their research has concluded that investors make self- decision regarding their investment. Investments are
made for a period of less than three years and there is a significant relationship between age and awareness.

Manasa Vipparthi and Ashwin Margam (2012)

Revealed that the investors’ perception is dependent on the demographic profile and assesses that the
investors age, marital status and occupation has direct impact on the investor’s choice of investment. The
study further revealed that female segment are not fully tapped and even there is low target on higher income
people. It reveals that Liquidity, Flexibility, Tax savings, Service Quality and Transparency are the factors
which have a higher impact on perception of investors.

Arvid O.I. Hoffmann, Thomas Post and Joost M.E. Pennings (2012)

In their research found out that investor perception during 2008-09 financial crisis fluctuate significantly
with risk tolerance and risk perceptions being less volatile than return expectations. During the worst months
of the crisis investors’ return expectations and risk tolerance decrease while risk perception increase.
Towards the end of the crisis, investor perceptions recover. They also documented substantial swings in
trading and risk-taking behaviour that are driven by changes in investors’ perceptions. Overall individual
investors continued to trade actively and did not de-risk their investment portfolios during the crisis.
Gagan Kukreja(2012)

Has found in his research that age, educational qualification, tax advantages, liquidity and investment
attributes are mediating factor for investors’ perception. Investment influences and investment benefits are
having high relevance.

Pasha (2013)

Studied retail investors’ perception on financial derivatives in India. It is found that 55 percent of the small
investors (respondents) are of the opinion that derivatives are new, complex, and high-tech products. 38
percent of the respondents, who are familiar with derivatives, said derivatives are not new, complex, and
high – tech products. And the remaining 7 percent of the investors could not answer the question. This
shows that a large number of investors are not familiar with derivatives. The study also found that 62 percent
of the small investors are of the opinion that derivatives are purely speculative and highly leveraged
instruments.

Narang Sunita (2013)

Has discussed the implications of financial derivatives on the Indian capital market and conducted a survey
among members and sub members of NSE and BSE to understand their perception towards derivative
trading. She found that lack of awareness, high transaction costs, malpractices adopted by illegal financial
advisors and shorter trade timings are few impediments to derivative trading in India.

Neel Kamal Purohit (2013)

In his research has found out that income has significant impact on frequency of trading in stock market,
selection of mode of trading and selection of market segments. Age and income has significant impact on
taking exposure.
Tripathi (2014)

Studied investor’s perception towards derivative trading. The study shows Indian investors mainly invest
their money in real estates and insurance as they are the options offering great returns with minimum risk
associated with it. It is found that more than 75 percent of investors are aware about derivatives, out of
which 74 percent have invested in derivatives. Most of the users often invest 10 percent – 20 percent of their
total investment in derivatives followed by users who invest 20 percent – 35 percent of their total investment
in derivatives. Out of derivative users 76 percent investors have invested in options which offer benefits like
risk diversification and promises their investors great profits with minimum investment. The study
concluded that derivative market is dominated by male investor with 72 percent whereas female investors
are only 28 percent. He has found in his research that education, profession and gender do not affect the
derivative investing behaviour. However income is found to have a significant role on derivatives. He also
added that investors are using these securities for different purposes namely risk management, profit
enhancement, speculation and arbitrage.

Ruta Khaparde and Anjali Bhute (2014)

In their research suggested that the perception of investors differs around on the basis of different factors like
age, income, experience of investing, investment objectives and individual social needs. They also suggest
that stocks are the most wonderful category of financial instruments and one of the greatest tools ever
invented for building financial wealth.

Supriya (2014)

Reviewed derivative as a tool for managing risk which comes out of uncertainty and makes it difficult for
businesses to estimate their future production cost and revenues. The NSE figures reveal that in equity
derivative almost 90% of activity is due to stock futures and index futures, whereas trading in options is still
limited to few stocks, partly because they are settled in cash and not the underlying stock. Further she found
NSE has programmes to inform and educate brokers, dealers, traders and market personnel.
Dr. Y. Nagaraju (2014)

Studied investors' perception towards derivative instruments and markets. The study shows that even though
most people look at derivatives with fear, they should understand the fact that derivatives help in shifting the
risk to the other party. There are many myths that surround derivative market. All these can be done away
with proper system in place. Derivative instruments and derivative markets are not so popular among
individual investors. Only educated investors with the help of friends and brokers are investing in this
market. The reasons for not investing in this market are lack of knowledge and very complex nature of
instruments. Some people have a wrong perception about derivatives. The study suggests that measures
should be taken to make sure that the investors get a right picture of the instruments and their risk factors.

Bhatt Babaraju K and Chauhan Apurva A (2014)

Studied investor’s perception towards derivatives as an investment avenue and found that most of the
investors invest in derivative market on the basis of their own awareness, guidance from financial advisor
and broker. They found that there is a significant positive correlation between age of the respondents and
their decision to invest in derivatives and a negative correlation between annual income of the respondents
with their decision to invest in derivatives. Hedging fund, risk control, knowledge regarding financial
product and high volatility in the stock market were some of the important factors influencing the investor’s
decision.

Stein (1987)

In his pioneering theoretical model concluded that opening a futures market improves risk sharing and
therefore reduces price volatility and if the speculators observe a noisy but informative signal, the hedgers
react to the noise in the speculative trades producing an increase in volatility. These uninformed traders
could destabilize the cash market.
Sabri (2008)

Examined the impact of change in trade volume on volatility of stock prices as expressed by unified Arab
Monetary fund stock price index. He reported increase in both trading volume & stock price volatility. He
also found the correlation between volume and price movement is higher in the stock markets of the oil Arab
states compared to the nonoil Arab states.

Rahman (2001)

Examined the impact of trading in DJIA Index future & future option on the conditional volatility of
component stock. The study used GARCH model to make comparison of conditional volatility of intra-day
return before and after introduction of derivatives. The result confirms that introduction of index future &
future option on DJIA has no impact on conditional volatility of component stock.

Vipul (2006)

Investigated the change in volatility in Indian Stock market after introduction of derivatives by using
extreme value measure of volatility. The result shows that there is reduction in volatility of underlying share
after introduction of derivatives attributable to a reduced persistence in previous day’s volatility. However,
Nifty shows contradictory pattern of increase in its unconditional GARCH volatility & persistence.

Samanta (2007)

Analyzed the impact of introducing index futures and stock future on the volatility of underlying spot market
in India. He considered S&P CNX Nifty, Nifty Junior and S&P 500 and used GARCH model for the study.
He found that there is no significant change in the volatility of spot market, but the structural changes in the
volatility to some extent. He also found mixed result in spot market volatility in case of 10 individual stocks.
Rajput N, Kakkar R and Batra G (2013)

Investigated in their study how much of the volatility in one market can be explained by volatility
innovations in the other market and how fast these movements transfer between these markets. They found
that there is a unidirectional volatility spill over from spot to futures market but not vice-versa. Spot market
reacts to information faster than futures market and serves as a price discovery vehicle for futures market.

Barua et al (1994)

Undertakes a comprehensive assessment of the private corporate debt market, the public sector bond market,
the govt. securities market, the housing finance and other debt markets in India. This provides a diagnostic
study of the state of the Indian debt market, recommending necessary measures for the development of the
secondary market for debt. It highlights the need to integrate the regulated debt market with the free debt
market, the necessity for market making for financing and hedging options and interest rate derivatives, and
tax reforms.

Abhyankar (1995)

Compared the FTSE 100 stock index with the stock index futures market. He found support for the
hypothesis that lower transaction costs is the primary reason for traders with market wide information to use
the futures market.

Pericli and Koutmos (1997)

Analyzed the impact of the US S&P 500 index futures on spot market volatility. Their results showed that
index futures did not have an escalating effect on spot market volatility. Pierluigi and Laura (2002) reported
a decrease in the volatility of the underlying market on Italian Stock Market after the introduction of
derivatives.
Anna A. Merikas et.al. (1999)

Studied the factors that influence individual investor behavior in the Greek Stock Exchange. The results
revealed that there is a certain degree of correlation between the factors that behavioral finance theory and
previous empirical evidence identify as the influencing factors for the average equity investors, and the
individual behavior of active investors in the Athens Stock Exchange.

Oliveira and Armada (2001)

Did not find any significant change on the spot market volatility of the Malaysia and Portuguese stock
markets respectively.

Chuang (2003)

examined the price discovery Stock Exchange Capitalization Weighted Index Futures) and MSCI (Morgan
Stanley Capital International Taiwan Index Futures) during 1998-99 and found strong statistical evidence of
market efficiency in its weak form.

Bandivadekar and Ghosh, Sah and Omkarnath (2003)

Also investigated the behavior of volatility in cash market in futures trading era. They also found that futures
trading have led to reduction in volatility in the underlying asset market but they attributed the degree of
decline in volatility in the underlying market to the trading volume in futures market. They inferred that as
the trade volume in the Futures and Options segment of BSE is very low, the volatility in BSE has not
significantly declined; whereas in the case of NSE (where the trade volume is at the peak), the volatility in
NIFTY has reduced significantly.
Shenbagraman (2004)

Reviewed the role of some non-price variables such as open interests, trading volume and other factors, in
the stock option market for determining the price of underlying shares in cash market. The study covered
stock option contracts for four months from Nov. 2002 to Feb. 2003 consisting 77 trading days. The study
concluded that net open interest of stock option is one of the significant variables in determining future spot
price of underlying share. The results clearly indicated that open interest based predictors are statistically
more significant than volume based predictors in Indian context.

Pok and Poshakwale (2004)

In their studies on the KOSPI200 index of the Korean market and KLSE on the Malaysian one, found that
while the derivatives increased the volatility of the underlying market, they simultaneously improved its
effectiveness as well by increasing the speed at which information was impounded into the spot market
prices.

Reddy and Sebastin (2008)

Studied the temporal relationship between the equities market and the derivatives market segments of the
stock market using various methods and by identifying lead-lag relationship between the value of a
representative index of the equities market and the price of a corresponding index futures contract in the
derivatives market. The study observed that price innovations appeared first in the derivatives market and
were then transmitted to the equities market. The dynamics of such information transport between stock
market and derivatives market were studied using the information theoretic concept of entropy, which
captures non-linear dynamic relationship also.

Kasman (2008)

Examined the impact of futures on volatility of the underlying asset (via GARCH model) including the
question of whether a integrating relation exists between spot prices and futures prices (via ECM model).
They used the Istanbul Stock Price Index 30 (ISE 30) futures and spot prices and concluded that there is a
long run relation (nearly one-to-one) between spot and futures prices and causality runs from spot prices to
future prices, but not vice versa.
Bodla and Kiran (2008)

Investigated the impact of index derivatives on the return, efficiency and volatility of the S&P CNX Nifty.
The results of the study indicate increased market efficiency and reduced volatility with no price change in
the underlying market due to introduction of derivatives. However, a significant increase in volatility on the
expiration day of derivative contracts has been observed.

Satya Swaroop Debasish (2009)

In his paper investigated the effect of Nifty Futures trading on the volatility and operating efficiency of
Indian Stock Market in general and the underlying stock in particular. The study covers a period of fourteen
years i.e. from 1995 to 2009. The author has applied event study approach to test the change in volatility and
efficiency of stock returns by making a comparison between pre and post introduction of Nifty Index
Futures. The study revealed mixed results i.e. reduced spot volatility and reduced trading efficiency and in
the short run, there is a trade-off gains and costs associated with the introduction of derivatives. The study
concluded that the derivatives have led to market stabilization cut the market has to pay a price for it in the
future of loss in the market efficiency.

YogeshManharlalDoshit (2011)

In his study is focused on how the risk could be managed. Products, markets and institutions have been
developed to manage the price and income risks. Commodity exchanges provide facility for hedging the
risks. This study finds that these commodity exchanges in India are not efficient and require depth to make
them meaningful for large number of potential participants, primary producers of commodity.

ChiraOldani (2011)

In his journal focused on the assumption that the prices of the commodities are influenced by their
derivatives. The inclusion of derivatives in the financial market has increased the volume of transactions and
general price strength.
Michael Suchanecki (2011)

In their article, extended to the existing literature on options to Parisian exchange options, i.e. the option to
exchange one asset for the other contingent on the occurrence of the Parisian time. Thus, these options are a
special kind of barrier option which is knocked out or knocked in only if the value of the first asset is worth
more than the other for a certain period of time, i.e. the ratio of the assets must be above or below one (or, in
general, a given barrier) for a certain period of time. They derived closed- form solutions in terms of Laplace
transforms for these options, introduce new options which are automatically exercised at the Parisian time,
conduct some illustrative numerical analyses and give a number of examples from structured equity
products, corporate finance, M&A, risk arbitrage and life insurance where the application of Parisian
exchange options can be very useful.

Sanjay Kanti Das (2012)

Studied the investment habits and preferred investment avenues of the household. He examined investment
attitude, preference & knowledge of capital market Institutions and instruments among the household. It was
opined that households assign highest weight age to safety of investment and in most cases investors across
all categories found insurance products to be the preferred avenue of investment.

P. M. Vasudev (2012)

In his paper focused on Credit derivatives played an important role in the Credit Crisis of 2008-09. The US
Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 as a
comprehensive response to the Credit Crisis. Collateralized Debt Obligations (CDO) and Credit Default
Swaps (CDS), which are among the major credit derivatives developed by the financial industry in the recent
decades, are among the subjects covered in the lengthy Dodd-Frank legislation. Regulation seeks to
streamline trade in derivatives and promote smooth clearing and settlement of transactions. He reviewed that
measures proposed in the Dodd-Frank Act for regulating credit derivatives and question their adequacy. The
Dodd-Frank Act merely attempts to improve the procedures or mechanics governing the trade in credit
derivatives and promote prudential standards for the entities dealing in swaps. These are obviously inspired
by experience – namely, freezing of the market during the Credit Crisis and companies such as AIG issuing
Credit Default swaps without serious concern about their ability to honor the obligations assumed under the
contracts.
Erik F. Gerding (, 2012)

Has focused on the understanding and concerns about credit derivatives this Article argues for viewing many
of the policy responses to credit derivatives, such as requirements that these derivatives be exchange traded,
centrally cleared, or otherwise subject to collateral or 'margin' requirements, in a second, macroeconomic
dimension. These rules have the potential to change – or at least better measure – the amount of liquidity and
the supply of credit in financial markets and in the 'real' economy. By examining credit derivatives, this
Article illustrates the need to see a wide array of financial regulations in a macroeconomic context.

Raghavendra (2013)

Has focused on the price movement of Nifty and Junior Nifty indices for a period of sixteen years divided
into two phases: Phase One, from 1996 to 2002 when derivatives were not introduced in India, and Phase
Two, from 2002 to 2012, that is, after the introduction of derivatives. A risk return analysis was undertaken
to study on the impact of derivatives in spot market.

Shaofang Li (2014)

Examines the impact of financial derivatives on systematic risk of publicly listed U.S. bank holding
companies (BHCs) from1997 to 2012.The study revealed that higher use of interest rate derivatives,
exchange rate derivatives, and credit derivatives corresponds to greater systematic interest rate risk,
exchange rate risk and credit risk. There is a positive relationship between derivatives and risks persisting to
derivatives for trading as well as for derivatives for hedging.

Rose Mary Joy (2015)

In her study on derivatives revealed that the main purpose of investment in derivatives is to hedge risk.
Investors considered derivative market as a hedging tool than a speculative tool. The study had put insight
into the level of acceptance among investors towards the different types of derivatives. The study concluded
that the respondents are satisfied with the derivative market and is satisfied with the level of services offered
by the broker/agent at the exchanges on derivative instruments. The level of awareness programmers carried
out by regulators on derivative are found satisfactory
MarouanIbenTaarit (2016)

In this paper highlights new developments in pricing derivatives within a default event. Based on stochastic
expansion arguments, the pricing is made under a generic stochastic model for the default intensity. The
derivative‘s price is expressed through a deterministic proxy for the default intensity to which is added an
explicit summation of terms involving only Greeks computed under the proxy model. The impacts of the
intensity‘s volatility and the correlation between the default and the remaining risk processes become
explicit and can be directly estimated. In addition, the accuracy of the formula does minimally Depend on
the smoothness of the payoff function, which makes our approach very suitable for pricing in real market
situations.

VilimirYordanov (2016)

Provides a novel methodology for precise diagnostics of the dependence in portfolio credit derivatives under
a top-down setting. For the purpose he used a powerful but not so popular techniques based on
memorization. The structure gives a direct access to the dependence structure of the portfolio. The study is
focused on its boundary cases and sees how they are related to the memorization.

Lawrence R. Glosten, Suresh Nallareddy and Yuan Zou (2016)4

His paper investigates the effect of exchange-traded funds‘ (ETF) trading activity on the informational
efficiency of their underlying securities. They found that ETF trading increases informational efficiency for
stocks with weak information environments and for stocks with imperfectly competitive equity markets.

K. Soniya, G. Mohanraj and P. Karthikeyanin( 2013)

In their journal have focused on the operational concepts of derivative instruments and its operations. The
study was narrowed down to focus the profit/loss position for buyers and sellers trading in derivatives.
Peter Christoffersen et. Al (2016)

In their research has gone a long way toward correcting lacuna for derivatives based on crude oil. Their
approach is at the current frontier for research on equity derivatives, or indeed beyond it since they allow the
jump intensity to vary stochastically over time. Their large sample of daily data spans nearly 25 years of
crude oil futures and options, including multiple maturities and degrees of moneyless on each date. Bringing
information from both the futures and options markets into the estimation allows much greater statistical
power and, more importantly, enforces consistency in the modeling of both derivatives and their underlying.
This is a significant advance in our understanding of the price dynamics of the most important commodity,
and the futures and option contracts that are based on it.

Julian Cook and Dennis Philip ( 2016)

Proposed a new set of modeling tools for pricing options on this market and demonstrate their applicability
to five liquid currencies versus the dollar. The discrete time affine nested GARCH based model specification
is the first of its type to be estimated directly from spot foreign exchange and short rate (timed deposit)
quotes. Out-of-sample testing suggests that an affine term structure with stochastic volatility model
estimated at a monthly frequency outperforms most specifications with no recourse to option market quotes
to assist calibration.

Peter Christoffersen et. Al (2016)

In their research has gone a long way toward correcting lacuna for derivatives based on crude oil. Their
approach is at the current frontier for research on equity derivatives, or indeed beyond it since they allow the
jump intensity to vary stochastically over time. Their large sample of daily data spans nearly 25 years of
crude oil futures and options, including multiple maturities and degrees of moneyless on each date. Bringing
information from both the futures and options markets into the estimation allows much greater statistical
power and, more importantly, enforces consistency in the modeling of both derivatives and their underlying.
This is a significant advance in our understanding of the price dynamics of the most important commodity,
and the futures and option contracts that are based on it.
 Data Analysis

Growth of Indian Derivative Market:

This segment of the thesis particularly emphasis on the genesis and growth of Indian Capital Market over the
years and also it shows the various factors which have contributed towards it. It also outlines the major
events which took place over the years.

Growth of Indian Capital Markets:

Pre- Liberalization:

The first instance of equity trading has started on or about 18 th century and it was mainly by under British
leadership. However, the trading structure was mainly unstructured until late nineteenth century because at
that time, there were two trading points named Bombay and Calcutta. Bombay however can be regarded as
the main and important trading centre wherein initially shares of the banks were mainly traded.

Trading flourished in Mumbai the middle of the 18th century as it was an important source of cotton and
high demand of cotton resulted in boom in the share prices. After flourishing in the market for nearly half a
decade market saw a major slump in year 1865.

Also the Britishers didn’t want the 70 Indian economy to flourish therefore they didn’t make any efforts to
develop and organize the Indian capital market. At that point of time the investors depended mainly on
London Stock Exchange (LSE) funds.
At this point of time trading was limited to only handful of brokers and there were no up-scale offices where
trading could be done. However, these stock brokers initially formulated an informal association in Bombay
in the name of Native shares & stock brokers in the year 1875. After some time, trading centres of Calcutta
and Ahmedabad also materialized. Under the Bombay Securities Contracts Control Act of 1925, Bombay
Stock Exchange (also known as BSE) was recognized in year 1927.

Post-independence, the Indian economy took many years to organize and develop its capital market. This
was mainly because of the intention and priority of the Indian Government to develop public sector
undertaking and agriculture in the first phase. Even though the agricultural and public sector undertakings
shares were not listed on the exchanges, because of the main reason that they were financially very strong
and the Controller of capital issues very well managed every aspect of private sector undertaking like timing,
compositions, interest rates, floating costs of new issues.

The tough and strictness in regulations halted the growth of Indian capital market for many years. This also
demotivated the companies in releasing public interest litigations for almost 40-45 years.

In 1950s, Indian stock market has witnessed certain types of speculation by the number of brokers especially
on the shares of Tata Steel and Bombay Dyeing. The stock market at this point of time was also known as
“Satta Bazaar”. In order to regulate the stock markets, government passed the Securities Contract Act in year
1956. Also simultaneously the company’s act was enacted in the same year. This decade also marked the
establishment of development of financial institutions and state financial co-operations.

Next decade has witnessed the wars with neighbouring countries and also has faced severe draught in the
country. And at the same time, the Government has banned the Badla trading. Because of all these
conditions, share market has faced tremendous set back and faced lot of financial difficulties. Luckily, few
companies like GIC and LIC pumped money into the market and it has helped immensely by bringing back
the stock market in a normal conditions and it has also helped to revive the investors’ confidence. Also the
first mutual fund i.e. Unit Trust of India (UTI) was also launched in this decade in year 1964.
Badla trading which was banned in 1969 came into play and in 1974 again revived the market. However,
market has faced a major setback because of restriction of dividend. The Government has introduced an
Ordinance through which the companies can pay the dividend of 12% of the face value of the shares or on
third of the profits of the company. It was another headache for the market. The BSE market saw a slump of
20% overnight. Also the effect of this slump was that the market was closed for almost 15 days. The market
gained some momentum when under the FERA Act of 1973, the multinational companies were asked to
reduce their shareholding by selling to Indian counterparts.

Dilution of shares by multinational companies created a cult equity market in India. Also this gave the
opportunities to the Indian investors to invest in MNCs. Also in year 1977 Dhirubhai Ambani’s Reliance
Textiles was launched in the market, which still dominates the trade circles.

1980s saw tremendous growth in the securities market, as many investors took this as a lucrative or
profitable way to expand one’s income. The liberalized policies initiated by the government led to the
participation of small investors, and also enhanced speculation, plus ban on badla and then resumption of
badla were some of the success factors behind the growth of Indian Capital Market.

Convertible debentures were also launched in this decade which acted as resource mobilize in the primary
market. Basically, this decade characterized the advent of other stock exchanges, saw an increase in the
listing of companies, and also saw increase in market capitalization.
Post-Liberalization:

Through the liberalization and globalization, Indian Capital Market has showed a tremendous growth from
the year 1990 onwards. Also the Capital Issues (Control) Act was repealed during this period. New industrial
policies were introduced by the government. SEBI emerged as a regulator of the market. Other than that, the
period also saw the advent of investments from foreign institutions, new trading practices were introduced,
and private mutual funds and banks were boosted the market. However, major scams were also observed in
this decade which shocked the investors and discouraged small investors to participate in the stock
investments. Also the scams made the government to work on efficient management of the stock exchanges
and also regulate the financial system.

The changes in the system also led to create the Over the Counter Exchange of India, National Stock
Exchange, National Securities Clearing Corporation and National Securities Depository Limited and these
have created a great momentum in the market.

Option trading was initiated in 1996-96 and rolling settlement was initiated in year 1998 for dematerialized
segments of the company. The wider reach, better regulation and automation in the system lead to increase
in the market participation.

In the last decade, disinvestment in the public sector and privatization of the companies lead to further
growth and development of the Indian economy. The derivative market has also started on or about June
2000 after the final approval of SEBI.

Indian capital market saw a major slump in year 2008 when the world economies observed a period of
recession. Indian market also took 2-3 years to gain back momentum. The present capital market is fairly
organized, integrated with the world market, has modernized and its global reach as also expanded many
folds in comparison to the time it was incepted. Internet trading which was until recently had been a global
phenomenon has also reached India and most of the Indian traders today have their demat accounts which
can be accessed through their mobile phones and laptops at any given time.
Derivative Market in India:

Since the inception, Indian Derivative market has seen immense growth and the growth is continue to grow
for years to come. The growth has been observed due to traded contracts as well as total volume of the
business.

The overall Derivatives Market Growth Story

Comparing the two markets i.e. BSE and NSE, the NSE is performing well and the performance of
derivatives in BSE is not at all encouraging as far as volume and contracts are concerned.

The reason for the growth NSE was because of its efficiency and liquidity. As per Krishnamurti (2006), in
his study at National University of Singapore, he found that the NSE showed more efficiency than BSE.As
per the findings the trading frequency is lower on BSE as compared to NSE, while the average size per trade
is higher on the BSE. But at the same time, BSE provided less liquidity compared to NSE. The number of
contracts in year 2000-01 was 90,580 which in 2009-10 reached 679,293,922. As of March 2013, the
number of contracts in National Stock Exchange had touched, 107,062,605.

However, in the Bombay stock exchange the turnover rate and number of contracts declined in FY 2005-06.
Although it gained momentum in the subsequent years from 2006-07 till 2007-08 with turnover touching Rs.
2423.08 billion. However, again in FY 2008-09 the number of contracts 78 78 2000-01 2001-02 2002-03
2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 decreased to
496,502 with a turnover rate of Rs. 117.75. It further declined to 9,028 with a turnover rate of Rs. 2.34
billion. As of March 2013 the number of contracts in BSE were 94, 58,404 with turnover rate of Rs 2,
69,446 billion.
As per the cumulative data, at NSE maximum turnover during a period of 2000-13, maximum turnover was
observed in the last financial year i.e. 2012-13 i.e. 262,443,366 and the maximum number of contracts has
been registered in financial year 2011-12 i.e. 120, 50, 45,464.

Factors accountable for the growth of derivatives Market

As per Gopinath, 2010, there are number of factors which have been responsible for the growth of
derivatives. Prices of any asset can be determined by the supply and demand ratio of that asset. The changes
in these forces can be lead to changes price dynamics which in turn leads to price volatility in the market.
One of reasons for rapid growth in the derivative market across the globe has been the sharp volatility in the
prices of different assets like; commodities, currencies and securities. There are imminent risks which are
associated with price volatility which can be considerably reduced using a host of instruments, and
techniques available in the derivatives market.

As seen in the previous paragraphs, the first integration between two international markets i.e. AMEX and
PHLX took place in year 1975. Since then a number of integrations have taken place. The size, reach the
magnitude and the volume of business operations have increased manifolds over the years. This can be
attributed to the globalization of markets. Another effect of globalization could be seen on financial markets
as well. Global investors, exchanges, and financial institutions started participating on the global financial
markets.

The growth in the Derivatives operations market can also be attributed to the kind and magnitude of
technological breakthroughs in the communication industry. Much advancement has been observed in terms
of computer satellite technologies which helped in the faster transmission of information across the globe.
The advancement in the theories related to financial management have also influenced and contributed
towards the innovation of derivative products. These theories helped in the development of risk management
tools and gave advantage of better and efficient management of risks which generally arise in the financial
markets. Some of these theories which contributed towards the growth of financial markets are Black and
Scholes Theory (1973) which helped in evaluating the value of put and call options and Lewis Edeington
(1970s) who laid down ways of hedging financial risks, attached with financial futures.

Major Milestones in the Derivatives Market

Although the derivative trading commenced in FY 2000, however the foundation was laid down by half a
decade ago in 1995, when NSE asked SEBI to grant the permission to trade index futures.

After almost 11 months, SEBI in order to initiate the derivative trading formulated a committee under the
Chairmanship of L.C. Gupta and they have created a policy framework for the Index futures. They have
taken two years to generate and submit the report. They submitted their report on May, 1998. On or about
July 1999, the Reserve bank Of India permitted over the counter forward agreement and Interest rate swaps.
Later on index futures, Nifty futures and futures and options on Nifty have commenced. SEBI has given
permission for all these derivatives.

After almost a year later, NSE has started Equity Index Options and simultaneously in July 2001 trade of
stock options was also initiated in NSE. Then after a gap of 1.5 years in November 2002, single stock
options started trading in BSE interest rate futures were commenced in June 2003. In 2004 weekly options
were commenced trading at the BSE. In 2008, BSE has started trading of Chhota (Mini) Sensex and
accordingly, the NSE has initiated mini index futures and options. And at the same time trading of currency
futures has started by NSE and BSE.
SEBI had standardized many equity derivatives in 2010. In 2010, the non- banking financial companies
permitted to trade currency futures and it was initiated in the United Stock Exchange.

Growth of Derivatives: Marketwise

Equity Derivative System:

Derivative product wise analysis also reflects a different story about the derivative trading. It is vibrant,
active and important area of the overall derivative market. The increase in volume has increased manifolds
over the years. The overall increase in turnover rate over the last financial year to this financial year has been
recorded at 12.3%.

1. Index Future:

The Index future trading was initiated on the National Stock Exchange on or about June 2000. Now it is
available on S& P CNX Nifty, CNX Bank, CNX IT etc. As far as all Index futures are concerned, the Nifty
futures are in the number one position having around 94% of the total volume of the Index futures and it
shows that retail investors are actively participating in this sector. Exploring the journey of Index futures
since its inception in 2000, the index future registered a turnover of Rs. 23.65 billion. The turnover rates
increased massively in 2003-04 with a record turnover rate of Rs. 5,544.46 billion. Until financial year 2007-
08, index futures registered upward moving trend with registered turnover rate in 2007-08 equal to Rs. 38,
206.67 billion, however during the recession period of 2008-09 it declined to Rs. 33, 501.11 billion. It again
gained momentum in FY 2009-10 and in last FY 2012-13 it registered a turnover of Rs. 25, 271.31 billion
which is lower in comparison to the overall trend in the last 12.
 2. Stock Future:

As far as the trading in the stock future are concerned, in terms of contracts and turnover rate over the years,
one can observe that the turnover rate has increased in NSE until 2007-08 when the turnover rate was Rs.
75,485.63 billion. However, just as the index future saw a slump during the period of global recession; stock
futures also saw a dip in year 2008-09. It gained momentum in 2009-10 with 51,952.47. The growth of stock
futures again saw a dip in year FY 2011-12 however it has started peaking upwards in the last FY with
registered growth of Rs. 42,238.72 billion. As of 2012-13, 146 stocks have been allowed to trade at NSE.

3. Index Option:

In India, the Index options were introduced on or about June 2001. Globally, we can see that Options are the
number one product in the derivative market. In India, the futures contract has got the prominent importance.
Index options were not traded much until FY 2007-08. In 2008-09 when the future contracts saw a slump,
the index options gained momentum. Turnover rate at the start was Rs. 37.65 billion which increased to
13,621.11 billion in 2007-08 and jumped to 37,315.02 in 2008-09. As of FY 2012-13 the turnover rate of
index options has touched Rs. 2, 27,81,574 crores.

4. Stock Option:

The single stock option was allowed to trade from 2001 and the stock options grew from Rs. 251.63 billion
in 2001 slowly. It hasn’t gained any massive peak in the past 11 years. In FY 2010-11 the recorded turnover
was Rs. 10,303.44 billion and currently in 2012-13 it has doubled to Rs. 20,004.27 billion. Currently 146
stock options are traded under national stock exchange.
Currency Derivative Market:

Currency future trading was initiated in India in August 2008 at the National Stock Exchange. Later MCX-
SX and BSE were also granted permission on October 2008. BSE has stopped its currency derivative trading
activities since FY 2010. The third exchange, United Stock Exchange of India (USE), started trading
currency future trading in September 2010.

As per the data the turnover rate for FY 2008-09 was near about same for both MCX-SX and NSE. As of FY
2012-13 the turnover rate among the three exchanges was not comparable. While it was Rs. 33, 031.79
billion in MCX-SX, it was Rs. 52,744.65 billion at NSE and Rs. 1,328.61 billion at USE.

The products of Currency futures were added at NSE and USE in FY 2010. Since USD: INR futures are the
oldest product it dominates the market and therefore occupy 76.4% of the total market. This is followed by
USD-INR options with market share of 20.2%. Other products like; EURINR futures 1.7%, followed by
JPY-INR futures at 0.9% and GBP-INR futures at 0.8%.

Interest Rate Derivatives:

Trading of interest rate derivatives have started in the National Stock Exchange on or about 2009. Further,
interest rate futures on 91 day GOI treasury bills started at NSE on July, 2011. Since its inception in FY
2009- 10, the number of contracts and turnover rate has decreased manifolds. At the starting period, there
were 1, 60,894 contracts with net turnover of Rs. 2975 crores. A major slump was observed in FY 2010-11
with 3,348 contracts and turnover of Rs. 62 crores. The interest rate derivatives again gained momentum in
the subsequent FY, however, in FY 2012-13 it drastically reduced to 12 contracts and Rs. 0.2 crores.
Derivatives products traded in derivatives segment of BSE

The Bombay Stock Exchange (BSE) created history on June 9, 2000 when it launched trading in Sensex
based futures contract for the first time. It was then followed by trading in index options on June 1, 2001;
in stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002,
respectively. It permitted trading in the stocks of four leading companies namely; Satyam, State Bank of
India, Reliance Industries and TISCO (renamed now Tata Steel). Chhota (mini) SENSEX7 was launched on
January 1, 2008. With a small or 'mini' market lot of 5, it allows for comparatively lower capital outlay,
lower trading costs, more precise hedging and flexible trading. Currency futures were introduced on October
1, 2008 to enable participants to hedge their currency risks through trading in the U.S. dollar rupee future
platforms. In addition to the SENSEX®, five sect oral indices belonging to the 90/FF series are also
available for trading in the Futures and Options Segment of BSE Limited. Table below shows the trade
details of equity derivatives segment at BSE.

Year No. of Contract Traded Turnover (Rs in million)

2013-14 285,640,217 92,194,346
2012-13 262,443,366 71,635,180
2011-12 32,222,825 8,084,770
2010-11 5623 1,540
Derivatives products traded in derivatives segment of NSE

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of
index futures on June 12, 2000. The futures contracts are based on the popular benchmark Nifty 50 Index.
The Exchange introduced trading in Index Options (also based on Nifty 50) on June 4, 2001. NSE also
became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on
individual securities were introduced on November 9, 2001. Futures and Options on individual securities are
available on 162 securities stipulated by SEBI. Table below shows the trade details of equity derivatives
segment at NSE.

Year No. of Contract Traded Turnover (Rs in million)

2013-14 1,284,424,321 382,114,077
2012-13 1,131,467,418 315,330,040
2011-12 1,205,045,464 313,437,318
2010-11 1,034,212,062 292,482,211
Unresolved Issues and Future Prospects

Even though the derivatives market has shown good progress in the last few years, the real issues facing the
future of the market have not yet been resolved. The number of products allowed for derivative trading have
increased and the volume and the value of business has zoomed, but the objectives of setting up different
derivative exchanges may not be achieved and the growth rates witnessed may not be sustainable unless
these real issues are sorted out as soon as possible. Some of the main unresolved issues are as under.

1. Issues for Market Stability and Development:

The enormous size and fast growth of the Over the Counter (OTC) derivatives market has attracted the
attention of regulators and supervisory bodies. Some OTC derivatives have been viewed as amplifiers of
the stress in the present global financial crisis. The more common criticisms relate to the fact that the OTC
markets are less transparent and highly leveraged, have weaker capital requirements and contain elements of
hidden systemic risk.

2. The Warehousing and Standardization:

For commodity derivatives market to work smoothly, it is necessary to have a sophisticated, cost-
effective, reliable and convenient warehousing system in the country. The Habibullah (2003) task
force admitted, “A sophisticated warehousing industry has yet to come about”. Further, independent
labs or quality testing centres should be set up in each region to certify the quality, grade and
quantity of commodities so that they are appropriately standardized and there are no shocks waiting for the
ultimate buyer who takes the physical delivery.
 3. Cash vs. Physical Settlement:

Only about 1% to 5% of the total commodity derivatives trade in the country is settled in physical delivery.
It is probably due to the inefficiencies in the present warehousing system. Therefore the warehousing
problem obviously has to be handled on a war footing, as a good delivery system is the backbone of any
commodity trade. A major problem in cash settlement of commodity derivative contracts is that at
present, under the Forward Contracts (Regulation) Act 1952, cash settlement of outstanding contracts at
maturity is disallowed. In other words, all outstanding contracts at maturity should be settled in physical
delivery. To avoid this, participants settle their positions before maturity. So, in practice, most contracts are
settled in cash but before maturity. There is a need to modify the law to bring it closer to the widespread
practice and save the participants from unnecessary hassles.

4. Increased Off-Balance Sheet Exposure of Indian Banks:

The growth of derivatives as off-balance sheet (OBS) items of Indian Banks has been an area of concern for
the RBI. The OBS exposure/risk has increased significantly in recent years. The notional principal amount of
OBS exposure increased from Rs.8,42,000 crore at the end of March 2002 (approximately $181 billion at
the exchange rate of Rs.46.6 to a US $) to Rs.149,69,000 crore (approximately $321 billion) at the
end of March 2008. (RBI, 2009).

5. The Regulator:

As the market activity pick-up and the volumes rise, the market will definitely need a strong and
independent regulator; similar to the Securities and Exchange Board of India (SEBI) that regulates the
securities markets. Unlike SEBI which is an independent body, the Forwards Markets Commission
(FMC) is under the Department of Consumer Affairs (Ministry of Consumer Affairs, Food and Public
Distribution) and depends on it for funds. It is imperative that the Government should grant more powers to
the FMC to ensure an orderly development of the commodity markets. The SEBI and FMC also need to
work closely with each other due to the inter-relationship between the two markets.
 6. Tax and Legal bottlenecks:

In India, at present there are tax restrictions on the movement of certain goods from one state to another.
These need to be removed so that a truly national market could develop for commodities and derivatives.
Also, regulatory changes are required to bring about uniformity in octroi and sales taxes etc. VAT has been
introduced in the country in 2005, but has not yet been uniformly implemented by all states.