EQUITY DERIVATIVES AND TYPES OF DERIVATIVES IN EQUITY

MARKET
TABLE OF CONTENTS

S.NO PARTICULARS PAGE NO.

CHAP 1 INTRODUCTION

1.1 STATEMENT OF THE PROBLEM

1.2 CONCEPT OF DERIVATIVES

1.3 ORIGIN OF DERIVATIVES

1.4 CHARACTERISTICS OF DERIVATIVES

1.5 OBJECTIVE OF THE STUDY

1.6 SCOPE OF THE STUDY

1.7 SIGNIFICANCE OF THE STUDY

1.8 LIMITATIONS OF THE STUDY

1.9 RESEARCH METHODOLOGY

CHAP 2 REVIEW OF LITERATURE

CHAP 3 THEORETICAL CONCEPT

3.1 WHAT IS DERIVATIVE AND EQUITY

3.2 FEATURES OF DERIVATIVES

3.3 BENEFITS OF DERIVATIVES

3.4 BASICS OF DERIVATIVES

3.5 NEED FOR FINANCIAL DERIVATIVES

3.6 ROLE AND FUNCTION OF DERIVATIVES

3.7 RATIONALE BEHIND DEVELOPMENT

3.8 MAJOR PLAYERS IN THE FIELD

3.9 CLASSIFICATION OF DERIVATIVES

3.10 RISKS INVOLVED IN DERIVATIS

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3.11 ECONOMIC FUNCTIONS

3.12 APPLICATION OF DERIVATIVES

3.13 DERIVATIVE PRODUCTS

CHAP 4 TYPES OF DERIVATIVES

4.1 OPTIONS

4.2 FORWARDS

4.3 FUTURES

4.4 SWAPS

CHAP 5 SEBI GUIIDELINES

CHAP 6 ANALYSIS OF DATA

CHAP 7 CONCLUSION AND SUGGESTIONS

CHAP 8 BIBLIOGRAPHY

CHAP 9 ANNEXURE

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 INTRODUCTION
Indian stock market marks to be one of the oldest stock market in Asia. It dates back to the
close of 18th century when the East India Company used to transact loan securities. In the
1830s, trading n corporate stocks and shares in Bank and Cotton presses took place in
Bombay, though the trading was broad but the brokers were hardly half dozen during 1840
and 1850.

An informal group of 22 stockbrokers began trading under a banyan tree opposite the town
hall of Bombay from the mid-1850s, each investing a (then) princely amount of rupee 1. This
informal group of stockbrokers organized themselves as the Native Share and Stockbrokers
Association which, in 1875, was formally organized as the Bombay Stock Exchange (BSE)

In 1956, the government of India recognized the Bombay Stock Exchange as the first stock
exchange in the country under the Securities Contract (Regulation) Act. The most decisive
period in the history of the BSE took place after 1992. In the aftermath of a major scandal
with market manipulation involving a BSE member named Harshad Mehta, BSE responded
to call for reforms with intransigence. The foot-dragging by the BSE helped radicalize the
position of the government, which encouraged the creation of the National Stock Exchange
(NSE), which created an electronic marketplace.

A derivative security is a security whose value depends on the value of together more basic
underlying variable. These are also known as contingent claims. Derivatives securities have
been very successful in innovation in capital markets.

The emergence of the market for derivative products most notably forwards, futures and
options can be traced back to the willingness of risk adverse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very
nature, financial markets are markets by a very high degree of volatility. Through the use of
derivative products, it is possible to partially or fully transfer price risks by locking – in asset
prices.

As instruments of risk management these generally don’t influence the fluctuations in

the underlying asset prices. However, by locking-in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash-flow situation
of risk-averse investor.

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Derivatives are risk management instruments which derives their value from an underlying
asset. Underlying asset can be Bullion, Index, Share, Currency, Bonds, Interest, etc.

STATEMENT OF THE PROBLEM

In India, the retail investors see derivative instruments as a risky investment option because
many of them lack the basic knowledge regarding their purpose and modus operandi. Most of
the investors withdraw their investment decision in financial derivative due to lack of
knowledge and technical support. A close examination of the derivative market brings out the
fact that the retail investors are ready to invest in the derivatives with a support extended by a
third party. The investors are encouraged to invest in these instruments through
intermediaries like stock brokers and financial experts. The retail investors leave their
investment decision in derivatives in the hands of the intermediaries. Even the most
experienced investors in the market is facing difficulties due to lack of information at the
right time.

The stakeholders in the market like, SEBI and organized exchanges have adopted various
measures and have set up guidelines to protect the interest of the investors. The exchanges
and intermediaries are organizing various awareness programs, workshops and campaigns
targeting the promotion of derivatives trading among the investors. The recent activities of
the stakeholders have influenced many investors to trade in derivatives with help of
intermediaries. A detailed enquiry among investors, experts and intermediaries gave an
insight into the present situation. On this basis, the study focused on the investor‘s preference
in Futures and Options segment and brought out the problems confronted by them.

CONCEPT OF DERIVATIVES
A derivative is a financial product which has been derived from another financial product or
commodity. The derivatives do not have independent existence without underlying product
and market. Derivatives are contracts which are written between two parties for easily
marketable assets

A Study of Derivatives Market in India Derivatives is also known as deferred delivery or

deferred payment instruments. Since financial derivatives can be created by means of a

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mutual agreement, the types of derivative products are limited only by imagination and so
there is no definitive list of derivative products. A derivative is a financial product which has
been derived from another financial product or commodity.

DEFINITION OF DERIVATIVES:
The securities contracts (Regulation) Act 1956 defines “derivative” as under section 2 (ac).
As per this “Derivative” includes (a) “a security derived from a debt instrument, share, loan
whether secured or unsecured, risk instrument or contract for differences or any other form of
security.” A derivative is a financial product which has been derived from another financial
product or commodity. The derivatives do not have independent existence without underlying
product and market. Derivatives are contracts which are written between two parties for
easily marketable assets A Study of Derivatives Market in India. Derivatives are also known
as deferred delivery or deferred payment instruments. Since financial derivatives can be
created by means of a mutual agreement, the types of derivative products are limited only by
imagination and so there is no definitive list of derivative products. A derivative is a financial
product which has been derived from another financial product or commodity. Definition of
derivatives: The securities contracts (Regulation) Act 1956 defines “derivative” as under
section 2 (ac). As per this “Derivative” includes

(a) “a security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.”

(b) “A contract which derived its value from the price, or index of prices at underlying
securities.”

Participants in the derivative trading Hedgers

Derivative products are used to hedge or reduce their exposures to market variables such as
interest rates, share values, bond prices, currency exchange rates and commodity prices. This
is done by corporations, investing institutions, banks and governments alike. A classic
example is the farmer who sells futures contracts to lock into a price for delivering a crop on
a future date. The buyer could be a food processing company, which wishes to fix a price for
taking delivery of the crop in the future.

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Speculators/Traders
Derivatives are well suited to trading on key market variables such as interest rates, stock
market indices and currency exchange rates and on prices of commodities and financial
assets. It is much less expensive to create a speculative position using derivatives than by
actually trading the underlying commodity or asset. As a result, the potential returns are much
greater.

A classic application is the trader who believes that increasing demand or scarce production
is likely to boost the price of the commodity. He has two options with him - first option is to
buy and store the physical commodity whereas other option is to go long on futures contract.

Trader chooses the second option to go long futures contract on the underlying asset. If
commodity price increases, the value of the contract will also rise and he can reverse back
position to book his profit.

Arbitrageurs
An arbitrage is a deal that produces risk free profits by exploiting a mispricing in the market.
A simple arbitrage occurs when a trader purchases an asset cheaply in one exchange and
simultaneously arranges to sell it at another exchange at a higher price. Such opportunities
are unlikely to persist for very long, since arbitrageurs would rush in to buy the asset in the
cheap location and simultaneously sell at the expensive location, thus reducing the price gap.

ORIGIN OF EQUITY DERIVATIVE

Before derivatives trading began, NSE and BSE were all-electronic equity spot markets. By
international standards, they were small markets. Derivatives trading, which started in June
2000, were a turning point in many ways. And after all the changes had fallen into place,
NSE and BSE were both amongst the top 10 exchanges in the world by the number of
transactions.

At NSE, at the outset, there was only one contract: Nifty futures. A full set of equity
derivatives products was only available by November 2001. The 9/11 attacks on the World
Trade Centre in the US were the first important event surrounding which index derivatives

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trading came to be of interest. Starting from November 2001, the growth in the number of
contracts traded at NSE has been remarkable: an average compounded growth of 5.1% per
month. Few derivatives exchanges worldwide have obtained such a hectic pace of growth in
the early years after launch.

In early 2002, the market had a new technique (options and futures) for expressing old ideas
(views on individual stocks). The idea of trading an index was something new. Gradually,
knowledge about the index percolated within the community, and the share of index
derivatives went up to over 80% of the overall equity derivatives trading.

There has also been a shift away from equity derivatives. Currency derivatives trading
commenced at NSE in August 2008 with a limited form of currency futures trading. At the
time, trading was permitted in only futures on the rupee-dollar rate, options and swaps were
banned, participations by FIIs and NRIs was banned. Yet, currency derivatives trading
rapidly gained prominence at NSE, rising to above 10% of the overall NSE derivatives
business within six months.

EVOLUTION OF DERIVATIVES
‘’If anyone owes a debt for a loan, and a storm prostrates the grain, or the harvest fail, or the
grain does not grow for lack of water; in that year, he need not give his creditor any grain, he
washes his Debt tablet in water and pays no rent for the year.”

- The Cradle of Derivatives

This text is the 48th law out of 282 contained in the Code of Hammurabi. Hammurabi was a
king of Babylon who reigned, according to some sources, from around 1792 to 1750 BC.
Hammurabi engraved the eponymous code on stone steles. This code counts among the oldest
written body of laws known today and covers almost all the aspects of civil as well as
commercial laws of that time. It deals to a great extent with contractual matters, establishing
for example the wages to be paid to an ox driver or to a doctor. It is renowned to be the most
complete code of the Mesopotamian laws that have been conserved until today. In terms of
contracts, one may recognise in this 48th law a kind of contract that once translated into a
more modern language would stipulate the following: A farmer who has a mortgage on his

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property is required to make annual interest payments in the form of grain, however, in the
event of a crop failure, this farmer has the right not to pay anything and the creditor has no
alternative but to forgive the interest due. Experts in the field of derivatives would classify
such a contract as a put option. In another word: If the harvest is plentiful and the farmer has
enough grain to pay his mortgage interest, the put option would expire worthless. If his
harvest fell short, however, he would exercise his right to walk away from making the
payment

In Ancient Mesopotamia, with a view to encouraging trade and securing the supply of
commodities, both in time and geographical distance, the ruler’s codes actually required that
Purchases, sales and other commercial agreements be in written form in order to provide
buyers and sellers with the greatest possible legal certainty to engage in trade. The purpose
was to minimise the ―your word against mine‖ maxim in case of disputes. Merchants of the
city-states of the region thus developed, in addition to the codes, commercial contracts.
Records of such contracts have been found in cuneiform script on clay tablets. Some types of
contracts were arrangements on the future delivery of grain that stipulated for instance before
planting that a seller would deliver a certain quantity of grain for a price paid at the time of
contracting. Such types of contracts not only dealt with grain but also with all sorts of
commodities. Some of the contracts were ―bearer‖ securities that could be transferred to
third parties maturity.

These types of contracts had the features of today‘s forwards and were used across borders.
By about 1,400 BC, cuneiform script in the Babylonian language was even used in Egypt to
record transactions with Crete, Cyprus, the Aegean Islands, Assyria and the Hittites. During
the Ancient Mesopotamian period, derivatives contained, most of the time, a description of
the parties, a description of the asset to be transferred, the price of the transaction, the date of
delivery and sometimes a list and even a description of witnesses. Trading took place at the
gates of the cities, at the quaysides in port cities and in the city centres, more precisely at the
temples. In addition to their religious, political and military functions, the temples played a
significant commercial role. They were directly and indirectly involved in trade and as a
consequence in derivatives transactions. They functioned as trade repositories, were parties to
contracts and offered warehouse facilities.

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They also provided quantity and quality measurement standards. Some functions of central
clearing already appeared in Ancient Mesopotamia where temples operated as
clearinghouses. Long-distance trade, including derivatives was regulated and supervised by
the government

DERIVATIVE TRADING IN INDIA

The origin of derivatives can be traced back to the need of farmers to protect themselves
against fluctuations in the price of their crop. From the time it was sown to the time it was
ready for harvest, farmers would face price uncertainty. Through the use of simple derivative
products, it was possible for the farmer to partially or fully transfer price risks by locking-in
asset prices. These were simple contracts developed to meet the needs of farmers and were
basically a means of reducing risk.

Derivative markets in India have been in existence in one form or the other for a long time. In
the area of commodities, the Bombay Cotton Trade Association started future trading way
back in 1875. This was the first organized futures market. Then Bombay Cotton Exchange
Ltd. in 1893, Gujarat Vyapari Mandall in 1900, Calcutta Hesstan Exchange Ltd. in 1919 had
started future market. After the country attained independence, derivative market came
through a full circle from prohibition of all sorts of derivative trades to their recent
reintroduction. In 1952, the government of India banned cash settlement and options trading,
derivatives trading shifted to informal forwards markets. In recent years government policy
has shifted in favour of an increased role at market based pricing and less suspicious
derivatives trading. The first step towards introduction of financial derivatives trading in
India was the promulgation at the securities laws (Amendment) ordinance 1995. It provided
for withdrawal at prohibition on options in securities. The last decade, beginning the year
2000, saw lifting of ban of futures trading in many commodities. Around the same period,
national electronic commodity exchanges were also set up.

The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE and
NSE to deal in equity derivative segment. To begin with, SEBI approved trading in index

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Futures contracts based on S&P CNX Nifty and BSE–30 Sensex index, which commenced
trading in June 2000. Later, trading in Index options commenced in June 2001 and trading in
options on individual stocks commenced in July 2001. Futures contracts on individual stocks
started in November 2001. In July 2012, SEBI has granted permission to MCX-SX to deal in
equity derivatives. Starting from a controlled economy, India has moved towards a world
where prices fluctuate every day. The introduction of risk management instruments in India
gained momentum in the last few years due to liberalisation process and Reserve Bank of
India‘s (RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation process to manage risk.

NSE gauging the market requirements initiated the process of setting up derivative markets in
India. In July 1999, derivatives trading commenced in India. In less than three decades of
their coming into vogue, derivatives markets have become the most important markets in the
world. Today, derivatives have become part and parcel of the day-to-day life for ordinary
people in major part of the world. Until the advent of NSE, the Indian capital market had no
access to the latest trading methods and was using traditional out-dated methods of trading.
There was a huge gap between the investors ‘aspirations of the markets and the available
means of trading. The opening of Indian economy has precipitated the process of integration
of India‘s financial markets with the international financial markets. Introduction of risk
management instruments in India has gained momentum in last few years thanks to Reserve
Bank of India‘s efforts in allowing forward contracts, cross currency options etc. which have
developed into a very large market.

DEVELOPMENT OF DERIVATIVE TRADING IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the
Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options
in securities. The market for derivatives, however, did not take off, as there was no regulatory
framework to govern trading of derivatives. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India. The committee submitted its report on March 17,
1998 prescribing necessary pre– conditions for introduction of derivatives trading in India.
The committee recommended that derivatives should be declared as ‗securities ‘so that
regulatory framework applicable to trading of ‗securities ‘could also govern trading of

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securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma,
to recommend measures for risk containment in derivatives market in India. The report,
which was submitted in October 1998, worked out the operational details of margining
system, methodology for charging initial margins, broker net worth, deposit requirement and
real–time monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include
derivatives within the ambit of ‗securities ‘and the regulatory framework was developed for
governing derivatives trading. The act also made it clear that derivatives shall be legal and
valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC
derivatives. The government also rescinded in March 2000, the three decade old notification,
which prohibited forward trading in securities. Derivatives trading commenced in India in
June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted
the derivative segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved derivatives contracts. To
begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and
BSE–30 (Sense) index. This was followed by approval for trading in options based on these
two indexes and options on individual securities.

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

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CHARACTERISTICS OF DERIVATIVES

 Their value is derived from an underlying instrument such as stock index, currency,
etc.
 They are vehicles for transferring risk.
 They are leveraged instruments.

OBJECTIVES OF THE STUDY

After verifying the existing literature, the following objectives were framed:

 To examine the structure of equity derivatives within Indian stock market.

 To study the various tends in derivative market.
 To study in detail the role of derivative products such as options, forwards, futures
and swaps.
 To study the role of derivatives in Indian financial market.
 To study equity derivatives and types of derivatives in the equity market.
 To analyze the current position of NSE in the derivative exchanges.
 To examine the growth of derivative market in India.
 To find out new opportunities in equity derivative market.

SCOPE OF EQUITY DERIVATIVES

In India, all attempts are being made to introduce derivative instruments in the capital market.
The National Stock Exchange has been planning to introduce index-based futures. A stiff net
worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enrol for such
trading. But, it has not yet received the necessary permission from the securities and
Exchange Board of India.

In the Forex market, there are brighter chances of introducing derivatives on a large scale. In
fact, the necessary groundwork for the introduction of derivatives in Forex market was
prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P.
Sodhani. Committee’s report was already submitted to the Government in 1995. As it is, a
few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed

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rate agreements are available on a limited scale. It is easier to introduce derivatives in Forex
market because most of these products are OTC products (Over-the-counter) and they are
highly flexible. These are always between two parties and one among them is always a
financial intermediary.

However, there should be proper legislations for the effective implementation of derivative
contracts. The utility of derivatives through Hedging can be derived, only when, there is
transparency with honest dealings. The players in the derivative market should have a sound
financial base for dealing in derivative transactions. What is more important for the success
of derivatives is the prescription of proper capital adequacy norms, training of financial
intermediaries and the provision of well-established indices? Brokers must also be trained in
the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and
index futures. Index options and index futures are basically derivate tools based on stock
index. They are really the risk management tools. Since derivates are permitted legally, one
can use them to insulate his equity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management
using index derivatives is of far more importance than risk management using individual
security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the
composition of the portfolio. Hence, investors would be more interested in using index-based
derivative products rather than security based derivative products.

There are no derivatives based on interest rates in India today. However, Indian users of
hedging services are allowed to buy derivatives involving other currencies on foreign
markets. India has a strong dollar- rupee forward market with contracts being traded for one
to six month expiration. Daily trading volume on this forward market is around $500 million
a day. Hence, derivatives available in India in foreign exchange area are also highly
beneficial to the users

The study is limited to Equity Derivatives with special reference to Futures, Forwards, Swaps
and Options in the Indian context.

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The study cannot be said as totally perfect, any alteration may come. The study has only
made humble attempt at evaluating Equity Derivatives markets only in Indian context. The
study is not based on the International perspective of the Derivatives markets.

SIGNIFICANCE OF DERIVATIVES

Derivatives are becoming increasingly important in world markets as a tool for risk
management. Derivatives instruments can be used to minimize risk. Derivatives are used to
separate risks and transfer them to parties willing to bear these risks. The kind of hedging that
can be obtained by using derivatives is cheaper and more convenient than what could be
obtained by using cash instruments. It is so because, when we use derivatives for hedging,
actual delivery of the underlying asset is not at all essential for settlement purposes.

Moreover, derivatives would not create any risk. They simply manipulate the risks and
transfer to those who are willing to bear these risks.

For example, Mr. A owns a bike If he does not take insurance, he runs a big risk. Suppose he
buys insurance [a derivative instrument on the bike] he reduces his risk. Thus, having an
insurance policy reduces the risk of owing a bike. Similarly, hedging through derivatives
reduces the risk of owing a specified asset, which may be a share, currency, etc.

The uses of derivative instruments are generally attributed to:

1) Risk Sharing Derivatives are mainly used to hedge risk associated with the underlying
asset to the willing parties to take risk. The risk comes from several sources and is
unavoidable. Derivatives are mainly intended to reduce the risks through transferring,
spreading, etc. to the third parties who are risk seekers. The reducible risks include
business risk, market risk, interest rate risk, inflation risk, currency risk/exchange rate
risk, political risk, credit risk, weather risk, legal and regulatory risks, operational
risks, valuation risks, etc.

These risks can be reduced in different ways such as:

 By selling the source of it

 By diversification
 By buying insurance against losses

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2) Implementation of Asset allocation Decisions Derivatives are useful in implementing the
asset allocation strategies on account of their property of low cost of diversification and
leverage.

3) Information gathering Derivative markets affect the information structure of the financial
system. The economic benefit of the information is that the potential imbalances can be
visualized more easily by the higher implied volatilities.

4) Price discovery and Liquidity Derivative markets offer liquidity in their transactions.
Futures and forwards markets are the important source of price information.

Over the past three decades, China and India have attained economic power close to that of
Japan and the U.S. During this period, the importance of the derivatives market within the
financial market has been widely recognized. However, little supporting evidence is available
on its economic effects. This paper investigates the dynamic relationship between the
derivatives markets and economic development in these four large economies, which we
consider together as the CIJU (China, India, Japan, and the U.S.) group.

We use a Granger-causality test in the framework of a vector error correction model (VECM)
to examine this causal and dynamic relation with data for the period 1998Q1 to 2017Q4.
Derivative markets are found to positively contribute to economic development in the short
run in the U.S., Japan, and India, but the effect disappears in the long run. In China, the
derivatives market has a negative effect on economic development in the short run. However,
in the long run, we observe a positive effect from the derivatives market on economic
development based on two long-run estimation techniques, namely, dynamic ordinary least
squares and fully modified ordinary least squares. Also, the development of derivative
markets causes growth volatility in India, both in the short run and long run.

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LIMITATIONS OF THE STUDY
 The study does not take any Nifty Index Futures and Options and International
markets into consideration.

 This is a study conducted within a period of 14 days.

 During this limited period of study, it may not be a detailed, full-fledged and
utilitarian in all aspects.

 As the time was limited, study was confined to conceptual understanding of

derivatives markets in India.

RESEARCH METHODOLOGY

Defining objectives won’t suffice unless and until a proper methodology is used to achieve
the objectives. The present study has been undertaken with empirical analysis of status of
financial derivatives in India with the use of secondary data. Data and information for the
research study were collected and analyzed from secondary published sources like
newspapers, web sites, books etc.

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 REVIEW OF LITERATURE

Dr. Shree Bhagwat, Ritesh Omre, Deepak Chand, (2012) opined that the basic
purpose of these instruments is to provide commitments to prices for future dates for giving
protection against adverse movements in future prices, in order to reduce the extent of
financial risks. Derivatives trading in India has surpassed cash segment in terms of turnover
and number of traded contracts.

Nuñez (1995) argue that the transference of the risk to the derivative markets could
improve, to a substantial extent, the transactions of the spot market, because there is an
inverse relationship between volatility and liquidity.

Nabar and Park (1994) opined that information that options supply about the future
strategies of the investors is better than that offered by combinations of assets.

Skinner (1989) examined that the introduction of the option markets produces a smaller
bid-ask spread in the underlying market and therefore a greater liquidity and he also observed
about the whether the introduction of derivative markets has increased or decreased the
variance and the trading volume of the underlying asset.

Stein (1987) recognized that the entry of new speculators in the market could constitute a
negative factor that would increase the volatility of the spot market.

Cox (1976) emphasized that the introduction of derivatives markets causes a affirm
influence on the underlying market because of the speed at which information is available in
the form of the prices as well as the amount of information reflected in expected prices due to
the derivative markets attract an additional set of traders to the market and because these

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markets, which have lower transaction costs, transmit the new information to the spot market
more quickly.

Makbul Rahim (2001) argued in his speech that the regulatory framework must provide
the right environment for the development and the growth of the market. High standards of
probity and professional conduct have to be maintained and reach world class standards.
Integrity is very important as well confidence. The development of a proper free flow of
information and disclosure helps investors to make informed investment decisions.

Rajeswari, T. R. and Moorthy, V. E. R. (2005) said that expectations of the

investors influenced by their perception and human generally relate perception to action. The
study revealed that the most preferred vehicle is bank deposit with mutual funds and equity
on fourth and sixth respectively. The survey also revealed that the investment decision is
made by investors on their own, and other sources influencing their selection decision are
news papers, magazine, brokers, television and friends or relatives.

B. Das, Ms. S. Mohanty and N. Chandra Shil (2008) studied the behaviour of the
investors in the selection of investment vehicles. Retail investors face a lot of problem in the
stock market. Empirically they found and concluded which are valuable for both the investors
and the companies having such investment opportunities. First, different investment avenues
do not provide the same level of satisfaction. And majority of investors are from younger
group.

Jayanth R. Varma (2009) stated that derivative exchanges have fared much better
banks during the global financial crisis (2007-2008) as their models were stronger

Cho (1998) points out the reasons for which reforms were made in Indian capital market
stating the after reform developments.

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 THEORETICAL CONCEPTS OF EQUITY DERIVATIVES

WHAT IS EQUITY

Equity is a form of ownership in the firm and equity holders are known as the ‘owners’ of the
firm and its assets. Any company at its stage of start-up requires some form of capital or
equity to begin business operations. Equity is commonly obtained by small organizations
through the owner’s contributions, and by larger organizations through the issue of shares.
Equity may act as a safety buffer for a firm and a firm should hold enough equity to cover its
debt.

The advantage to a firm in obtaining funds through equity is that there are no interest
payments to be made as the holder of equity is also an owner of the firm. However, the
disadvantage stands that dividend payments made to equity holders are not tax deductible.

WHAT IS DERIVATIVE

Derivatives are special types of financial instruments that derive their value from a number of
underlying assets. A derivative will serve as a contract between parties and specifies a
number of conditions such as the date at which payments are to be settled. Examples of
derivatives include futures, forwards, swaps and options. These derivatives derive their
values from a number of underlying assets such as stocks, bonds, commodities (gold, silver,
coffee, etc.), various currencies, and fluctuations in interest rates.

FEATURES OF EQUITY DERIVATIVES

 Derivatives have a maturity or expiry date post which they terminate automatically.
 Derivatives are of four types that is futures, options, forwards and swaps and these
assets can equity, commodities, foreign exchange or financial bearing assets.
 All the transactions in the derivatives take place in the future specified date. Doing
this makes it easier to sell because an individual can take of markets and take position
accordingly because one has more time in derivatives.

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  A derivative can be used as a leverage instrument. The value of the derivative can
move exponentially in comparison to the value of its underlying.
 There are no specified limits on the number of the units that can be transacted in the
derivative markets as there are no physical assets for transactions.
 The derivatives market is liquid and thus the transactions can be effected

easily.

BENEFITS OF DERIVATIVES
“Derivative” concept was first introduced in Chicago Board of Trade in 1848. After 152
years, from 2000 year on wards this concept was introduced in India.

The main Purpose and benefits of derivatives instruments are described below:

The financial markets are very risky markets as unexpected incidents also influence the
market. To ensure, these unexpected incidents risk, this concepts was introduced as a
“Hedging” product. The main purpose of derivative markets is:

 Changes in equity markets around the world.

 Currency exchange rate shifts.
 Changes in interest rates around the world.
 Changes in global supply and demand for commodities such as agricultural products,
precious and industrial metals and energy products such as oil and natural gas.

“Derivatives” are financial instruments. These represent the value the asset such as Equity,
Bullion, Currency, Commodity etc. So when you invest in derivatives, you actually place a
bet on whether the value of the asset represented will increase or decrease by a certain
percentage and within a set period of time. Therefore, derivatives are merely contracts or bets
that get their value from existing or future prices of underlying securities. In derivatives, you
are essentially buying a promise from the original owner of the asset to transfer ownership of
the asset rather than the asset itself.

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The benefits of derivative instruments are described below:

1. Price Discovery

Futures market prices of the assets depend on a continuous flow of information from around
the world. A broad range of factors (such as climatic conditions, political situations, debt
default, refugee displacement, environmental condition etc.) can influence the demand and
supply of assets and thus the current and future prices of the underlying asset on which the
derivative contract is based, changes the price as per the kind of information. This process is
known as “Price Discovery”.

2. Risk Management

Risk management is the process of identifying the desired (future) level of risk, identifying
the actual (Present) level of risk and altering the latter to equal the former. This process is
widely termed as hedging and speculation. “Hedging” is defined as a strategy for reducing
the risk in holding a market position while “Speculation’’ is taking a position in the way the
markets will move.

3. They improve Market efficiency for the Underlying Asset.

For example, investors who want exposure to the NIFTY 50 can buy an NIFTY Bees stock
index fund or replicate the fund by buying NIFTY 50 futures and investing in risk-free bonds.
Either of these methods will give them exposure to the index without the expense of
purchasing all the underlying assets in the NIFTY 50 Stocks.

4. Derivatives help to reduce “Market Transaction” costs.

Because derivatives are a form of insurance or risk management, the cost of trading in them
has to be low or investors will not find it economically sound to purchase such “insurance”
for their positions.

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DIFFERENCE BETWEEN EQUITY AND DERIVATIVE

Primarily, equities are instruments for investment, while derivatives are used for speculation
or hedging purposes.

The value of equity is affected by a host of considerations, such as performance of the

company, market conditions, investor mood, volume of buying/ selling, etc. The value of a
derivative lies in the value of the underlying asset.

Equity refers to the capital contributed to a business by its owners; which may be through
some sort of capital contribution such as the purchase of stock. A derivative is a financial
instrument that derives its value from the movement/performance of one or many underlying
assets. The main difference between derivatives and equity is that equity derives its value on
market conditions such as demand and supply and company related, economic, political, or
other events. Derivatives derive their value from other financial instruments such as bonds,
commodities, currencies, etc. Certain derivatives also derive their value from equity such as
shares and stocks. Therefore, while investing in equity may be for the purposes of making
profits, investing in derivatives may be, not just for making profits (through speculation), but
also for hedging against possible risks.

BASICS OF EQUITY DERIVATIVE

Equity derivatives are financial instruments whose value is derived from price movements of
the underlying asset. Equity derivatives can act like an insurance policy. The investor
receives a potential payout by paying the cost of the derivative contract, which is referred to
as a premium in the options market. An investor that purchases a stock can protect against a
loss in share value by purchasing a put option. On the other hand, an investor that
has shorted shares can hedge against an upward move in the share price by purchasing a call
option. Other equity derivatives include stock index futures, equity index swaps, and
convertible bonds.

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THE NEED FOR FINANCIAL DERIVATIVES

PURPOSE #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.

PURPOSE # 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.

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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.

PURPOSE # 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.

PURPOSE # 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

24
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.

ROLE AND FUNCTIONS OF DERIVATIVES

Derivatives usually perform the following functions:

1) PRICE DISCOVERY OF THE UNDERLYING ASSET:

Price discovery is a method of determining the price for a specific commodity or security
through basic supply and demand factors related to the market. Price discovery is the general
process used in determining the spot price. These prices are dependent upon market
conditions affecting supply and demand. For example, if the demand for a particular
commodity is higher than its supply, the price will typically increase and vice versa.

Futures market prices depend on a continuous flow of information from around the
world and require a high degree of transparency. A broad range of factors (climatic
conditions, political situations, debt default, refugee displacement, land reclamation and
environmental health, for example) impact supply and demand of assets (commodities in
particular) - and thus the current and future prices of the underlying asset on which the
derivative contract is based. This kind of information and the way people absorb it constantly
changes the price of a commodity. This process is known as price discovery.

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 2) TECHNIQUES OF RISK MANAGEMENT:

Financial derivatives are useful for dealing with various types of risks, mainly market, credit
and operational risks. The importance of derivatives has been increasing since the instrument
has been used to hedge against price movements. The financial tool assists with the transfer
of risks associated with a specific portfolio without requiring selling the portfolio itself.
Essentially, derivatives allow investors to manage their risks and so reach the desired risk
profile and allocation more efficiently.

The relationship between derivatives and risk management is relatively simple.

Derivatives are seen as the tool that enables banks and other financial institutions to break
down risks into smaller elements. From this, the elements can be bought or sold to align with
the risk management objectives. So, the original purpose of derivatives was to hedge and
spread risks. The main motive of the financial tool has aided with the great development and
expansion of derivatives.

3) OPERATIONAL ADVANTAGES:

Derivative markets entail lower transaction costs. They have greater liquidity compared to
spot markets. Derivative markets allow short selling of underlying securities more easily.

4) MARKET EFFICIENCY:

Spot markets for securities probably would be efficient even if there were no derivative
markets. A few profitable arbitrage opportunities exist, however, even in markets that are
usually efficient. The presence of these opportunities means that the price of some assets is
temporarily out of line. Investors can earn return s that exceed what the market deems fair for
the given risk level. There are important linkages between 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 profit opportunities .Society benefits because
the prices of underlying goods more accurately reflect the good’s true economic values.

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RATIONALE BEHIND THE DEVELOPMENT OF DERIVATIVES
Holding portfolio of securities is associated with the risk of the possibility that the investor
may realize his returns, which would be much lesser than what he expected to get. There
are various influences, which affect the returns.

1. Price or dividend (interest)

2. Sum is internal to the firm like:

 Industry policy
 Management capabilities
 Consumer’s preference
 Labour strike, etc.

These forces are to a large extent controllable and are termed as “Non-systematic Risks”. An
investor can easily manage such non- systematic risks by having a well-diversified portfolio
spread across the companies, industries and groups so that a loss in one may easily be
compensated with a gain in other. There are other types of influences, which are external to
the firm, cannot be controlled, and they are termed as “systematic risks”.

Those are:

 Economic
 Political
 Sociological changes are sources of systematic risk

Their effect is to cause the prices of nearly all individual stocks to move together in the same
manner. We therefore quite often find stock prices falling from time to time in spite of
company’s earnings rising and vice –versa. Rational behind the development of derivatives
market is to manage this systematic risk, liquidity. Liquidity means, being able to buy & sell
relatively large amounts quickly without substantial price concessions.

In debt market, a much larger portion of the total risk of securities is systematic. Debt
instruments are also finite life securities with limited marketability due to their small size
relative to many common stocks. These factors favour for the purpose of both portfolio

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hedging and speculation. India has vibrant securities market with strong retail participation
that has evolved over the years.

It was until recently a cash market with facility to carry forward positions in actively traded
“A” group scripts from one settlement to another by paying the required margins and
borrowing money and securities in a separate carry forward sessions held for this purpose.
However, a need was felt to introduce financial products like other financial markets in the
world.

MAJOR PLAYERS IN THE DERIVATIVE MARKET

There are four major players in the derivatives trading.

1. Hedgers

2. Speculators

3. Arbitrageurs

4. Margin traders

HEDGERS:

The party, which manages the risk, is known as “Hedger”. Hedgers seek to protect
themselves against price changes in a commodity in which they have an interest.

These are risk-averse traders in stock markets. They aim at derivative markets to secure their
investment portfolio against the market risk and price movements. They do this by assuming
an opposite position in the derivatives market. In this manner, they transfer the risk of loss to
those others who are ready to take it. In return for the hedging available, they need to pay a
premium to the risk taker.

Imagine that you hold 100 shares of XYZ Company which are currently priced at Rs. 120.
Your aim is to sell these shares after three months. However, you don’t want to make losses

28
due to a fall in market price. At the same time, you don’t want to lose opportunity to earn
profits by selling them at a higher price in future. In this situation, you can buy a put option
by paying a nominal premium that will take care of both the above requirements

SPECULATORS:

They are traders with a view and objective of making profits. They are willing to take risks
and they bet upon whether the markets would go up or come down.

These are risk-takers of the derivative market. They want to embrace risk in order to earn
profits. They have a completely opposite point of view as compared to the hedgers. This
difference of opinion helps them to make huge profits if the bets turn correct. In the above
example, you bought a put option to secure yourself from a fall in the stock prices. Your
counterparty i.e. the speculator will bet that the stock price won’t fall. If the stock prices
don’t fall, then you won’t exercise your put option. Hence, the speculator keeps the premium
and makes a profit.

ARBITRAGEURS:

Risk less profit making is the prime goal of arbitrageurs. They could be making money even
without putting their own money in, and such opportunities often come up in the market but
last for very short time frames. They are specialized in making purchases and sales in
different markets at the same time and profits by the difference in prices between the two
centres.

These utilize the low-risk market imperfections to make profits. They simultaneously buy
low-priced securities in one market and sell them at higher price in another market. This can
happen only when the same security is quoted at different prices in different markets.
Suppose an equity share is quoted at Rs 1000 in stock market and at Rs 105 in the futures

29
market. An arbitrageur would buy the stock at Rs 1000 in the stock market and sell it at Rs
1050 in the futures market. In this process he/she earns a low-risk profit of Rs 50.

MARGIN TRADERS

A margin refers to the minimum amount that you need to deposit with the broker to
participate in the derivative market. It is used to reflect your losses and gains on a daily basis
as per market movements. It enables to get leverage in derivative trades and maintain a large
outstanding position. Imagine that with a sum of Rs. 2 lakhs you buy 200 shares of ABC Ltd.
of Rs 1000 each in the stock market.

However, in the derivative market you can own a three times bigger position i.e. Rs 6 lakh
with the same amount. A slight price change will lead to bigger gains/losses in the derivative
market as compared to stock market.

CLASSIFICATION OF DERIVATIVE

Types of Derivatives in India

 Commodity Derivatives and financial derivatives

 Basic Derivatives and Complex Derivatives
 Exchange Traded Derivatives and OTC Derivatives

COMMODITY DERIVATIVES AND FINANCIAL DERIVATIVES

Derivative contract are made into the different types of commodities such as jutes, sugar, tea,
oil. These derivative contracts are traded in commodity exchanges. The major commodity
exchanges in India are three:

 National Commodity & Derivatives Exchange Limited (NCDEX)

 Multi- Commodity Exchange of India Limited (MCX)
 National Multi commodity Exchange of India Limited (NMCEIL)

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 These exchanges provide different types of contracts (Which are called future contracts).
The derivatives in currencies gilt-edged debt securities, share, share indices, etc. are known
as financial derivatives. These are traded at different exchanges all over the world. Financial
derivatives can be broadly classified into currency derivatives, interest rate derivatives and
stock and stock index derivatives. In India, stock future, stock Index Futures, Stock Options
and Stock Index Options are traded at BSE OR NSE. Interest rate derivative have also been
allowed by the Government of India

BASIC DERIVATIVES AND COMPLEX DERIVATIVES

• Basic Types: Those financial assets under which underlying assets are binding in an
agreement by any one of the contract I.e. Forwards, future, Options, warrants etc.

• Complex Derivatives: Those financial assets under which underlying assets are binding an
agreement by the any one of the contract. Example swap

EXCHANGE TRADED AND OTC DERIVATIVES

Derivatives which are made and regulated by some market mechanism and trade on an
exchange are called exchange traded derivatives. Exchange traded derivatives are well
standardized and organized in nature and available in a well set financial or commodity
market. Exchange traded derivatives are available in NSE, BSE, NCDEX, MCX etc.

 All exchange traded derivatives can be financial or commodity derivatives and they
are based upon underlying assets such as stock, debt or foreign currency and different
contracts which has basic of some underlying assets and designed to trade into
exchange market I.e. . Forwards, futures, options, warrant swaps etc.

 Any derivative contracts if traded outside the exchange market and privately
negotiated are called over the counter contracts. Which is not bonded by rules and
regulations of exchange markets? They offer customized products and which are very
much tailor made in nature.

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RISKS INVOLVED IN DERIVATIVE
Derivatives are used to separate risks from traditional instruments and transfer these risks to
parties willing to bear these risks. The fundamental risks involved in derivative business
includes

CREDIT RISK:

This is the risk of failure of a counterpart to perform its obligation as per the contract. Also
known as default or counterparty risk, it differs with different instruments.

Credit Risk is the risk of a company, government or individual being unable to make
payments on principal and interest on borrowed money. Government bonds are considered
investment grade securities because governments have a good track record of making debt
payments.

The bonds of issuers with a high default risk – or lack of liquidity to make payments on debt
– are called junk, or non-investment grade, bonds. Credit rating agencies provide credit
scores so potential investors and lenders can assess investment risk. AAA is the highest rating
while junk bonds are rated BB/BA or lower

MARKET RISK:

Market risk is a risk of financial loss as a result of adverse movements of prices of the
underlying asset/instrument.

This refers to the general risk in any kind of investment. Investors base their decisions on
different factors – technical analysis, fundamental analysis, and assumptions. Some even base
it on luck – which is also a kind of risk.

An essential part in investing is knowing, your risk-reward ratio and acknowledging that
there will always be market risk. As an investor, you have to ask: What are the risks involved
in this investment? If I risk this much, how much will I gain? Is my risk-reward ration worth
pursuing? What kinds of investing mistakes am I prone to if I go through with this?

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LIQUIDITY RISK:

The inability of a firm to arrange a transaction at prevailing market prices is termed as

liquidity risk. A firm faces two types of liquidity risks:

 Related to liquidity of separate products.

 Related to the funding of activities of the firm including derivatives.

Liquidity risks are present for investors who want to finish a trade before its maturity.
However, doing so presents large bid-ask spreads and may lead to inefficient, large costs.

LEGAL RISK:

Derivatives cut across judicial boundaries, therefore the legal aspects associated with the
deal should be looked into carefully

COUNTERPARTY RISK

Counterparty risk happens when one side of a derivatives trade – whether it’s the buyer or
seller – defaults on the contract. Basically, it’s the risk of not having anyone to trade with
anymore.

This is highly evident in over-the-counter contracts that are not regulated properly. This
played a vital role in the 2008 financial crisis with the housing market wherein people who
couldn’t afford houses were allowed to take loans on unreasonable grounds. Eventually,
these borrowers had to default on the agreement. If this happens on a massive volume, you
get the 2008 financial crisis.

INTERCONNECTION RISKS

Remember that derivatives rely on its underlying assets’ performance. Aside from its assets,
it is also affected by external grounds. External factors and all the assets in a derivative are all
inevitably interconnected.

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One market can greatly affect what happens to another market, and that market affects
another market, and so on. If an investor is in this situation, it is possible for her to lose her
whole investment.

POLITICAL RISK

Political instability or the risk of political change is a greater risk in emerging markets, but as
Greece’s debt crisis demonstrates, political stability can also hit developed markets.

How the different types of investment risks are weighted depends on the type of investments
being analysed. A stock investment has more exposure to unsystematic risk, which are risks
that affect a certain investment or asset class. The focus of your investment analysis will be
on fundamentals (earnings, sales, cash flow, etc), competition, industry developments, credit
risk, and so on.

In reality, company and industry fundamentals rather than the Greek default drama will
influence your investment decision in the new coffee company. The example of risk
spreading globally, though, is a daily occurrence. Spreading your money across a portfolio of
different investments is the best way to manage these risks.

COUNTRY RISK

Country risk should be considered in emerging market investments, but even developed
countries can face risks in the business environment. Greece, for example, has faced high
default risk on its debt in recent years. All types of investments are subject to country risk.

Commonwealth countries Britain, Canada and Australia have the lowest country risk, while
Africa has the most countries with high country risk. Country risk is very sensitive to changes
in the business environment. Saudi Arabia’s country risk has increased while oil prices have
fallen.

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INTEREST RATE RISK

Interest rates represent the cost of borrowing money. Bond investing is very sensitive to
changes in interest rates. On a macro level, all investments are affected by changes in interest
rates to some extent.

When monetary authorities raise the funds’ rate – the overnight cost of borrowing money –
the cost of borrowing money is raised, whereas a decrease in interest rates makes it cheaper
to borrow money, and thus increases the money supply in the economy. The increase or
tightening of interest rates slows economic growth while a decrease or loosening stimulates
economic growth.

ECONOMIC FUNCTION OF DERIVATIVES MARKET

In spite of the fear and criticism with which the derivative markets are commonly looked at,
these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants

about the future and lead the prices of underlying to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration of the derivative
contract. Thus derivatives help in discovery of future as well as current prices.

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

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

3. Speculative trades shift to a more controlled environment of derivatives market. In the

absence of an organized derivatives market, speculators trade in the underlying cash

35
 markets. Margining, monitoring and surveillance of the activities of various
participants become extremely difficult in these kinds of mixed markets.

4. An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting
many bright, creative, well-educated people with an entrepreneurial attitude. They
often energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense. In a nut shell, derivatives markets
help increase savings and investment in the long run. Transfer of risk enables market
participants to expand their volume of activity.

According to survey conducted in India regarding the sub brokers’ opinion

on the impact of derivatives market on financial market, the result
obtained is given as under.

Derivative securities have penetrated the Indian stock market and it emerged that investors
are using these securities for different purposes, namely, risk management, profit
enhancement, speculation and arbitrage.

High net worth individuals and proprietary traders account for a large proportion of broker
turnover. Interestingly, some retail participation was also witnessed despite the fact that these
securities are considered largely beyond the reach of retail investors (because of complexity
and relatively high initial investment).

Based on the survey results, the authors identified some important policy issues such as the
need to bring in more institutional participation to make the derivative market in India more
efficient and to bring it in line with the best practices. Further, there is a need to popularize
option instruments because they may prove to be a useful medium for enhancing retail
participation in the derivative market.

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APPLICATION OF FINANCIAL DERIVATIVES

RISK AVERSION TOOLS:

One of the most important services provided by the derivatives is to control, avoid, shift and
manage efficiently different types of risks through various strategies like hedging,
arbitraging, spreading, etc. Derivatives assist the holders to shift or modify suitably the risk
characteristics of their portfolios. These are specifically useful in highly volatile financial
market conditions like erratic trading, highly flexible interest rates, volatile exchange rates
and monetary chaos.

PREDICTION OF FUTURE PRICES:

Derivatives serve as barometers of the future trends in prices which result in the discovery of
new prices both on the spot and futures markets. Further, they help in disseminating different
information regarding the futures markets trading of various commodities and securities to
the society which enable to discoverer form suitable or correct or true equilibrium prices in
the markets. As a result, they assist in appropriate and superior allocation of resources in the
society.

ASSIST INVESTORS:

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

CATALYSE GROWTH OF FINANCIAL MARKETS:

The derivatives trading encourage the competitive trading in the markets, different risk taking
preference of the market operators like speculators, hedgers, traders, arbitrageurs, etc.
resulting i n increase in trading volume in the country.

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BRINGS PERFECTION IN MARKET:

Complete market concept refers to that situation where no particular investors can be better
off than others, or patterns of returns of all additional securities are spanned by the already
existing securities in it, or there is no further scope of additional security.

ENHANCE LIQUIDITY:

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

DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are

 Forwards
 Futures
 Options
 Swaps

We take a brief look at various derivatives contracts that have come to be used.

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 TYPES OF DERIVATIVES

4.1 OPTIONS
Options are financial instruments that are derivatives based on the value of underlying
securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—
depending on the type of contract they hold—the underlying asset. Unlike futures, the holder
is not required to buy or sell the asset if they choose not to.

 Call options allow the holder to buy the asset at a stated price within a specific
timeframe.
 Put options allow the holder to sell the asset at a stated price within a specific
timeframe.

Options allow investors to hedge risk or to speculate by taking additional risk. Buying a
call or put option obtains the right but not the obligation to buy (call options) or to sell (put
options) shares or futures contracts at a set price before or on an expiration date. They are
traded on exchanges and centrally cleared, providing liquidity and transparency, two critical
factors when taking derivatives exposure.

Primary factors that determine the value of an option:

 Time premium that decays as the option approaches expiration

 Intrinsic value that varies with the price of the underlying security
 Volatility of the stock or contract.

Each option contract will have a specific expiration date by which the holder must exercise
their option. The stated price on an option is known as the strike price. Options are typically
bought and sold through online or retail brokers.

An option is a derivative instrument since its value is derived from the underlying asset. It is
essentially a right, but not an obligation to buy or sell an asset. Options can be a call option
(right to buy) or a put option (right to sell). An option is valuable if and only if the prices are
varying.

An option by definition has a fixed period of life, usually three to six months. An option is a
wasting asset in the sense that the value of an option diminishes as the date of maturity

39
approaches and on the date of maturity it is equal to zero. An investor in options has four
choices before him. Firstly, he can buy a call option meaning a right to buy an asset after a
certain period of time. Secondly, he can buy a put option meaning a right to sell an asset after
a certain period of time. Thirdly, he can write a call option meaning he can sell the right to
buy an asset to another investor. Lastly, he can write a put option meaning he can sell a right
to sell to another investor. Out of the above four cases in the first two cases the investor has
to pay an option premium while in the last two cases the investors receives an option
premium.

OPTIONS TERMINOLOGY:

CALL OPTION:

A call option gives the holder the right but not the obligation to buy an asset by a certain date
for a certain price.

PUT OPTION:

A put option gives the holder the right but the not the obligation to sell an asset by a certain
date for a certain price.

OPTION PRICE:

Option price is the price, which the option buyer pays to the option seller. It is also referred to
as the option premium.

EXPIRATION DATE:

The date specified in the option contract is known as the expiration date, the exercise date,
the straight date or the maturity date.

STRIKE PRICE:

The price specified in the option contract is known as the strike price or the exercise price.

40
IN-THE-MONEY OPTION:

An in-the-money option (ITM) is an option that would lead to a positive cash flow to the
holder if it were exercised immediately. A call option in the index is said to be in the money
when the current index stands at higher level that the strike price (i.e. spot price > strike
price). If the index is much higher than the strike price the call is said to be deep in the
money. In the case of a put option, the put is in the money if the index is below the strike
price.

AT-THE-MONEY OPTION:

An At-the-money option (ATM) is an option that would lead to zero cash flow if it exercised
immediately. An option on the index is at the money when the current index equals the strike
price (I.e. spot price = strike price).

OUT-OF-THE-MONEY OPTION:

An out of the money (OTM) option is an option that would lead to a negative cash flow if it
were exercised immediately. A call option on the index is out of the money when the current
index stands at a level, which is less than the strike price (i.e. Spot price < strike price). If the
index is much lower than the strike price the call is said to be deep OTM. In the case of a put,
the put is OTM if the index is above the strike price.

INTRINSIC VALUE OF AN OPTION:

It is one of the components of option premium. The intrinsic value of a call is the amount the
option is in the money, if it is in the money. If the call is out of the money, its intrinsic value
is Zero. For example X, take that ABC November-call option. If ABC is trading at 102 and
the call option is priced at 2, the intrinsic value is 2. If ABC November-100 put is trading at
97 the intrinsic value of the put option is 3. If ABC stock was trading at 99 an ABC
November call would have no intrinsic value and conversely if ABC stock was trading at 101
an ABC November-100 put option would have no intrinsic value. An option must be in the
money to have intrinsic value.

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TIME VALUE OF AN OPTION:

The value of an option is the difference between its premium and its intrinsic value. Both
calls and puts have time value. An option that is OTM or ATM has only time value. Usually,
the maximum time value exists when the option is ATM. The longer the time to expiration,
the greater is an options time value. At expiration an option should have no time value.

CHARACTERISTICS OF OPTIONS:

The following are the main characteristics of options:

1. Options holders do not receive any dividend or interest.

2. Options holders receive only capital gains.

3. Options holder can enjoy a tax advantage.

4. Options are traded at O.T.C and in all recognized stock exchanges.

5. Options holders can control their rights on the underlying asset.

6. Options create the possibility of gaining a windfall profit.

7. Options holders can enjoy a much wider risk-return combinations.

8. Options can reduce the total portfolio transaction costs.

9. Options enable the investors to gain a better return with a limited amount of investment.

CALL OPTION:
An option that grants the buyer the right to purchase a desired instrument is called a call
option. A call option is contract that gives its owner the right but not the obligation, to buy a
specified asset at specified prices on or before a specified date.

An American call option can be exercised on or before the specified date. But, a European
option can be exercised on the specified date only.

The writer of the call option may not own the shares for which the call is written. If he owns
the shares it is a ‘Covered Call’ and if he does not owns the shares it is a ‘Naked call’

42
STATEGIES:

The following are the strategies adopted by the parties of a call option. Assuming that
brokerage, commission, margins, premium, transaction costs and taxes are ignored.

A call option buyer’s profit/loss can be defined as follows:

 At all points where spot price < exercise price, there will be a loss.
 At all points where spot prices > exercise price, there will be a profit.
 Call Option buyer’s losses are limited and profits are unlimited.

Conversely, the call option writer’s profits/loss will be as follows:

 At all points where spot prices < exercise price, there will be a profit
 At all points where spot prices > exercise price, there will be a loss
 Call Option writer’s profits are limited and losses are unlimited.

Following is the table, which explains in the-money, Out-of-the-money and

At-the-money position for a Call option

Exercise call option Spot price>Exercise price In-the money

Do not exercise Spot price<Exercise price Out-the money
Exercise/Do not exercise Spot price=Exercise price At-the money

PUT OPTION:

An option that gives the seller the right to sell a designated instrument is called put option. A
put option is a contract that gives the owner the right, but not the obligation to sell a specified
number of shares at a specified price on or before a specified date.

An American put option can be exercised on or before the specified date. But, a European put
option can be exercised on the specified date only.

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 THE FOLLOWING ARE THE STRATEGIES ADOPTED BY THE PARTIES OF PUT
OPTION

A put option buyer’s profit/loss can be defined as follows:

 At all points where spot price<exercise price, there will be a gain.

 At all points where spot price>exercise price, there will be a loss.

Conversely, the put option writer’s profit/loss will be as follows:

 At all points where spot price<exercise price, there will be a loss.

 At all points where spot price>exercise price, there will be a profit.

Following is the table, which explains In-the-money, Out-of-the Money and

At-the-money positions for a Put option:

Exercise put option Spot price<Exercise price In-the money

Do not exercise Spot price>Exercise price Out-the money
Exercise/Do not exercise Spot price=Exercise price At-the money

PRICING OPTIONS:

FACTORS DETERMINING OPTIONS VALUE:

1. EXERCISE PRICE AND SHARE PRICE:

If the share price is more than the exercise price then the holder of the call option will
get more net payoff, means the value of the call option is more. If the share price is
less than the exercise price then the holder of the put option will get more net pay-off.

2. INTEREST RATE:
The present value of the exercise price will depend on the interest rate. The value of
the call option will increase with the rise in interest rates. Since, the present value of
the exercise price will fall; the effect is reversed in the case of a put option. The buyer

44
 of a put option receives exercise price and therefore as the interest increases, the value
of the put option will decrease.

3. TIME OF EXPIRATION:
The present value of the exercise price also depends on the time to expiration of the
option. The present value of the exercise price will be less if the time to expiration is
longer and consequently value of the option will be higher. Longer the time to
expiration higher is the possibility of the option to be more in the money.

4. VOLATILITY:
The volatility part of the pricing model is used to measure fluctuations expected in
the value of the underlying security or period of time. The more volatile the
underlying security, the greater is the price of the option. There are two different
kinds of volatility.
They are Historical Volatility and Implied Volatility. Historical volatility estimates
volatility based on past prices. Implied volatility starts with the option price as a
given, and works backward to ascertain the theoretical value of volatility which is
equal to the market price minus any intrinsic value.

4.2 FORWARD
A forward contract is a customized contract between two parties to buy or sell an asset at a
specified price on a future date. A forward contract can be used for hedging or speculation,
although its non-standardized nature makes it particularly apt for hedging.

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.

45
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. Forwards are the simplest and basic form of
derivative contracts. These are instruments are basically used by traders/investors in order to
hedge their future risks. It is an agreement to buy/sell an asset at certain in future for a certain
price. They are private agreements mainly between the financial institutions or between the
financial institutions and corporate clients.

One of the parties in a forward contract assumes a long position i.e. agrees to buy the
underlying asset on a specified future date at a specified future price. The other party assumes
short position i.e. agrees to sell the asset on the same date at the same price. This specified
price referred to as the delivery price. This delivery price is chosen so that the value of the
forward contract is equal to zero for both the parties. In other words, it costs nothing to
the either party to hold the long/short position.

A forward contract is settled at maturity. The holder of the short position delivers the asset to
the holder of the long position in return for cash at the agreed upon rate. Therefore, a key
determinate of the value of the contract is the market price of the underlying asset. A forward
contract can therefore, assume a positive/negative value depending on the movements of the
price of the asset. For example, if the price of the asset rises sharply after the two parties
entered into the contract, the party holding the long position stands to benefit, that is the value
of the contract is positive for him. Conversely the value of the contract becomes negative for
the party holding the short position.

The concept of forward price is also important. The forward price for a certain contract is
defined as that delivery price which would make the value of the contract zero. To explain
further, the forward price and the delivery price are equal on the day that the contract is
entered into. Over the duration of the contract, the forward price is liable to change while the
delivery price remains the same.

46
ESSENTIAL FEATURES OF FORWARD CONTRACT:
1. A forward contract is a Bi-party contract, to be performed in the future, with the terms
decided today.
2. Forward contracts offer tremendous flexibility to the parties to design the contract in
terms of the price, quantity, quality, delivery time and place
3. Forward contracts suffer from poor liquidity and default risk
4. Contract price is generally not available in public domain
5. On the expiration date the contract will settle by delivery of the asset
6. If the party wishes to reverse the contract, it is compulsorily to go to the same counter
party, which often results high prices

FORWARD TRADING IN SECURITES:

The Securities Contract (amendment) Act of 1999 has allowed the trading in derivative
products in India. As a further step to widen and deepen the securities market the government
has notified that with effect from March 1st 2000 the ban on forward trading in shares and
securities is lifted to facilitate trading in forwards and futures. It may be recalled that the ban
on forward trading in securities was imposed in 1986 to curb certain unhealthy trade practices
and trends in the securities market. During the past few years, thanks to the economic and
financial reforms, there have been many healthy developments in the securities markets.

The lifting of ban on forward deals in securities will help to develop index futures and other
types of derivatives and futures on stocks. This is a step in the right direction to promote the
sophisticated market segments as in the western countries.

4.3 FUTURES

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security
at a predetermined price at a specified time in the future. Futures contracts are standardized
for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures
contract is taking on the obligation to buy and receive the underlying asset when the futures
contract expires. The seller of the futures contract is taking on the obligation to provide and
deliver the underlying asset at the expiration date.

47
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.

The future contract is an agreement between two parties to buy or sell an asset at a certain
specified time in future for certain specified price. In this, it is similar to a forward contract.
A futures contract is a more organized form of a forward contract; these are traded on
organized exchanges. However, there are a number of differences between forwards and
futures. These relate to the contractual futures, the way the markets are organized, profiles of
gains and losses, kind of participants in the markets and the ways they use the two
instruments.

Futures contracts in physical commodities such as wheat, cotton, gold, silver, cattle, etc.
have existed for a long time. Futures in financial assets, currencies, and interest bearing
instruments like treasury bills and bonds and other innovations like futures contracts in stock
indexes are relatively new developments.

The futures market described as continuous auction markets and exchanges providing the
latest information about supply and demand with respect to individual commodities, financial
instruments and currencies, etc. Futures exchanges are where buyers and sellers of an
expanding list of commodities; financial instruments and currencies come together to trade.
Trading has also been initiated in options on futures contracts. Thus, option buyers participate
in futures markets with different risk. The option buyer knows the exact risk, which is
unknown to the futures trader.

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FEATURES OF FUTURES CONTRACT:
The principle features of futures contract are as follows:

1. ORGANIZED EXCHANGES:
Unlike forward contracts which are traded in an over- the-counter market, futures are
traded on organized exchanges with a designated physical location where trading
takes place. This provides a ready, liquid market which futures can be bought and sold
at any time like in a stock market.

2. STANDARDIZATION:
In the case of forward contracts the amount of commodities to be delivered and the
maturity date are negotiated between the buyer and seller and can be Tailor made to
buyer’s requirement. In a futures contract both these are standardized by the
exchange on which the contract is traded.

3. CLEARING HOUSE:
The exchange acts a clearing house to all contracts struck on the trading floor. For
instance a contract is struck between capital A and B. Upon entering into the records
of the exchange, this is immediately replaced by two contracts, one between A and the
clearing house and another between B and the clearing house. In other words the
exchange interposes itself in every contract and deal, where it is a buyer to seller, and
seller to buyer. The advantage of this is that A and B do not have to undertake any
exercise to investigate each other’s credit worthiness. It also guarantees financial
integrity of the market. This enforces the delivery for the delivery of contracts held
for until maturity and protects itself from default risk by imposing margin
requirements on traders and enforcing this through a system called marking – to –
market.

4. ACTUAL DELIVERY IS RARE

: In most of the forward contracts, the commodity is actually delivered by the seller
and is accepted by the buyer. Forward contracts are entered into for acquiring or
disposing of a commodity in the future for a gain at a price known today. In contrast
to this, in most futures markets, actual delivery takes place in less than one percent of
49
 the contracts traded. Futures are used as a device to hedge against price risk and as a
way of betting against price movements rather than a means of physical acquisition of
the underlying asset. To achieve this most of the contracts entered into are nullified by
the matching contract in the opposite direction before maturity of the first.

5. MARGINS:
In order to avoid unhealthy competition among clearing members in reducing margins
to attract customers, a mandatory minimum margins are obtained by the members
from the customers. Such a stop insures the market against serious liquidity crisis
arising out of possible defaults by the clearing members. The members collect
margins from their clients as may be stipulated by the stock exchanges from time to
time and pass the margins to the clearing house on the net basis i.e. at a stipulated
percentage of the net purchase and sale position.

The stock exchange imposes margins as follows:

 Initial margins on both the buyer as well as the seller.

 The accounts of buyer and seller are marked to the market daily

The concept of margin here is same as that of any other trade, i.e. to introduce a financial
stake of the client, to ensure performance of the contract and to cover day today adverse
fluctuations in the prices of the securities.

The margin for future contracts has two components:

 Initial margin
 Marking to market
5A) Initial margin:
In futures contract both the buyer and seller are required to perform the contract.
Accordingly, both the buyers and the sellers are required to put in the initial margins.
The initial margin is also known as the “performance margin” and usually 5% to 15%
of the purchase price of the contract. The margin is set by the stock exchange keeping

50
 in view the volume of business and size of transactions as well as operative risks of
the market in general.

The concept being used by NSE to compute initial margin on the futures transactions is called
“value- at –Risk” (VAR) where as the options market had SPAN based margin system”

5B) Marking-to-market:
Marking to market means, debiting or crediting the client’s equity accounts with the
losses/profits of the day, based on which margins are sought.

It is important to note that through marking to market process, the clearing house substitutes
each existing futures contract with a new contract that has the settlement price or the base
price. Base price shall be the previous day’s closing Nifty value. Settlement price is the
purchase price in the new contract for the next trading day.

FUTURES TERMINOLOGY:

1. SPOT PRICE:
The price at which an asset is traded is spot market.’

2. FUTURES PRICE:
The price at which the futures contract is traded is the futures market.

3. EXPIRY DATE:
It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.

4. CONTRACT SIZE:
The amount of asset has to be delivered less than one contract. For instance contract
size on NSE futures market is 100 Nifties.

5. BASIS/SPREAD:

51
 In the context of financial futures basis can be defined as the futures price minus the
spot price. There will be a different basis for each delivery month for each contract. In
formal market, basis will be positive. This reflects that futures prices normally exceed
spot prices.

6. COST OF CARRY:
The relationship between futures prices and spot prices can be summarized in terms of
what is known as the cost of carry. This measures the storage cost plus the interest
that is paid to finance the asset less the income earned on the asset.

7. MULTIPLIER:
It is a pre-determined value, used to arrive at the contract size. It is the price per index
point.

8. TICK SIZE:
It is the minimum price difference between two quotes of similar nature.

9. OPEN INTEREST:
Total outstanding long/short positions in the market in any specific point of time. As
total long positions for market would be equal to total short positions for calculation
of open Interest, only one side of the contract is counted.

10.LONG POSITION:
Outstanding or unsettled purchase position at any point of time is long position

11.SHORT POSITION:
Outstanding or unsettled sale position at any time point of time is short position.

12.INDEX FUTURES:

Stock Index futures are most popular financial futures, which have been used to hedge
or manage systematic risk by the investors of the stock market. They are called hedgers, who
own portfolio of securities and are exposed to systematic risk. Stock index is the apt hedging

52
asset since, the rise or fall due to systematic risk is accurately shown in the stock index. Stock
index futures contract is an agreement to buy or sell a specified amount of an underlying
stock traded on a regulated futures exchange for a specified price at a specified time in future.

Stock index futures will require lower capital adequacy and margin requirement as
compared to margins on carry forward of individual scrip’s. The brokerage cost on index
futures will be much lower. Savings in cost is possible through reduced bid-ask spreads
where stocks are traded in packaged forms. The impact cost will be much lower in case of
stock index futures as opposed to dealing in individual scrip. The market is conditioned to
think in terms of the index and therefore, would refer trade in stock index futures. Further, the
chances of manipulation are much less.

The stock index futures are expected to be extremely liquid, given the speculative nature of
our markets and overwhelming retail participation expected to be fairly high. In the near
future stock index futures will definitely see incredible volumes in India. It will be a
blockbuster product and is pitched to become the most liquid contract in the world in terms of
contracts traded. The advantage to the equity or cash market is in the fact that they would
become less volatile as most of the speculative activity would shift to stock index futures.
The stock index futures market should ideally have more depth, volumes and act as a
stabilizing factor for the cash market. However, it is too early to base any conclusions on the
volume or to form any firm trend. The difference between stock index futures and most other
financial futures contracts is that settlement is made at the value of the index at maturity of
the contract.

13.STOCK FUTURES:
With the purchase of futures on a security, the holder essentially makes a legally
binding promise or obligation to buy the underlying security at same point in the
future (the expiration date of the contract). Security futures do not represent
ownership in a corporation and the holder is therefore not regarded as a share holder.
A futures contract represents a promise to transact at same point in the future. In this
light, a promise to sell security is just as easy to make as a promise to buy security.
Selling security futures without previously owing them simply obligates the trader to
sell a certain amount of the underlying security at same point in the future.

53
4.4 SWAPS
A swap is an agreement between two parties to exchange sequences of cash flows for a set
period of time. Usually, at the time the contract is initiated, at least one of these series of cash
flows is determined by a random or uncertain variable, such as an interest rate, foreign
exchange rate, equity price or commodity price.

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
The two commonly used swaps are:

• INTEREST RATE SWAPS:

These entail swapping only the interest related cash flows between the parties in the same
currency. Interest rate swaps, as a name suggest involves an exchange of different payment
streams, which are fixed and floating in nature. Such an exchange is referred to as an
exchange of borrowings. For example, ‘B’ to pay the other party ‘A’ cash flows equal to
interest at a pre-determined fixed rate on a notional principal for a number of years. At the
same time, party ‘A’ agrees to pay ‘B’ cash flows equal to interest at a floating rate on the
same notional principal for the same period of time. The currencies of the two sets of interest
cash flows are the same. The life of the swap can range from two years to fifty years.

Usually two non-financial companies do not get in touch with each other to directly arrange
a swap. They each deal with a financial intermediary such as a bank. At any given point of
time, the swaps spreads are determined by supply and demand. If no participants in the swaps
market want to receive fixed rather than floating, Swap spreads tend to fall. If the reverse is
true, the swaps spread tend to rise. In real life, it is difficult to envisage a situation where two
companies contact a financial institution at an exactly same with a proposal to take opposite
positions in the same swap.

• CURRENCY SWAPS:

These entail swapping both principal and interest between the parties, with the cash flows in
one direction being in a different currency than those in the opposite direction.

54
Financial swaps are a funding technique, which permit a borrower to access one market and
then exchange the liability for another type of liability. Global financial markets present
borrowers and investors with a variety of financing and investment vehicles in terms of
currency and type of coupon – fixed or floating. It must be noted that the swaps by
themselves are not a funding instrument: They are devices to obtain the desired form of
financing indirectly. The borrower might otherwise as found this too expensive or even
inaccessible.

A common explanation for the popularity of swaps concerns the concept of comparative
advantage. The basic principle is that some companies have a comparative advantage when
borrowing in fixed markets while other companies have a comparative advantage in floating
markets. Swaps are used to transform the fixed rate loan into a floating rate loan.

55
 SEBI GUIDELINES FOR DERIVATIVES MARKET

SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its Clearing
Corporation/House to ensure that Derivative Exchange/Segment and Clearing
Corporation/House provide a transparent trading environment, safety and integrity and
provide facilities for redressed of investor grievances. Some of the important eligibility
conditions are:

1) Derivative trading to take place through an on-line screen based Trading System.

2) The Derivatives Exchange/Segment shall have on-line surveillance capability to

monitor positions, prices, and volumes on a real time basis so as to deter market
manipulation.

3) The Derivatives Exchange/ Segment should have arrangements for dissemination of

information about trades, quantities and quotes on a real time basis through at least
two information vending networks, which are easily accessible to investors across the
country.

4) The Derivatives Exchange/Segment should have arbitration and investor grievances

redressed mechanism operative from all the four areas/regions of the country.

5) The Derivatives Exchange/Segment should have satisfactory system of monitoring

investor complaints and preventing irregularities in trading.

6) The Derivative Segment of the Exchange would have a separate Investor Protection
Fund.

7) The Clearing Corporation/House shall perform full notation, i.e., the Clearing

56
 Corporation/House shall interpose itself between both legs of every trade,
becoming the legal counterparty to both or alternatively should provide an
unconditional guarantee for settlement of all trades.

8) The Clearing Corporation/House shall have the capacity to monitor the overall
position of Members across both derivatives market and the underlying securities
market for those Members who are participating in both.

9) The level of initial margin on Index Futures Contracts shall be related to the risk of
loss on the position. The concept of value-at-risk shall be used in calculating required
level of initial margins. The initial margins should be large enough to cover the one-
day loss that can be encountered on the position on 99 per cent of the days.
10) The Clearing Corporation/House shall establish facilities for electronic funds transfer
(EFT) for swift movement of margin payments

11) In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent
Member or close-out all open positions.

12) The Clearing Corporation/House should have capabilities to segregate initial margins
deposited by Clearing Members for trades on their own account and on account of his
client. The Clearing Corporation/House shall hold the clients‘margin money in trust
for the client purposes only and should not allow its diversion for any other purpose.

13) The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the
trades executed on Derivative Exchange/Segment

SEBI has specified measures to enhance protection of the rights of

investors in the Derivative Market. These measures are as follows:

57
 Investor’s money has to be kept separate at all levels and is permitted to be used only
against the liability of the Investor and is not available to the trading member or
clearing member or even any other investor.

 The Trading Member is required to provide every investor with a risk disclosure
document which will disclose the risks associated with the derivatives trading so that
investors can take a conscious decision to trade in derivatives.

 Investor would get the contract note duly time stamped for receipt of the order and
execution of the order. The order will be executed with the identity of the client and
without client ID order will not be accepted by the system. The investor could also
demand the trade confirmation slip with his ID in support of the contract note. This
will protect him from the risk of price favour, if any, extended by the Member.

 In the derivative markets all money paid by the Investor towards margins on all open
positions is kept in trust with the Clearing House /Clearing Corporation and in the
event of default of the Trading or Clearing Member the amounts paid by the client
towards margins are segregated and not utilised towards the default of the member.
However, in the event of a default of a member, losses suffered by the Investor, if
any, on settled/closed

 Our position is compensated from the Investor Protection Fund, as per the rules, bye-
laws and regulations of the derivative segment of the exchanges.

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 CONCLUSION

Derivatives have existed and evolved over a long time, with roots in commodities market. In
the recent years advances in financial markets and the technology have made derivatives easy
for the investors.

Derivatives market in India is growing rapidly unlike equity markets. Trading in derivatives
require more than average understanding of finance. Being new to markets maximum number
of investors have not yet understood the full implications of the trading in derivatives. SEBI
should take actions to create awareness in investors about the derivative market.

Introduction of derivatives implies better risk management. These markets can give greater
depth, stability and liquidity to Indian capital markets. Successful risk management with
derivatives requires a thorough understanding of principles that govern the pricing of
financial derivatives.

In order to increase the derivatives market in India SEBI should revise some of their
regulation like contract size, participation of FII in the derivative market. Contract size
should be minimized because small investor cannot afford this much of huge premiums.

In cash market the profit/loss is limited but where in F& O an investor can enjoy unlimited
profits/loss

At present scenario the Derivatives market is increased to a great position. Its daily turnover
teaches to the equal stage of cash market.

The derivatives are mainly used for hedging purpose.

In cash market the investor has to pay the total money, but in derivatives the investor has to
pay premiums or margins, which are some percentage of total money.

In derivative segment the profit/loss of the option holder/option writer is purely depended on
the fluctuations of the underlying asset.

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 SUGGESTIONS TO AN INVESTOR
The investors can minimize risk by investing in derivatives. The use of derivative equips the
investor to face the risk, which is uncertain. Though the use of derivatives does not
completely eliminate the risk, but it certainly lessens the risk. It is advisable to the investor to
invest in the derivatives market because of the greater amount of liquidity offered by the
financial derivatives and the lower transactions costs associated with the trading of financial
derivatives. The derivatives products give the investor an option or choice whether to
exercise the contract or not. Options give the choice to the investor to either exercise his right
or not. If on expiry date the investor finds that the underlying asset in the option contract is
traded at a less price in the stock market then, he has the full liberty to get out of the option
contract and go ahead and buy the asset from the stock market. So in case of high uncertainty
the investor can go for options. However, these instruments act as a powerful instrument for
knowledgeable traders to expose them to the properly calculated and well understood risks in
pursuit of reward i.e. profit.

TOP TIPS FOR CHOOSING INVESTMENTS

1. REVIEW YOUR NEEDS AND GOALS

It’s well worth taking the time to think about what you really want from your investments.

Knowing yourself, your needs and goals and your appetite for risk is a good start, so start by
filling in a Money fact find.

2. CONSIDER HOW LONG YOU CAN INVEST

Think about how soon you need to get your money back.

Time frames vary for different goals and will affect the type of risks you can take on. For
example:

If you’re saving for a house deposit and hoping to buy in a couple of years, investments such
as shares or funds will not be suitable because their value goes up or down. Stick to cash
savings accounts like Cash ISAs.

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If you’re saving for your pension in 25 years’ time, you can ignore short-term falls in the
value of your investments and focus on the long term. Over the long term, investments other
than cash savings accounts tend to give you a better chance of beating inflation and reaching
your pension goal.

3. MAKE AN INVESTMENT PLAN

Once you’re clear on your needs and goals – and have assessed how much risk you can take –
draw up an investment plan.

This will help you identify the types of product that could be suitable for you.

A good rule of thumb is to start with low risk investments such as Cash ISAs.

Then, add medium-risk investments like unit trusts if you’re happy to accept higher volatility.

Only consider higher risk investments once you’ve built up low and medium-risk
investments.

Even then, only do so if you are willing to accept the risk of losing the money you put into
them.

4. DIVERSIFY!

It’s a basic rule of investing that to improve your chance of a better return you have to accept
more risk.

But you can manage and improve the balance between risk and return by spreading your
money across different investment types and sectors whose prices don’t necessarily move in
the same direction – this is called diversifying.

It can help you smooth out the returns while still achieving growth, and reduce the overall
risk in your portfolio.

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5. DECIDE HOW HANDS-ON TO BE

Investing can take up as much or as little of your time as you’d like:

If you want to be hands-on and enjoy making investment decisions, you might want to
consider buying individual shares – but make sure you understand the risks.

If you don’t have the time or inclination to be hands-on – or if you only have a small amount
of money to invest – then a popular choice is investment funds, such as unit trusts and Open
Ended Investment Companies (OEICs). With these, your money is pooled with that of lots of
other investors and used to buy a wide spread of investments.

If you’re unsure about the types of investment you need, or which investment funds to
choose, get financial advice.

6. CHECK THE CHARGES

If you buy investments, like individual shares, direct, you will need to use a stock broking
service and pay dealing charges.

If you decide on investment funds, there are charges, for example to pay the fund manager.

And, if you get financial advice, you will pay the adviser for this.

Whether you’re looking at stockbrokers, investment funds or advisers, the charges vary from
one firm to another.

Ask any firm to explain all their charges so you know what you will pay, before committing
your money.

While higher charges can sometimes mean better quality, always ask yourself if what you’re
being charged is reasonable and if you can get similar quality and pay less elsewhere.

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7. INVESTMENTS TO AVOID

Avoid high-risk products unless you fully understand their specific risks and are happy to
take them on. Only consider higher risk products once you’ve built up money in low and
medium-risk investments. And some investments are usually best avoided altogether.

8. REVIEW PERIODICALLY – BUT DON’T ‘STOCK-WATCH’

Regular reviews – say, once a year – will ensure that you keep track of how your investments
are performing and adjust your savings as necessary to reach your goal.

You will get regular statements to help you do this. Find out more below.

However, don’t be tempted to act every time prices move in an unexpected direction.

Markets rise and fall all the time and, if you’re a long-term investor, you can just ride out
these fluctuations.

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 BIBLIOGRAPHY

NEWS PAPERS:-
The Financial Express

Business World

Economic Times

INTERNET:-
www.nseindia.org

www.bseindia.com

www.Unicon.com

www.sebi.gov.in

www.economictimes.indiatimes.com

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 ANNEXURE

QUESTIONNAIRE

Dear Sir/Madam,

The following questions seek information from investors doing derivative trading. Please
answer all the questions. Your sincere opinion on all the questions is the most appropriate
answer for my study. Kindly co-operate to complete my research successfully. Thank You!

SECTION 1

Personal Profile

1. Name (Optional) :

2. Gender : Male Female

3. Age : 20-30 years 31-40 years

41-50 years 50 years & above

4. Educational Qualification : S S C and below 12th/pre degree

Degree Professional

Others (specify…………………………)

5. Occupation : Government/Semi-Government service

Private sector business Retired

Professional practice others(specify)

6. Monthly Income: Rs 20,000 &below

Rs 21,000 to Rs 50000

Rs 51,000 to Rs 90,000

Rs 91,000 and above

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SECTION 2
1) Do you trade in derivatives? Yes No

2) How many years of experience do you have in stock market?

 5years and below

 5 to 10 years
 11 to 15 years
 15 years and above

2) How many years of experience do you have in derivatives trading?

 Less than 1 year
 1 to 3 years
 4 to 6 years
 More than 6 years

4) How frequently do you trade in derivatives?

 Always
 Frequently
 Occasionally
 Rarely
,

5) What is your personal level of tolerance for investment risk?

 Low
 Medium
 High

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 6) As a percentage of the total amount in your investment portfolio, how much do you
invest in derivative products?

 Less than 10%

 10% to 30%
 30% to 50%
 50% to 100%

7) The information from the following sources below influenced you to choose derivative
trading?

 Friends/relatives
 Stock broker
 Channels/media
 Experts/experienced people

8) As per your opinion, what are the reasons behind comparatively less derivative trading in
India?

 Lack of technical and fundamental knowledge

 Lack of awareness
 Misleading information
 Risks involved
 Other factors

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