A PROJECT REPORT ON OVERVIEW OF DERIVATIVES IN INDIAN CONTEXT AT VALUE PROP CORPORATE SOLUTIONS MASTER OF BUSINESS ADMINISTATION By K.

VENKATA SRINIVASARAO (09D01E00H7)

ST. MARYS COLLEGE OF ENGINEERING AND TECHNOLOGY Deshmukhi(vil),Pchampalli(m.d),Nalgonda(d.t)

A STUDY ON OVERVIEW OF DERIVATIVES IN INDIAN CONTEXT AT VALUE PROP CORPORATE SOLUTIONS Submitted to

ST. MARYS COLLEGE OF ENGINEERING AND TECHNOLOGY Deshmukhi (VIL), Nalgonda (D.T)

In partial fulfillment of the requirement for the award of MASTER OF BUSINESS ADMINSTRATION By JNTU University, Hyderabad-500007 During the year 2009-2011 Submitted By K.VENKATA SRINIVASARAO

DECLARATION

I here by declare that the summer internship project report, titled OVERVIEW OF DERIVATIVES IN INDIAN CONTEXT submitted to ST. MARYS College of engineering & technology is my own and it has not been submitted to any other university or institution.

Place : Deshmukhi Date : (k.venkata srinivasarao)

ACKNOWLEDGEMENT
I am grateful to the VALUE PROP CORPORATE SOLUTIONS management for giving me on opportunity to enhance my learning and to take up my project in their organization. I sincerely thank Mr. SATISHISH KUMAR (Project External Guide) for his strong support and for providing valuable inputs My special thanks Mr.P.Sai Kumar (internal guide) permitting and supporting throughout the study I specially thank the staff of VALUE PROP CORPORATE SOLUTIONS I would like to thanks Mr.P.KRISHNA DWAIPAYANA (Head of department of MBA) for his guidance and his kind help and motivation in completing the project. My special gratitude to Professor Mr.kamalahasan (Principal of ST. MARYSCollege of engineering and technology) encouragement for successful completion of my project work. I would like to thanks Dr.SATYANARAYANA. Director of the ST. MARYS Collee of engineering&techbnology Hyderabad for his encouragement for successful completion of my project work. I would like to thanks Dr. PRAKASH (managing director of the company) for his encouragement for successful completion of my project work. I owe my sincere thanks to all other who assisted and co-operated in completing my project work successful

K.VENKATA SRINIVASARAO Roll: 09D01E00H7

CERTIFICATE BY THE GUIDE

This is certify that the project report title OVERVIEW OF DERIVATIVES IN INDIAN CONTEXT of VALUE PROP CORPORATE SOLUTIONS submitted in partial fulfillment of masters degree in commerce of JNTU UNIVERSITY, Hyderabad was carried by K.VENKATA SRINIVASARAO(H.T.NO-09D01E00H7) under my guidance of Mr. Mr. SATISHISH KUMAR. This has not been submitted to any other university or institution for the award of any Degree/Diploma/Course.

Signature of the Guide Place: SATHISH KUMAR Lecturer in management

CONTENTS
PAGE NO S.NO 1. a) b) c) d) e) 2. a) b) c) d) e) f) 3. a) 4. a) 5. a) b) c) d) e) CHAPTERS CHAPTER-I Introduction Need of the Study Objectives Methodology Scope of the study Limitations CHAPTER-II Introduction to derivatives Derivatives markets in India Futures Options Trading procedure for futures and options Salient Features of committee reports CHAPTER-III Company profile CHAPTER-IV Data Analysis and interpretation CHAPTER-V Result of the Study Suggestions and Conclusions(or)findings List of abbreviations Annexure Bibliography

CHAPTER-I

INTRODUCTION

INTRODUCTION
The turnover of the stock exchange has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margining system, unclear expiration date and generating counter party risk. In view of this problem SEBI abolished the BADLA system. After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. SEBI thought the introduction of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr. L.C. Gupta to develop the appropriate framework for derivatives trading in India, SEBI accepted the recommendation of the committee on may 11, 1998 and approved the phase introduction of the derivatives trading beginning with stock index futures. There are many investors who are willing to trade in the derivatives segment, because of its advantages like limited loss unlimited profit by paying the small premiums.

NEED OF THE STUDY

Different investment avenues are available to investors. Stock market also offers good investment opportunities to the investor alike all investments, they also carry certain risks. The investor should compare the risk and expected yields after adjustment off tax on various instruments, while talking investment decision the investor may seek advice from experts and consultancy include stock brokers and analysts while making investment decisions. The objective is to make the investor aware of the functioning of the derivatives. Derivatives act as a risk hedging tool for the investors. The objective is to help the investor in selecting the appropriate derivatives instrument in order to attain maximum return and to construct the portfolio. The investor should decide how best to reach the goals from the securities available. To identity investor objective constraints and performance, which help to formulate the investment policy? The development and improvement strategies in the investment policy are formulated. They will help the investors in selection of asset classes and securities in each class depending upon their real attributes.

OBJECTIVES OF THE STUDY To study the derivatives market in India. To study the pay-off of futures and options. To present the trading procedure of futures and options.

To study the salient features of Committee reports

SCOPE OF THE STUDY The study is an overview of Derivatives markets which includes forwards, futures, options and Swaps. The Study cant be said as totally perfect. The Study has only made a humble attempt of evaluation of derivatives market only in Indian context. The study is not based on the international perspective of derivatives market, which exists in NASDAQ, CBOT etc.

RESEARCH METHODOLGY

Data Collection The data collected was mainly secondary in nature and the sources were website and text books. Some primary data was also collected by interacting with guide and other personalities such as Satish and Krishna Prasad. Data Analysis The collected data was grouped under relevant headings. The various topics were then so arranged those give logical studies of the topics. Conclusions The suggestions and conclusions were made mainly based on the observations from the data collected.

LIMITATIONS OF THE STUDY

The study is limited to derivatives market in India. The study was carried out for a period of 45 days and due to paucity of time an in-depth study was not possible.

The derivative market is a dynamic one, contract rates strike price fluctuate on demand and supply basis. Therefore data related to last few trading months was only consider and interpreted.

Secondary information may not be authentic.

CHAPTER III

COMPANY PROFILE

Value Prop Corporate Solutions

"When you reach an obstacle, turn it into an opportunity. You have the choice. You can overcome and be a winner, or you can allow it to overcome you and be a loser. The choice is yours and yours alone. Refuse to throw in the towel. Go that extra mile that failures refuse to travel. It is far better to be exhausted from success than to be rested from failure."- Mary Kay Ash

About Value Prop Value Prop Corporate Solutions, a start up proprietary enterprise, on its own and through a web of consultants & tie-ups operates in different business segments which are detailed in the services division. Value Prop is the shorter version word Value Proposition, which means an analysis and quantified review of the benefits, costs and value that organizations can deliver to customers. For Value Prop customer interest is the top priority. Each client will have his own requirement and we cater to their needs in the customized pattern. Value Prop believes and takes pride in maintaining strategic long-term relationship with the

clients.

Value Props Team:

Satish Mandava An MBA graduate & Associate Financial Planner offering over 10 years of proven skill-sets in leading banking & financial services companies and currently pioneering his entrepreneurial venture Value Prop Corporate solutions to introduce the same to success. During his career he successfully provided wealth management & investment consultancy services, handled commodity & stock broking, and also managed various activities spanning banking, mutual funds and insurance. As well he developed commodities hedging strategies, managed spot & future arbitrages, traded in derivatives, futures & equity, and ensured compliance with all related regulatory requirements. Mr.Satish is competent in leading functional teams by effectively mentoring and guiding individual members, recruiting personnel, and training new recruits for successfully developing human resources. He is experienced in evolving business growth plans, handling product pricing, managing credit & risks, advising on

investments & fund sourcing, building up strong & profitable relationships with clients, servicing HNW clientele including key corporate and successfully driving financial targets for achieving and enhancing corporate profitability. A committed financial expert desirous of assuming wider & more challenging roles for spearheading organizational growth & profitability by utilizing vast domain knowledge & functional abilities. His other areas of business interest include web site designing, knowledge dissemination through web portals, internet and digital marketing, and content development services.

Krishna Pradeep Lingala An MBA graduate and trained technical analyst, Mr.Krishna Pradeep is efficient in providing quality research services based on technical indicators. His 8 years stint in the industry and his association with companies per se Optimus Commodities; JRG Wealth Management; Vertex Securities has offered him complex challenges which he handled efficiently. He has the credit of setting up research department at Optimus as well as the commodities trading desk at Vertex Securities. He majorly focuses on providing short term investment or positional calls in the commodities segment with client safety as utmost priority. He has a proven record as a competent faculty in providing the training in the areas pertinent to trading and technical analysis.

Yasaswy Devineni

A bachelors graduate in technology in the faulty of electronics and electrical engineering (EEE), Mr.Yasaswy initiated his career in marketing of telecom products with Vodafone and shifted to financial markets. Started his profile as a terminal dealer on commodities desk in JRG Wealth Management, Mr.Yasaswy enhanced to business development manager and branch in charge with his next employer Vertex Securities Ltd. Irrespective of the assignment he was delegated he strived to execute the responsibility with 100% perfection applying his entrepreneurial strategies. His habit of continuous learning has assisted him to become a guided trader in the area of commodities providing the clients utmost service.

Services:-

Financial Markets

Research Services - Commodities

o Practical Education in Financial Markets

o o

Placement Services Commodities Trading

Internet and Digital Solutions

o o

Digital Marketing Proprietary Web Portals

o o o

Web Site Designing Domain/ Domain Hosting Customized SMS Solutions

Research Services Commodities

Value

Prop

Corporate

Solutions

through

its

sister

concern

KPcommodities.com offers informational services of forecasting/predicting various commodity/stocks movement on a day trade basis & position/swing trade basis. Predictions are based upon research & analysis carried on by our expert team, which are expected to be quite accurate and deemed to be reliable. We predict daily trends as well as trends for short term. We will also guide you when to buy/sell & will help you in maximizing your profits. Our services provide the latest updates of the trading market as to what is happening or going to happen instead of what had happened. We will help you in developing your own ways of trading and how to trade in the right and disciplined manner. Time is the key factor in the business. The trader trades efficiently at the right time are called as a successor but the one who lose his time is a loser. We teach you the right path of trading and how to make the best use of the time in every field a new beginner needs a highly skilled and specialized guideline.

Practical Education in Financial Markets With nearly 20 years cumulative experience in financial services industry the pioneers of Value Prop have ascertained the need for quality manpower. Yes, no

doubt the percentage of people being graduated is increasing year on year thus the range of opportunities for them in the service industry. Indian economy is gradually shifting its focus from agriculture to services. Currently around 60% of Indian Gross Domestic Product is contributed by service industry and in specific the educational services industry. However the gap still exists between the employer and employee. This gap can be ascribed to lack of employable skills which are not given due credit in the university education. Value Prop would focus on finishing education for management graduates who specialize with finance. Its emphasis would be primarily on real time training and education in the areas of stock and commodity markets, fundamental analysis, technical analysis, mutual funds, derivatives, financial planning et al.

Modules: National Stock Exchange Certification in Financial Markets (NCFM)

Bombay Stock Exchanges Certification in Financial Markets(BCFM)

National Institute of Securities Markets (NISM) Association of Mutual Funds (AMFI)

Money Management & Trading Psychology Fundamental Analysis Stock Markets for Beginners

 Futures trading and Strategies Options trading and strategies Currency Derivatives Trading Commodities Trading

Placement Services

Value Prop also provides human capital solutions at all levels with emphasis financial services. Areas where the concern doesnt have a presence would fulfill the needs through tie-ups and adhoc partners. Our clients range in size including multinational companies (MNCs), mid-cap organizations, and startup companies across India. Sectors chiefly served included Banking Investment Advisory Portfolio Management Mutual Fund Advisory Insurance Stock Broking & Commodity Broking

Commodities Trading

Today commodities exchanges have become an integral part of Indian financial system. Their volumes have gone through the roof; from a humble Rs 5000 crores in 2003 today it stands north of Rs 27 lack crores per year. This rise in volumes has been led by bullion (gold and silver) trading. Simultaneously, MCX has emerged as the second largest commodity exchange in the world in terms the number of silver contracts traded. Similarly it is the third largest commodity exchange in the world today considering the number of gold contracts traded. Coming to commodities, today Indian investors can trade in a great number of commodities on these bourses, and the list is getting bigger by the day. Through our association with Durga Prasad & Co, a Hyderabad based brokerage house we offer guided trading to the clients. Digital Marketing Digital marketing can be defined as the process of promoting of brands using digital distribution channels comprising internet, mobile and other interactive channels. The basic advantage in this form of advertising lies in its low cost model. Digital Marketing can be classified into Pull and Push marketing. Pull

Pull digital marketing technologies involve the user having to seek out and directly grab (or pull) the content via web searches. Web site/blogs and streaming media (audio and video) are good examples of this. In each of these examples, users have a specific link (URL) to view the content.

Push Push digital marketing technologies involve both the marketer (creator of the message) as well as the recipients (the user). Email, SMS, RSS are examples of push digital marketing. In each of these examples, the marketer has to send (push) the messages to the users (subscribers) in order for the message to be received. Web Site Designing

Value Prop through its tie up venture www.hanuinfo.com offers a complete package of affordable website design and ecommerce web development. From the initial process of taking inputs from clients, planning on the basis of such inputs to final implementation and testing all are done using latest web designing techniques and skills.

Our Service Includes:

Website Design

Website Redesign Shopping Cart Web Design Detailed and Advanced Page Layout Custom Logo Design Banner Ads Custom Graphics Design using advanced design tools.

Value Props portfolio till now includes:

www.shrigurupeetham.com www.narenit.com www.justsms.info www.kpcommodities.com www.petrobazaar.com www.wiseandhra.com

Customized SMS modules:Through bulk SMS venture www.justsms.info Value Prop offers high quality, reliable and cost effective, high speed SMS services right from individuals to enterprise level solutions. We provide cost effective mobile messaging solutions, with facilities like Web-API, reporting systems and ensuring prompt and rapid delivery with carrier-grade quality and reliability. We offer real-time, secure, unlimited deployment of SMS delivery, utilizing innovative technology in both the outbound and inbound application. We provide a wide range mobile messaging solutions (SMS, MMS, Flash, Blinking, two-way messaging, Unicode Messaging and much more) for a wide range of solutions for all Business communication needs. Proprietary Web Portals Value Prop through its proprietary portals, which are being developed, in the areas of financial markets, career, news space, general knowledge & current affairs engages in the knowledge dissemination to the target classes. These projects are being developed by in-house technical team.

Chapter- II

INTRODUCTION TO DERIVATIVES

INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest, etc. Banks, Securities firms, companies and investors to hedge risks, to gain to cheaper money and to make profit, se derivatives. Derivatives are likely to grow even at a faster rate in future.

History of Derivatives
Derivatives trading began in 1865 when the Chicago Board of Trade

(CBOT) listed the first exchange traded derivatives contract in the USA. These contracts were called Futures Contracts. In 1919, the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index future contract in the world is based on the Standard & Poors 500 indexes traded on the CME. In April 1973, the Chicago Board of Options Exchange was set up specially for the purpose of trading in options. The market for options developed so rapidly that by early 80s the number of shares traded on option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange and there has been no looking back ever since.

Derivatives Markets in India

In India, derivatives markets have been functioning since the nineteenth century, with organized trading in cotton through the establishment of the Cotton Trade Association in 1875. Derivatives, as exchange traded financial instruments were introduced in India in June 2000. The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index futures contract. In a span of one and a half years after the introduction of index futures, index options, stock options and stock futures were also introduced in the derivatives segment for trading. NSEs equity derivatives segment is called the Futures & Options Segment or F&O Segment. NSE also trades in Currency and Interest Rate Futures contracts under a separate segment.

A series of reforms in the financial markets paved way for the development

of exchange-traded equity derivatives markets in India. In 1993, the NSE was established as an electronic, national exchange and it started operations in 1994. It improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system with real-time price dissemination. A report on exchange traded derivatives, by the L.C. Gupta Committee, set up by the Securities and Exchange Board of India (SEBI), recommended a phased introduction of derivatives instruments with bi-level regulation (i.e., self-regulation by exchanges, with SEBI providing the overall regulatory and supervisory role). Another report, by the J.R. Verma Committee in 1998, worked out the various operational details such as margining and risk management systems for these instruments. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R) A, was amended so that derivatives could be declared as securities. This allowed the regulatory framework for trading securities, to be extended to derivatives. The Act considers derivatives on equities to be legal and valid, but only if they are traded on exchanges. The Securities and Exchange Board of India (SEBI) allowed trading in equities-based derivatives on stock exchanges in June 2000. Accordingly the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) introduced trading in futures on June 9, 2000 and June 12, 2000 respectively. Currently futures and options turnover on the NSE is Rs.7, 000-8,000 cores. In India stock index options were introduced from July 2, 2001.

18-Nov-96

Milestones in the development of Indian derivative market L.C. Gupta Committee set up to draft a policy framework for introducing derivatives

11-May-98 L.C. Gupta committee submits its report on the policy framework 25-May-00 SEBI allows exchanges to trade in index futures 12-Jun-00 4-Jun-01 2-Jul-01 9-Nov-01 29-Aug-08 31-Aug-09 Trading on Nifty futures commences on the NSE Trading for Nifty options commences o n the NSE Trading on Stock options commences on the NSE Trading on Stock futures commences on the NSE Currency derivatives trading commences on the NSE Interest rate derivatives trading commences on the NSE

DEFINITION Derivative is a product whose value is derived from the value of one or more basic variables, called underlying asset in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines "derivative" to include 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 contract which derives its value from the prices, or index of prices, of

underlying securities. FACTORS DRIVING THE GROWTH OF DERIVATIVES Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: Increased volatility in asset prices in financial markets.

Increased integration of national financial markets with the international markets. Marked improvement in communication facilities and sharp decline in their costs.

Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets

Emergence of financial derivative products

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use.

Participants in the derivatives market

The participants in the derivatives market are broadly classified into three groups: Hedgers Speculators Arbitrageurs Hedgers Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Speculators Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchangetraded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving

Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months average of a basket of assets. Equity index options are a form of basket options. Swaps: 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. 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. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

ECONOMIC FUNCTION OF THE DERIVATIVE MARKTS

In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions. 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. 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. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 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 markets. Margining, monitoring and surveillance of the activities of various

participants become extremely difficult in these kinds of mixed markets. Derivatives Trading acts as a catalyst for new entrepreneurial activity.

Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However 'credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest "financial" exchanges of any kind in the world today. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

TYPES OF DERIVATIVES
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market: Over the counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as Swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge. According to the Bank for International Settlements, the total outstanding notional amount is USD 516 trillion (as of June 2009). Exchange traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a Guarantee. The worlds largest derivatives exchanges (by number of transactions) are the Korea exchange (Which lists KOSPI

Index Futures & Options), Eurex (which lists a wide range of European and the Chicago Board of Trade). According to BIS, the combined turnover in the worlds derivatives exchanges totaled USD 344 trillion during Q4 2008. Some types of derivatives instruments also may trade on traditional exchanges. For instance, hybrid instructions such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants may be listed on stock or bond exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other Derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and

Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system. (i) The dynamic nature of gross credit exposures; (ii) Information asymmetries; (iii) The effects of OTC derivative activities on available aggregate credit; (iv) The high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts occur, which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter-party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing

Common Derivative contract types There are three major classes of derivatives: Futures/Forwards, which are contracts to buy or sell an asset at a specified future date. Optional, which are contracts that give a holder the right to buy or sell an asset at a specified future date. Swapping, where the two parties agree to exchange cash flows.

RATIONALE BEHIND THE DELOPMENT OF DERIVATIVES

Holding portfolios 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 factors, which affect the returns: Price or dividend (interest) Some are internal to the firm like Industrial policy Management capabilities Consumers preference Labor 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 by having a welldiversified 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 yet other of influence which are external to the firm, cannot be controlled and affect large number of securities. They are termed as systematic risk. They are: 1. Economic 2. Political 3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause 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 companys earnings rising and vice versa.

NSE's DERIVATIVES MARKET

The derivatives trading on the 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. Today, both in terms of volume and turnover, NSE is the largest derivatives exchange in India. Currently, the derivatives contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.

Turnover
The trading volumes on NSE's derivatives market has seen a steady increase since the launch of the first derivatives contract, i.e. index futures in June 2000. The average daily turnover at NSE now exceeds Rs. 35,000 cores. A total of

216,883,573 contracts with a total turnover of Rs.7, 356,271 cores were traded during 2006-2007.

GLOBAL DERIVATIVES MARKET

The global financial centers such as Chicago, New York, Tokyo and London dominate the trading in derivatives. Some of the worlds leading exchanges for the exchange-traded derivatives are: Chicago Mercantile Exchange (CME) & London International financial Futures Exchange (LIFFE) (for currency & Interest rate futures) Philadelphia Stock Exchange (PSE), London Stock Exchange (LSE) Chicago Board option Exchange (CBOE) (for currency options) New York Stock Exchange (NYSE) and London Stock Exchange (LSE) (for equity derivatives) Chicago Mercantile Exchange (CME) and London Metal Exchange (LME) (for commodities) These exchanges account for a larger portion of the trading volume in the respective derivatives segment.

ELIGIBILITY OF ANY STOCK TO ENTER IN DERIVATIVES

MARKET
Non promoter holding (free float capitalization) not less than Rs. 750 cores form last 6 months. Daily Average Trading value not less than 5 cores in last 6 months.

At least 90% of trading days in last 6 months. Non Promoters Holding at least 30% BETA not more than 4 (pervious last 6 months)

Regulatory Framework
The trading of derivatives is governed by the provisions contained in the SC(R)A, the SEBI Act, the rules and regulations framed there under and the rules and byelaws of stock exchanges.

SECURITIES CONTRACTS (REGULATION) ACT, 1956

SC(R) A aims at preventing undesirable transactions in securities by regulating the business of dealing therein and by providing for certain other matters connected therewith. This is the principal Act, which governs the trading of securities in India. The term securities has been defined in the SC(R) A. As per Section 2(h), the Securities include: 1. Shares, scripts, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate. 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes.

Derivative is defined to include: 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 contract which derives its value from the prices, or index of prices, of underlying securities. Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are: traded on a recognized stock exchange settled on the clearing house of the recognized stock exchange, in accordance with the rules and byelaws of such stock exchanges.

SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b) promoting the development of the securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over corporate in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for: regulating the business in stock exchanges and any other securities markets. registering and regulating the working of stock brokers, subbrokers etc.

 promoting and regulating self-regulatory organizations. prohibiting fraudulent and unfair trade practices. calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds and other persons associated with the securities market and intermediaries and selfregulatory organizations in the securities market. performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.

Regulation for Derivatives Trading:

SEBI set up a 24- member committee under the Chairmanship of Dr. L. C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. The provisions in the SC(R)A and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of securities in the SC(R)A made trading in derivatives possible within the framework of that Act. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report can apply to SEBI for grant of recognition under

Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The Exchange should have minimum 50 members. The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members of the derivative segment would need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee.

The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. Capital + Free reserves

Less non-allowable assets viz. (a) Fixed assets (b) Pledged securities (c) Members card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets (i) 30% marketable securities The minimum contract value shall not be less than Rs.2 Lakes.

Exchanges have to submit details of the futures contract they propose to introduce. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time. The L. C. Gupta committee report requires strict enforcement of Know your customer rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. The trading members are required to have qualified approved user and sales person who have passed a certification programmed approved by SEBI.

Requirements to become authorized / approved user:

Trading members and participants are entitled to appoint, with the approval of the F&O segment of the exchange authorized persons and approved users to operate the trading workstation(s). These authorized users can be individuals, registered partnership firms or corporate bodies. Authorized persons cannot collect any commission or any amount directly from the clients he introduces to the trading member who appointed him. However he can receive a commission or any such amount from the trading member who appointed him as provided under regulation. Approved users on the F&O segment have to pass a certification

program which has been approved by SEBI. Each approved user is given a unique identification number through which he will have access to the NEAT system. The approved user can access the NEAT system through a password and can change such password from time to time.

FUTURES

INTRODUCTION TO FUTURES
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.

The standardized items in a futures contract are:

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

HISTORY OF FUTURES
Merton Miller, the 1990 Nobel laureate had said that 'financial futures represent the most significant financial innovation of the last twenty years." The first exchange that traded financial derivatives was launched in Chicago in the year 1972. A division of the Chicago Mercantile Exchange, it was called the International Monetary Market (IMM) and traded currency futures. The brain behind this was a man called Leo Me lamed, acknowledged as the 'father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts traded at the Chicago

Mercantile Exchange totaled 50 trillion dollars. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board Options Exchange. By the 1990s, these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps, and their success transformed Chicago almost overnight into the risk-transfer capital of the world.

DEFINITION
A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

FEATURES OF FUTURES:
Futures are highly standardized.

The contracting parties need not pay any down payments.

Hedging of price risks. They have secondary markets to.

FUTURES TERMINOLOGY

 Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-month and three months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading. 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. Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. Basis: 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 a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. 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. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Distinction between futures and forwards Futures

Trade on an organized exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement

Forwards
OTC in nature Customized contract terms hence less liquid No margin payment Settlement happens at end of period

FUTURES PAYOFFS
Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two month Nifty index futures contract when the Nifty stands at 2220.The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Figure shows the payoff diagram for the buyer of a futures contract. Figure: Payoff for a buyer of Nifty futures

The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses. Figure shows the payoff diagram for the seller of a futures contract. Figure: Payoff for a seller of Nifty futures

The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

PRICING FUTURES
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below:

where: r Cost of financing (using continuously compounded interest rate)

T Time till expiration in years e 2.71828 Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows:

Pricing equity index futures

A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock

index futures are cash settled; there is no delivery of the underlying stocks. In their short history of trading, index futures have had a great impact on the world's securities markets. Its existence has revolutionized the art and science of institutional equity portfolio management.

Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are few

Historical cases of clustering of dividends in any particular month, it is useful to calculate the annual dividend yield. (r- q)T F = Se Where: F futures price S spot index value R cost of financing q Expected dividend yield T holding period

PRICING STOCK FUTURES

A futures contract on a stock gives its owner the right and obligation to buy or sell the stocks. Like index futures, stock futures are also cash settled; there is no delivery of the underlying stocks. Just as in the case of index futures, the between commodity and stock futures are that: There are no costs of storage involved in holding stock.

Stocks come with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are shorts the stock.

Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with stock futures as opposed to commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, The better is the estimate of the futures price.

Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: Physical delivery- the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position- that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nynex crude future contract uses this method of settlement upon expiration.

 Cash settlement a cash payment is made based on the underlying reference rate, such as a short term interest rate such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method. Expiry-is time when the final prices of the future are determined. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiry on December, the March future becomes the nearest contract.

OPTIONS

INTRODUCTION TO OPTIONS
The next derivative product to be traded on the NSE, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment.

HISTORY OF OPTIONS

Although options have existed for a long time, they traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firms would then attempt to find a seller or writer of the option either from its own client of those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered from two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April, 1973 CBOE was set up specifically for the purpose of trading options. The market for option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back. Option made their mark in financial history during the tulip bulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in the history. The first tulip was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular an expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began to rise. That was when options came into the picture. They were initially used for hedging.

DEFINITION

Option is a type of contract between two persons where one grants the other the right to buy a specific asset at a specific price within a specific time period. The assets on which option can be derived are Stocks, commodities, indexes etc. If the underlying asset is the financial asset, then the option are financial option like stock options, currency options, index options etc, and if options like commodity option.

Distinction between futures and options

Futures Exchange traded, with novation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Options Same as futures Same as futures Strike price is fixed, price moves Price is always positive Nonlinear payoff

Both long and short at risk

Only short at risk

OPTION TERMINOLOGY
Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. 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 not the obligation to sell an asset by a certain date for a certain price. Option price/premium: 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 options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at

any time up to the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than 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 ITM. In the case of a put, the put is ITM if the index is below the 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: The option premium can be broken down into two components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0, K St],i.e. the greater of 0 or (K St). K is the strike price and St is the spot price.

Time value of an option: The time 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 option's time value, all else equal. At expiration, an option should have no time value.

OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs.

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance, for 2220, and sells it at a future date at an unknown price. Once it is purchased, the investor is said to be "long" the asset. Figure shows the payoff for a long position on the Nifty. Figure: Payoff for investor who went Long Nifty at 2220

The figure shows the profits/losses from a long position on the index. The investor bought the index at 2220. If the index goes up, he profits. If the index falls he looses.

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance, for 2220, and buys it back at a future date at an unknown price. Once it is sold, the investor is said to be "short" the asset. Figure shows the payoff for a short position on the Nifty. Figure: Payoff for investor who went Short Nifty at 2220 The figure shows the profits/losses from a short position on the index. The investor sold the index at 2220. If the index falls, he profits. If the index rises, he looses.

Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 2250 bought at a premium of 86.60. Figure: Payoff for buyer of call option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure gives the

payoff for the writer of a three month call option (often referred to as short call) with a strike of 2250 sold at a premium of 86.60. Figure: Payoff for writer of call option The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty -close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends

on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets is option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 2250 bought at a premium of 61.70. Figure: Payoff for buyer of put option The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a

premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option unexercised and the writer gets to keep the premium. Figure gives the payoff for the writer of a three month put option (often referred to as short put) with a strike of 2250 sold at a premium of 61.70. Figure: Payoff for writer of put option he figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him.

PRICING OPTIONS
An option buyer has the right but not the obligation to exercise on the seller. The

worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option. There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in Black- Scholes options pricing formula so to price options we don't really need to memorize the formula. All we need to know is the variables that go into the model. The Black-Scholes formulas for the prices of European calls and puts on a nondividend paying stock are:

The Black/Scholes equation is done in continuous time. This requires continuous compounding. The r that figures in this is ln (l + r). Example: if the interest rate per annum is 12%, you need to use ln 1.12 or 0.1133, which is the continuously compounded equivalent of 12% per annum. N () is the cumulative normal distribution. N (d1) is called the delta of the option which is a measure of change in option price with respect to change in the price of the underlying asset.

 a measure of volatility is the annualized standard deviation of continuously compounded returns on the underlying. When daily sigmas are given, they need to be converted into annualized sigma.

TRADING

TRADING
The trading system for NSE's futures and options market. However, the best way to get a feel of the trading system is to actually watch the screen and observe trading.

FUTURES AND OPTIONS TRADING SYSTEM

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Index futures & options and Stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options.

Entities in the trading system

There are four entities in the trading system. Trading members, clearing members, professional clearing members and participants. 1) Trading members: Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange assigns a trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned an unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firms User IDs. 2) Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

3) Professional clearing members: A professional clearing members is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members. 4) Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle

through a single clearing member.

Marketed by price in NEAT F&O

Basis of trading
The NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are units and price in rupees. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.

Corporate hierarchy
In the F&O trading software, a trading member has the facility of defining a hierarchy amongst users of the system. This hierarchy comprises corporate manager, branch manager and dealer. 1) Corporate manager: The term 'Corporate manager' is assigned to a user placed at the highest level in a trading firm. Such a user can perform all the functions such as order and trade related activities, receiving reports for all branches of the member firm and also all dealers of the firm. Additionally, a corporate manager can define exposure limits for the branches of the firm. This facility is available only to the corporate manager . 2) Branch manager: The branch manager is a term assigned to a user who is placed under the corporate manager. Such a user can perform and view order and trade related activities for all dealers under that branch.

3) Dealer: Dealers are users at the lower most level of the hierarchy. A Dealer can perform view order and trade related activities only for oneself and does not have access to information on other dealers under either the same branch or other branches. Below given cases explain activities possible for specific user categories: 1) Clearing member corporate manager: He can view outstanding orders, previous trades and net position of his client trading members by putting the TM ID (Trading member identification) and leaving the Branch ID and Dealer ID blank. 2) Clearing member and trading member corporate manager: He can view: (a) Outstanding orders, previous trades and net position of his client trading members by putting the TM ID and leaving the Branch ID and the Dealer ID blank. (b) Outstanding orders, previous trades and net positions entered for himself by entering his own TM ID, Branch ID and User ID. This is his default screen. (c) Outstanding orders, previous trades and net position entered for his branch by entering his TM ID and Branch ID fields. (d) Outstanding orders, previous trades, and net positions entered for any of his users/dealers by entering his TM ID, Branch ID and user ID fields. 3) Clearing member and trading member dealer: He can only view requests entered by him.

4) Trading member corporate manager: He can view: (a) Outstanding requests and activity log for requests entered by him by entering his own Branch and User IDs. This is his default screen. (b) Outstanding requests entered by his dealers and/or branch managers by either entering the Branch and/or User IDs or leaving them blank. 5) Trading member branch manager: He can view: (a) Outstanding requests and activity log for requests entered by him by entering his own Branch and User IDs. This is his default screen. (b) Outstanding requests entered by his users either by filling the User ID field with a specific user or leaving the User ID field blank. 6) Trading member dealer: He can only view requests entered by him.

Client Broker Relationship in Derivative Segment

A trading member must ensure compliance particularly with relation to the following while dealing with clients: Filling of 'Know Your Client' form Execution of Client Broker agreement

Bring risk factors to the knowledge of client by getting acknowledgement of client on risk disclosure document

Timely execution of orders as per the instruction of clients in respective client codes Collection of adequate margins from the client

 Maintaining separate client bank account for the segregation of client money. Timely issue of contract notes as per the prescribed format to the client Ensuring timely pay-in and pay-out of funds to and from the clients Resolving complaint of clients if any at the earliest. Avoiding receipt and payment of cash and deal only through account payee cheques Sending the periodical statement of accounts to clients Not charging excess brokerage Maintaining unique client code as per the regulations.

Order types and conditions

The system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: Time conditions Price conditions Other conditions Several combinations of the above are allowed thereby providing enormous flexibility to the users. The order types and conditions are summarized below.

Security/contract/portfolio entry screen in NEAT F&O

 Time conditions
- Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. -Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

Price condition
- Stop-loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stoploss buy order, the trigger is 1027.00, the limit price is 1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 1030.00. For the stop-loss sell order, the trigger price has to be greater than the limit price.

 Other conditions
- Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price. - Trigger price: Price at which an order gets triggered from the stop-loss book. - Limit price: Price of the orders after triggering from stop-loss book. - Pro: Pro means that the orders are entered on the trading member's own account. - Cli: Cli means that the trading member enters the orders on behalf of a client.

THE TRADER WORKSTATION

The market watch window The following windows are displayed on the trader workstation screen: Title bar Ticker window of futures and options market Ticker window of underlying (capital) market Toolbar Market watch window Inquiry window Snap quote

 Order/trade window System message window As mentioned earlier, the best way to familiarize oneself with the screen and its various segments is to actually spend some time studying a live screen. In this section we shall restrict ourselves to understanding just two segments of the workstation screen, the market watch window and the inquiry window. The market watch window is the third window from the top of the screen which is always visible to the user. The purpose of market watch is to allow continuous monitoring of contracts or securities that are of specific interest to the user. It displays trading information for contracts selected by the user. The user also gets a broadcast of all the cash market securities on the screen. This function also will be available if the user selects the relevant securities for display on the market watch screen. Display of trading information related to cash market securities will be on "Read only" format, i.e. the dealer can only view the information on cash market but, cannot trade in them through the system. This is the main window from the dealer's perspective.

Inquiry window
The inquiry window enables the user to view information such as Market by Price (MBP), Previous Trades (PT), Outstanding Orders (OO), Activity log (AL), Snap Quote (SQ), Order Status (OS), Market Movement (MM), Market Inquiry (MI), Net Position, On line backup, Multiple index inquiry, Most active security and so on. Relevant information for the selected contract/security can be viewed. We shall look in detail at the Market by Price (MBP) and the Market Inquiry (MI) screens.

1. Market by price (MBP): The purpose of the MBP is to enable the user to view passive orders in the market aggregated at each price and are displayed in order of best prices. The window can be invoked by pressing the [F6] key. If a particular contract or security is selected, the details of the selected contract or security can be seen on this screen. 2. Market inquiry (MI): The market inquiry screen can be invoked by using the [F11] key. If a particular contract or security is selected, the details of the selected contract or selected security defaults in the selection screen or else the current position in the market watch defaults. The first line of the screen gives the Instrument type, symbol, expiry, contract status, total traded quantity, life time high and life time low. The second line displays the closing price, open price, high price, low price, last traded price and indicator for net change from closing price. The third line displays the last traded quantity, last traded time and the last traded date. The fourth line displays the closing open interest, the opening open interest, day high open interest, day low open interest, current open interest, life time high open interest, life time low open interest and net change from closing open interest. The fifth line display very important information, namely the carrying cost in percentage terms.

Placing orders on the trading system

For both the futures and the options market, while entering orders on the trading system, members are required to identify orders as being proprietary or client orders. Proprietary orders should be identified as 'Pro' and those of clients should be identified as 'Cli'. Apart from this, in the case of 'Cli' trades, the client account number should also be provided. The futures market is a zero sum game i.e. the

total number of long in any contract always equals the total number of short in any contract. The total number of outstanding contracts (long/short) at any point in time is called the "Open interest". This Open interest figure is a good indicator of the liquidity in every contract. Based on studies carried out in international exchanges, it is found that open interest is maximum in near month expiry contracts.

Market spread/combination order entry

The NEAT F&O trading system also enables to enter spread/combination trades. Figure shows the spread/combination screen. This enables the user to input two or three orders simultaneously into the market. These orders will have the condition attached to it that unless and until the whole batch of orders finds a counter match, they shall not be traded. This facilitates spread and combination trading strategies with minimum price risk. Market spread/combination order entry

Basket trading
In order to provide a facility for easy arbitrage between futures and cash markets, NSE introduced basket-trading facility. Figure shows the basket trading screen. This enables the generation of portfolio offline order files in the derivatives trading system and its execution in the cash segment. A trading member can buy or sell a portfolio through a single order, once he determines its size. The system automatically works out the quantity of each security to be bought or sold in proportion to their weights in the portfolio.

Portfolio office order entry for basket trades

FUTURES AND OPTIONS MARKET INSTRUMENTS

The F&O segment of NSE provides trading facilities for the following derivative instruments: 1. Index based futures 2. Index based options

Contract specifications for index futures

NSE trades Nifty, CNX IT, BANK Nifty, CNX Nifty Junior, CNX 100, Nifty Midcap 50 and Mini Nifty 50 futures contracts having one-month, two-month and three-month expiry cycles. All contracts expire on the last Thursday of every month. Thus a January expiration contract would expire on the last Thursday of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry would be introduced for trading. Thus, as shown in Figure at any point in time, three contracts would be available for trading with the first contract expiring on the last Thursday of that month. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts. The Instrument type refers to "Futures contract on index" and Contract symbol - NIFTY denotes a "Futures contract on Nifty index" and the Expiry date represents the last date on which the contract will be available for trading. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (similar to the existing capital market trading system). The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas the best sell order will be the order to sell the index at the lowest index level.

Example: If trading is for a minimum lot size of 100 units. If the index level is around 2000, then the appropriate value of a single index futures contract would be Rs.200, 000. The minimum tick size for an index future contract is 0.05 units. Thus

a single move in the index value would imply a resultant gain or loss of Rs.5.00 (i.e. 0.05*100 units) on an open position of 100 units.

Contract cycle
The figure shows the contract cycle for futures contracts on NSE's derivatives market. As can be seen, at any given point of time, three contracts are available for trading - a near-month, a middle-month and a far-month. As the January contract expires on the last Thursday of the month, a new three-month contract starts trading from the following day, once more making available three index futures contracts for trading.

Contract specification for index options

On NSE's index options market; there are one- month, two- month and three month expiry contracts with minimum nine different strikes available for trading. Hence, if there are three serial month contracts available and the scheme of strikes is 4-1-4, then there are minimum 3 x 9 x 2 (call and put options) i.e. 54 options contracts available on an index. Option contracts are specified as follows: DATEEXPIRYMONTH-YEAR-CALL/PUT-AMERICAN/ EUROPEAN-STRIKE. For example the European style call option contract on the Nifty index with a strike price of 2040 expiring on the 30th June 2005 is specified as '30 JUN 2005 2040 CE'. Just as in the case of futures contracts, each option product (for instance, the 8 JUN 2005 2040 CE) has its own order book and it's own prices. All index options contracts are cash settled and expire on the last Thursday of the month. The clearing corporation does the novation. The minimum tick for an index options contract is 0.05 paisa.

CRITERIA FOR STOCKS AND INDEX ELIGIBILITY FOR TRADING Eligibility criteria of stocks:
The stock is chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. The stock's median quarter-sigma order size over the last six months should be not less than Rs. 5 lakhs. For this purpose, a stock's quarter-sigma order size should mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The market wide position limit in the stock should not be less than Rs.100

crores. The market wide position limit (number of shares) is valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be 20% of the number of shares held by non promoters in the relevant underlying security i.e. freefloat holding. For an existing F&O stock, the continued eligibility criteria is that market wide position limit in the stock shall not be less than Rs. 60 crores and stocks median quarter-sigma order size over the last six months shall be not less than Rs. 2 lakh. If an existing security fails to meet the eligibility criteria for three months consecutively, then no fresh month contract will be issued on that security. However, the existing unexpired contracts can be permitted to trade till expiry and new strikes can also be introduced in the existing contract months. Further, once the stock is excluded from the F&O list, it shall not be considered for re-inclusion for a period of one year. Futures & Options contracts may be introduced on (new) securities which meet the above mentioned eligibility criteria, subject to approval by SEBI.

Eligibility criteria of indices

The exchange may consider introducing derivative contracts on an index if the

stocks contributing to 80% weightage of the index are individually eligible for derivative trading. However, no single ineligible stocks in the index should have a weightage of more than 5% in the index. The above criteria is applied every month, if the index fails to meet the eligibility criteria for three months consecutively, then no fresh month contract would be issued on that index, However, the existing unexpired contacts will be permitted to trade till expiry and new strikes can also be introduced in the existing contracts.

Eligibility criteria of stocks for derivatives trading specially on account of corporate restructuring
The eligibility criteria for stocks for derivatives trading on account of corporate restructuring are as under: I. All the following conditions shall be met in the case of shares of a company undergoing restructuring through any means for eligibility to reintroduce derivative contracts on that company from the first day of listing of the post restructured company/(s) (as the case may be) stock (herein referred to as post restructured company) in the underlying market, a)The Futures and options contracts on the stock of the original (pre restructure) company were traded on any exchange prior to its restructuring; b) The pre restructured company had a market capitalization of at least Rs.1000 crores prior to its restructuring; c) The post restructured company would be treated like a new stock and if it is, in the opinion of the exchange, likely to be at least one-third the size of the pre restructuring company in terms of revenues, or assets, or (where appropriate)

analyst valuations; and d) In the opinion of the exchange, the scheme of restructuring does not suggest that the post restructured company would have any characteristic (for example extremely low free float) that would render the company ineligible for derivatives trading. II. If the above conditions are satisfied, then the exchange takes the following course of action in dealing with the existing derivative contracts on the prerestructured company and introduction of fresh contracts on the post restructured company a) In the contract month in which the post restructured company begins to trade, the Exchange introduce near month, middle month and far month derivative contracts on the stock of the restructured company. b) In subsequent contract months, the normal rules for entry and exit of stocks in terms of eligibility requirements would apply. If these tests are not met, the exchange shall not permit further derivative contracts on this stock and future month series shall not be introduced.

Salient Features of L.C. Gupta And J.R. Verma Committee Report

SALIENT FEATURES:

L.C. GUPTA COMMITTEE REPORT

 Appointed on 18th November 2004. To develop appropriate regulator framework for derivatives trading. Focus of financial derivatives and in particular, equity derivatives. Submitted its report in March 2005. Approved by SEBI in May and are circulated in June 2005.

Executive Summary
Both Hedgers and speculators required for efficient markets. Equity derivatives could begin with index futures. Development in phased manner. Index Options and Options on shares to follow. Main emphasis on exchange-level regulation. Stricter governance by SEBI compared to cash segment. Stringent-entry requirement. Derivative Cell, Advisory Committee and Economic Research wing to be set up with in SEBI.

Legal Amendments

Securities Contracts Regulation Act.

Derivatives contract declared as a security in Dec 2000. Notification in June 1969 under section 16 of SC(R)A banning forward trading revoked in March 2000.

Survey Results
Committee conducted following number of surveys among some groups which are as under: Brokers: Mutual funds: Banks/FIs: Banks/FIIS: Merchant bankers: Total: 67 10 14 12 9 112

Wide recognition of need for derivatives. Stock index future most preference, stock index options second preference. Options on individual stock third preference. 70% respondents indicated hedging as the activity. 39% speculation/dealing 64% brokers, 36% option writing American Option were preferred over European option

Cash Market Suggestions

Committee has suggested the following improvements Uniform settlement cycles among all exchanges. Move towards rolling settlement cycles. Tighter supervision. Speeding up demat.

 Increase delivery transactions.

Derivatives Exchanges
Existing exchanges may start Derivatives segment or separate exchange may be set up On-line screen trading with disaster recovery site. Independent clearing Corporation/house. Online Surveillance capability. Real-time information dissemination over at least 2 networks. Minimum 50 members. Separate membership for derivative segment- no automatic membership. Separate governing council for derivative segment. Percentage of broker-members in the council to be prescribed by SEBI. Chairman cannot carry on broking/ dealing business during his team. Arbitration and investor grievance cells in 4 regions. Adequate inspection capability

Regulatory Recommendations
Emphasis on exchange level regulation. SEBI to act as regulator to last resort. All members to be inspected. SEBI will approve rules, bye-laws and regulations. New derivatives contracts to be approved by SEBI. Exchange to provide full details of proposed contract.

 Economic purpose of the contract. Safeguards incorporated for investor protection and fair trading. Contribution to the markets development.

Trading Stipulations
Trading days and hours to be stipulated in advance. Pre-determined expiration date and time for each contract. Last trading day to be stipulated in advance. Contract expiration period may not exceed 12 months.

Entry Rules
No automatic entry. Capital adequacy higher than cash market. Clearing and non-clearing members. Minimum net worth Rs.300 lakhs. Minimum deposit Rs.50 lakhs. Option writers-higher deposits. Broker members, sales persons and dealers to pass a certification program. Registration with SEBI in addition to registration with exchange.

Clearing Corporation
Full novation Upfront and mark-to-market margins

 Power to disable member from trading Margins to factor in volatility Margins based on value at risk- 99% confidence No trading interests on board National level clearing corporation in future Maximum deposit based exposure limit EFT for margin payments Cross-margining not advisable Margin collected from client Exposure limits on gross basis Trading to be clearly indicated as own/clients and opening/closing out

Segregation of own/clients margin

No set off permitted In case of default, only own margin can be set off against member dues Prompt transfer of clients in case of default by brokers Close out all open positions by CC at its option Special margins on members permitted Margins can b withheld-additional margins can be further demanded CC may prescribe maximum long/short positions by members Ask members to close out excess positions CC may close out such positions

Mark to Market and Settlement

Daily settlement of future contracts Daily settlement price - closing price of futures

 Final settlement price - closing price of underlying security

Categories of members
TM Clearing Member (own, clients, TMs, their clients) Trading Member (own, clients) Professional (Custodian) Clearing Member (TMs their clients)

Sales Practices
Risk disclosure document with each client mandatory Sales personnel to pass certification exam Specific authorization from clients board of directors/trustees

Trading Parameters
Each order buy/sell and open/close Unique order identification number Regular market lot size, tick size Gross exposure limits to be specified Price bands for each derivative contract Maximum permissible open position Off line order entry permitted

Brokerage
Prices on the system shall be exclusive of brokerage Maximum brokerage rates shall be prescribed by the exchange

 Brokerage to be separately indicated in the contract note

Margins from Clients

Margins to be collected from all clients/trading members Daily margins to be further collected Right of clearing member to close out positions of clients/TMs not paying daily margins Losses if any to be charged to clients/TMs and adjusted against margins

Salient Features J.R.VERMA COMMITTEE REPORT

Constituted in June 2003 Submitted its report in NOV 2005 Objectives- recommended measures for risk containment in the Indian Derivatives market Opertionalise the recommendations of the L C Gupta Committee

Background Scenario
Volatility in India is high compared to developed markets Cross margining not permitted Initial margin to b based on 99% value at Risk (VAR) Collection of margins before trading hours next day from all clients.

Margining System

 Exponential weighted moving average method for estimating daily volatility Variance at end of day t = (0.94 * variance at end of day (t-1) + (0.06 * square Of return of day t) Margins for 99% VAR based on 3 Sigma limits theoretically the maximum Amount of a portfolio can lose (typically in a day) During first 6 months, parallel estimated of cash and futures market Margins to be higher of the two Initial margins to b at least 5% Initial Calculations based on last 1 year of cash market Futures volatility expected to be higher The method attaches higher weights to more recent volatility Trading software would provide volatility information on real-time basis. Volatility of day to will be used for margin calculations on day to evening

Margining for Calendar Spreads

Basis risk and no market risk 0.5% per month of spread ( on far month contract ) Minimum 1% and maximum 3% margin, on expiry of near month contract, the far month become an open position. Position to be treated as open over the last 4 days gradually 100% open on day of expiry,80% open 1 day before, 60% open 2 days before, 40% open 3 days before and 20% open before 4 days before expiry calendar spread open position = 1/3 of mark to market value of the far month contract

Periodic Reporting
Exchange to report to SEBI highlighting specific instance price moves are beyond 99% VAR limits. Incidences of failure in collection of margin or settlement dues on quarterly basis. Failure defined as shortfall for 3 consecutive trading days of 50% or more of liquid net worth.

Liquid Net Worth

Total liquid assts deposited with the exchange/cc less Initial margin applicable to total gross open position Liquid net worth shall be at least Rs 50 lakhs Gross open positions shall not exceed 33.33 time liquid net worth Back-testing over 8 year that this level has been insufficient only twice on Nifty and never on Sensex. LNW includes cash, fixed deposits, bank guarantees, treasury bills, Govt securities, Dematerialized securities. Securities to b marked to market at least on weekly basis Only investment grade debt securities accepted haircut 10% Equity in demat form 15% haircut Acceptable equities top 100 by market cap out of top 200 by market cap and trading value

 All securities to pledge in favour of CC At least 50% shall be cash, bank guarantees, FDs, T-bills and govt sec position limits Persons acting in concert owing 15% of more interest to report this fact to the exchange Trading member limit 15% of open interest of Rs 100 crores whichever is higher Clearing member should ensure that this own position and his TMs are within above limits.

National Criteria
Minimum Net worth for Clearing Member specified as Rs 3 crores. Minimum Net worth for Trading Member specified as Rs5 crores. The criterion for computing net worth is given below: Capital + Free reserves

Less non allowable assets via fixed assets

Pledged securities Value of membership rights Unlisted securities Bad deliveries Doubtful debts (Debts/advances overdue for more than three months for given associates)

Prepaid expenses, losses intangible assets

30% of marketable securities What are liquid assets:Liquid assets is used for the purpose of initial margin as well as liquid net worth includes cash, fixed deposits, bank guarantees, treasury bills, government securities or dematerialized securities pledged in favour of the exchange/clearing corporation.

What is liquid net worth means:a) Total liquid assets deposited with exchange/clearing Corporation towards initial margin & capital adequacy; b) Initial margin applicable to the gross position at any point of time of all trades cleared through the clearing member. Minimum Liquid Net Worth Requirements:The J.R. Verma committee recommends that the clearing members liquid net worth must satisfy the following condition 1 & 2 on real time basis; Condition 1: Liquid net worth shall not be less than Rs.50 lakhs at any point of time this can b stated as: (liquid assets initial margin)>=50 lakhs. Condition 2:

The mark to market value of gross open position at any point of time for all trades cleared through the clearing member shall not exceed 33.33 times the member liquid net worth. This can be stated as (Liquid assets Initial Margin)*33.33>=Exposure.

CHAPTER IV

DATA ANAYSIS AND INTRPRETATION

Data Analysis of S&P CNX NIFTY

MARKET CLOSED

Index

Current

% Change

S&P CNX NIFTY CNX NIFTY JUNIOR CNX IT BANK NIFTY CNX 100 S&P CNX DEFTY S&P CNX 500 CNX MIDCAP NIFTY MIDCAP 50

5361.75 11024.25 5950.70 9656.50 5300.90 4195.70 4410.05 7980.40 2792.00

1.08 % 0.10 % 0.01 % 1.43 % 0.92 % 1.56 % 0.65 % 0.84 % 1.20 %

Data Interpretation:
On April 9th the opening points of S&P CNX NIFTY was 5305. At 10a.m the sensex increased to 5340 and at 12 p.m it further increased to 5360. Between 1 & 3 p.m there was a fluctuation from 5375 to 5355. The closing sensex of the day was 5361. Therefore, there was an increased in sensex as it was started at 5305 and closed with 5316.75. The percentage change of S&P CNX NIFTY was 1.08%.

GOLD GRAPH:

Data Interpretation: The price of gold as on March 3rd was Rs 17095. As on March 12th it came down to Rs 16405 & then it raised by Rs 16803 on March 18th. Then on March 25th the price fall down to Rs 16211as on 6th April. As we prices the prices of gold from March to April there was a steady decline in the price from Rs 17095 to Rs 16595.

SILVER GRAPH:

Data Interpretation: The price of silver as on Feb 6th was Rs 22625, then it gradually increased and on Feb 20th it was Rs 25720.Then the rate has decreased to Rs 24562 as on 24th of Feb. Then there was an increase till 10th March to Rs 27315. There was a fluctuation in rate as on 28th of March and it decreased to Rs 26151.

MARKET WATCH WINDOWS

BLUE COLOUR INDICATE VALUE INCREASE RED COLOUR INDICATES VALUE DECREASE

GOLD & SILVER Scrips

NSE Scrips

BSE Scrips

BUY ORDER

SELL ORDER

NIFTY- FUTURES
DATE OPEN 1/4/201 0 5225 1/5/201 0 5280 1/6/201 5303. 0 25 1/7/201 0 5293 1/8/201 5270. 0 5 1/11/20 10 5275 1/12/20 10 5260 1/13/20 5183. 10 35 1/14/20 10 5260 1/15/20 10 5268 1/18/20 10 5239 1/19/20 5260. 10 5 1/20/20 5233. 10 9 1/21/20 5192. 10 65 1/22/20 10 4990 1/25/20 10 4996 1/27/20 4933. 10 7 1/28/20 4902. 10 1 1/29/20 4826. 10 15 2/1/201 4847. 0 3 HIGH 5247 5295 5303. 25 5293 5286 5295 5285 5248. 4 5275 5271. 9 5290 5274. 95 5247 5207 5074 5039 4963. 8 4935 4889. 9 4924 LOW 5210 5263. 05 5266. 25 5245. 15 5236. 4 5248. 15 5200 5176. 1 5244 5245. 05 5232 5212. 35 5195. 05 5072. 65 4946. 2 4976 4832. 6 4823. 1 4757. 85 4822. 25 CLOS VOLUM OPEN E E INTERST 5239. 118615 2301415 8 50 0 5281. 169566 2406440 2 00 0 5288. 147578 2449925 7 00 0 5266. 162565 2439140 35 00 0 5249. 138545 2415560 45 00 0 5256. 125462 2506080 1 00 0 5208. 222243 2492625 9 50 0 219589 2491095 5243 00 0 5261. 141522 2460500 3 50 0 5254. 113812 2479545 4 50 0 5271. 160828 2427600 15 00 0 5220. 179321 2403810 7 00 0 5214. 183480 2385445 75 50 0 5084. 383014 2527840 55 00 0 5019. 437616 2499880 65 00 0 5002. 258750 2169160 05 00 0 4848. 436694 1589040 15 48 0 4867. 375376 2 48 8826150 4875. 400769 2992330 65 52 0 4899. 234509 2989650 45 50 0

2/2/201 0 2/3/201 0 2/4/201 0 2/5/201 0 2/6/201 0 2/8/201 0 2/9/201 0 2/10/20 10 2/11/20 10 2/15/20 10 2/16/20 10 2/17/20 10 2/18/20 10 2/19/20 10 2/22/20 10 2/23/20 10 2/24/20 10 2/25/20 10 2/26/20 10 3/2/201 0 3/3/201 0 3/4/201 0 3/5/201 0 3/8/201 0 3/9/201 0 3/10/20 10

4937. 25 4844. 5 4904. 7 4731. 1 4725 4723. 7 4754 4814. 65 4785. 65 4837. 9 4807. 9 4907. 9 4903. 5 4840. 35 4905. 3 4832. 3 4846. 1 4870 4867 4979. 9 5032. 3 5072 5100 5133. 6 5121 5097

4939. 6 4949. 9 4908. 65 4754. 8 4769. 8 4806. 6 4818 4823. 7 4849 4840 4893. 5 4927. 9 4914. 8 4884. 95 4917 4889 4884 4875. 25 5002. 4 5034. 7 5089 5090 5116. 8 5145 5124. 7 5139. 6

4807. 05 4844. 5 4824 4687 4725 4667. 25 4735 4740. 1 4782 4777. 05 4788 4878. 05 4873. 05 4797. 35 4849 4830 4842. 3 4832. 2 4865. 2 4967. 05 5024. 85 5050. 3 5065. 35 5105. 2 5092. 2 5095. 65

4821. 75 4925. 8 4833. 6 4708. 25 4749. 35 4764. 9 4793. 35 4751. 15 4828. 85 4795. 7 4865. 2 4906. 75 4886. 8 4845. 95 4856. 6 4870. 55 4862 4860. 1 4930. 35 5022. 8 5081. 1 5081. 25 5087. 55 5117. 5 5097. 05 5118. 25

324629 50 326474 00 270617 00 354892 00 418205 0 363032 48 270612 00 341795 00 269797 50 197934 50 209498 00 259911 00 196792 50 299311 50 224441 00 223841 50 234695 00 228539 50 433585 00 209109 00 195130 50 192611 00 190627 50 160679 00 136398 00 176233 00

3221625 0 2992495 0 3066805 0 3137630 0 3134980 0 3126555 0 2923020 0 2987370 0 2853715 0 2892805 0 2866585 0 2728965 0 2649900 0 2476240 0 2272740 0 2070205 0 1486005 0 1024905 0 2263825 0 2292950 0 2506895 0 2485590 0 2533715 0 2589160 0 2603810 0 2620175 0

3/11/20 10 3/12/20 10 3/15/20 10 3/16/20 10 3/17/20 10 3/18/20 10 3/19/20 10 3/22/20 10 3/23/20 10 3/25/20 10 3/26/20 10 3/29/20 10 3/30/20 10 3/31/20 10 4/1/201 0

5118. 9 5168. 8 5122. 2 5134. 95 5224. 4 5244 5255. 25 5200. 3 5234. 7 5214. 95 5276 5291. 5 5324. 9 5279 5286. 1

5160. 9 5168. 8 5136. 25 5218. 5 5271. 9 5263. 7 5281. 9 5259. 9 5241. 9 5263. 9 5309. 9 5344 5331 5296. 1 5319. 75

5102. 6 5126. 15 5105. 5 5128. 15 5222. 1 5221. 4 5248. 1 5180 5193. 6 5204 5272. 6 5279. 4 5263. 25 5245 5276. 05

5146. 85 5144. 7 5131. 9 5204. 65 5239. 6 5254. 15 5274. 7 5213. 3 5226. 7 5260. 65 5296. 95 5318. 8 5273. 9 5261. 6 5306. 8

187216 00 161483 00 151896 00 206334 00 228930 50 164766 00 153784 00 250940 00 253114 50 212691 00 159589 50 162328 50 177227 50 218374 50 134794 50

2529520 0 2515550 0 2447865 0 2363115 0 2235830 0 2235130 0 2205805 0 1838500 0 1600225 0 1194020 0 2310590 0 2390315 0 2340345 0 2333870 0 2376890 0

CHART:

Opening price is taken from the first trade of the day (or period). The public tend to place orders at the opening of the market, reacting to the previous day's close. High price refers to the highest value for that trading day. Low price refers to the lowest value for that trading day. Closing price generally refers to the last price at which a stock trades during a regular trading session. Volume is a measure of market liquidity based on the number of shares that are traded over a given period. It is the business of the market itself that is the buying and selling of shares. Open Interest means the total number of options and/or futures contracts that are not closed or delivered on a particular day and the number of buy market orders

before the stock market opens.

Data interpretation: In the chart the above line indicates open interest and bottom line indicates volume. The candles in the center represents price i.e. open, low, high, close. The candles which are of black indicates negative close and of white indicates positive close. Negative indicates todays price is less than yesterday closing price. Positive indicates todays price is more than yesterday closing price.

CHAPTER-V

RESULT OF THE STUDY

SUMMARY:

Derivatives market is an innovation to cash market. Approximately its daily turnover reaches to the equal stage of cash market. The average daily turnover of the NSE derivative segment is high. In cash market the profit/loss of the investor depend on the market price of the underline. The investor may incur huge profits, or he may incur huge loss. But in derivative segment the investor enjoys huge profits with limited downside. In cash market the investor has to pay the total money but in derivatives the

investor has to pay premium or margins which are some percentage of total money. Derivatives are mostly used for hedging purpose. In derivative segment the profit/loss of the option writer is purely depend on the fluctuations of the underlying assets.

CHAPTER-V

SUGGESTIONS AND CONCLUSION

SUGGESTIONS Speeding of Dematerialization is required for overcoming the settlement delays involved. Administrative machinery of the existing stock exchange should be trained for successful derivatives trading. SEBI has to take further steps in the risk management mechanism. The derivative market is newly started in India and it is known by every investor, so SEBI has to take steps to create awareness among the investors

about the derivative segment. SEBI has to take measure to use effectively the derivatives segment as a tool of hedging. FINDINGS(or)CONCLUSION In the global markets today, derivatives occupy an integral part of the economy and virtually driving the world markets. With the introduction of derivatives trading in the form of futures and options, the Indian capital market too, is about to witness a qualitative change. Derivatives being speculative in nature, it is important for the market participants, especially investors to understand the principles as well as the practical and functional aspects and the risk attached with such trading.

ANNEXURE

LIST OF ABBREVIATIONS

BSE NSE NSDL CDSL FII F&O MTM NSCCL

Bombay Stock Exchange National Stock Exchange National Securities Depository Limited Central Depositories services limited Foreign Institutional Investors Futures and Options Mark to Market National Securities Clearing Corporation Limited

OTC NEAT RBI SC(R) A SEBI T+2 TM CBOT CME ETD IMM ITM AIM OTM EFT CC VAR LNW FD T Bill IOC MBP PT OO SQ

Over the Counter National Exchange for Automated Trading Reserve Bank of India Securities Contract (Regulation) Act 1956 Securities and Exchange Board of India Second day from the trading day Trading Member Chicago Board of Trade Chicago Mercantile Exchange Exchange- traded derivatives International Monetary Market In-The Money At- The Money Out of-The Money Electronic Fund Transfer Clearing Corporations Value at Risk Liquid Net Worth Fixed Deposits Treasury Bills Immediate or Cancel Market by Price Previous Trades Outstanding Orders Snap Quote

BIBLIOGRAPHY

BIBILOGRAPHY BOOKS: DMDM capital market (Dealers) modules. Derivates markets in India Susan Thomas, Tata

McGraw

Hill Series 1998

Financial Markets and Services GORDAN and NATRAJAN.

Financial Management PRASANNA CHANDRA.

 WEBSITES:

www.derivativesindia.com www.indianinfoline.com www.nseindia.com www.bseindia.com www.google.com www.yahoofinance.com www.futureindustry.com www.derviative.com