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FROM : Pankaj Dongre


Keeping in view the experience of even strong and developed economies the world over, it is no denying the fact that financial market is extremely volatile by nature. Indian financial market is not an exception to this phenomenon. The attendant risk arising out of the volatility and complexity of the financial market is an important concern for financial analysts. As a result, the logical need is for those financial instruments which allow fund managers to better manage or reduce these risks. Out of various risks, Credit Risk and Interest Rate risk are the two core risks, which are commonly acknowledged by various categories of Financial Institutions particularly banks. Effective management of these core risks is a critical factor in comprehensive risk management and is essential for the long-term financial health of business organizations, especially banks. With gradual liberalization of Indian financial system and the growing integration among markets, the risks associated with operations of banks and All India Financial Institutions have become increasingly complex, requiring strategic management. In keeping with spirit of the guidelines on Asset-Liability Management (ALM) systems and on integrated risk management systems, it is very much required to design risk management architecture, taking into consideration the size, complexity of business, risk philosophy, market perception and the level of capital. In addition, fine-tuning the risk management system to deal with credit and market risk is also the need of the hour. For enabling the banks and the financial institutions, among others, to manage their risk effectively, the concept of derivatives comes into picture.

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 lockingin 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.


A derivative is a financial instrument, which derives its value from some other financial price. This other financial price is called the underlying. The underlying asset can be equity, FOREX, commodity or any other asset. A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the derivative and wheat on the spot market is the underlying. The terms derivative contract, derivative product, or derivative are used

interchangeably. The most important derivatives are futures and options.

Example: A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk, which in turn depends upon the demand, and supply of milk. See it this way. American depository receipts/ global depository receipts of ICICI, Satyam and Infosys traded on stock exchanges in the USA and England have their own values? No. They draw their price from the underlying shares traded in India. Consider how the value of mutual fund units changes on a day-to-day basis. Dont mutual fund units draw their value from the value of the portfolio of securities under the schemes? Arent these examples of derivatives? Yes, these are.

And you know what; these examples prove that derivatives are not so new to us. Nifty options and futures, Reliance futures and options, Satyam futures and options etc are all examples of derivatives. Futures and options are the most common and popular form of derivatives. HISTORY OF DERIVATIVES:The derivatives markets has existed for centuries as a result of the need for both users and producers of natural resources to hedge against price fluctuations in the underlying commodities. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desais government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities was allowed to trade on exchanges. In June 2000, NSE and BSE started trading in futures on Sensex and Nifty.

Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. The market lots keeps on changing from time to time. The minimum quantity you can trade in is one market lot.

DERIVATIVES: AN INDIAN CONTEXT:In Indian context, the intensity of derivatives usage by institutional investors (viz. Banks, Financial Institution; Mutual Funds, Foreign Institutional Investors, Life and General Insurers) depend on their ability and willingness to use derivatives for one or more of the following purposes: Risk containment: using derivatives for hedging and risk containment purposes Risk Trading/Market Making: Running derivatives trading book for profits and arbitrage; and/or Covered Intermediation: On-balance-sheet derivatives intermediation for client transaction, without retaining any net-risk on the balance sheet (except credit risks). TYPES OF DERIVATIVES Derivative as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few smart finance professionals. In reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor can benefit immensely. A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities.

Derivatives and futures are basically of 3 types: Forwards and Futures Options Swaps







Interest Rate Security



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. 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.

Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longerdated 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 upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. 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.


Buy No. of Contracts Value [Rs in Cr] 2439.4 11243.89 3865.47 455.24 No. of Contracts

Sell Value [Rs in Cr] 2668.82 10932.87 4184.91 439.54

Net Buy / Sell Value [Rs in Cr] -229.42 311.02 -319.44 15.7

Open Interest at the EOD No. of Value [Rs in Contracts Cr] 543271 1895497 1184606 45777 13571.12 47737.76 28494.08 1147.13

Index Futures Index Options Stock Futures Stock Options

97181 452364 153959 18295

106947 438898 167407 17522


Traded Qty. 1218 3866 3300 378 936 696 665 122 4125 1140 1596 354 1745 1359 186 1695 637 372 3925 366

Turnover 2758.77 11209.47 5900.4 869.02 1872.94 3266.68 1452.36 429.81 9091.5 3312.84 3975.64 994.74 2357.5 3533.4 535.87 4152.75 2258.4 166.66 21832.81 1058.01

Market Lot 2000 1000 500 2000 2000 500 4000 2000 8000 2000 1000 250 2000 4000 2000 14000 125 2000 2500 500


Spot Price 50.85 413.95 121.4 60.85 597.7 152 810.45 1277.7 67.55 73 277.85 462.75 95.35 1918.35 107.15 71.4 54.55 2066.55 333.65 100.15

Future Price 51.35 414.8 120.15 61.25 600.45 152.75 813.65 1284.05 67.85 73.3 278.4 465 96 1923.3 107.55 71.6 54.95 2076.35 334.95 100.5

Basis 0.5 0.85 -1.25 0.4 2.75 0.75 3.2 6.35 0.3 0.3 0.55 2.25 0.65 4.95 0.4 0.2 0.4 9.8 1.3 0.35

Basis % 0.98 0.21 -1.03 0.66 0.46 0.49 0.39 0.5 0.44 0.41 0.2 0.49 0.68 0.26 0.37 0.28 0.73 0.47 0.39 0.35

Previous Basis 0.05 0.1 -0.15 0.05 0.35 0.1 0.45 1.05 0.05 0.05 0.1 0.45 0.15 1.2 0.1 0.05 0.1 2.55 0.35 0.1

900 750 733.33 700 685.71 650 611.11 504.76 500 500 450 400 333.33 312.5 300 300 300 284.31 271.43 250


Expiry Date 29-Dec-11 29-Dec-11 31-Dec-15 24-Nov-11 30-Jun-16 24-Nov-11

Put 200 17000 1600 141000 800 68000

Call 20 5000 500 50500 350 30500

Ratio 10 3.4 3.2 2.79 2.29 2.23