STUDY OF DERIVATIVES IN THE FINANCIAL MARKET

“STUDY OF DERIVATIVES IN THE FINANCIAL MARKET”

Submitted to Punjab Technical University in Partial Fulfillment of the Requirements for the Degree of

Master of Business Administration

Submitted By

ACKNOWLEDGMENT The written word has an unfortunate tendency to degenerate genuine gratitude into stilted formality. However this is only way we have to record permanently our feelings.

The completion of any project work is the endeavor of all the individuals that support, inculcate and foster the much needed enthusiasm and confidence to the doer of the project, without which the whole task would prove to be an impossible mission.

At every outset, I wish to express my sincere gratitude to Dr.XYZ, for encouragement, guidance and critical comments during course of study. I am greatly indebted to his kind behavior and sympathetic attitude. His indefatigable fact-finding zeal was a source of constant learning. Infect this work is a testimony to the significant contribution he has made to the study.

I am thankful to all faculty members of the department for their cooperation extended to me in many ways.

XYZ

Declaration I, here by declare that the project report “Study of derivatives in the financial market� is compiled and submitted by me is my original work. The empirical findings in the report are based on the data collected by me. However, various respondents and my project guide Dr.XYZ helped me at various points while preparing this report.

XYZ

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Certificate of Completion

This is to certify that the project report entitled “Study of derivatives in the financial market� submitted to Gian Jyoti Institute of Management and Technology, in partial fulfillment of the requirement for the degree of Master of Business Administration of Punjab Technical University, Jalandhar is a bonafide research carried out by XYZ under my supervision and guidance.

Area of specialization (Finance)

Project Guide

Submitted By:

Dr,XYZ

XYZ

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Chapter 1.

2

3

4

5

6

Table Of Contents

Pg no 7

Executive summary

8

Objective

9

introduction to derivatives

45

Participants in derivatives market

63

Emerging challenges

64

Organization of derivatives market

75

Review of Literature

78

Research methodology

79

Research design

80

Limitations of the study

81

Analysis

Suggestions and recommendations

108 Conclusion 5

109

111

Annexure

115

Bibliography

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Executive Summary

To know that how academic knowledge is applied in actual business situation, a real time project work is essential. This project report is

“Study of

Derivatives in the financial markets” deals with the study of concept i.e.

Derivative. It reveals information future, option, and forward contract. , the contribution of index future and index option. F&O segment has consistently been more than 4-5 times of the cash segment. By their very nature, the financial market is marked by a very high degree of volatility and risks.

Through the use of derivative product, it is possible to partially or fully transfer price risks by locking in assets.

According to ‘investor’ perception although the derivative market is growing day by day but the problems confronting the derivative market segment is giving it a low customer base. These problems can be overcome easily be revising the lot size, conducting awareness seminars etc.

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Objectives Of The Study  To study the concept of derivatives in detail.  To study the level of awareness of future’s, option’s and other derivative’s among respondents  To identify reasons for choice of derivative trading among investors  To find out the growth and acceptability of derivative trading in Indian financial markets.

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Introduction

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Derivatives The word “DERIVATIVES” is derived from the word itself i.e “derived” as they are derived from an underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc. Derivatives is a financial product (shares, bonds) that includes any act which is concerned with lending and borrowing (bank) and that does not have its own value, rather it borrows the value from underlying asset/ basic variables.

Derivatives is derived from the following products: A. Shares B. Debentures C. Mutual funds D. Gold E. Steel F. Interest rate G. Currencies.

All these constitute tools for management of financial risk. Further warrants, swaps, swap, options, collars, caps, floors, circuses and scores of other products are collectively known as derivatives Derivatives is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be derivatives having same views about the market. In short it is like an INSURANCE market where investors cover their risk for a particular position. Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities.

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Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives as means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives were launched in America. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was index futures. Financial regulators around the world are worried about derivatives, since the biggest traders and counter parties are banks.

Trading in derivatives often exceeds transactions in market for underlying securities or currencies. Derivatives are used by banks, securities firm, companies and investors to hedge risks, to gain access to cheaper money and to make profits. With the increasing volume of products tailored to the needs of particular customer, trading in derivatives has increased even in the over the counter markets. The popularity of derivatives is also traced to simple familiarity and more sophisticated way of pricing and managing business risks. In Britain, unit trusts are allowed to invest in futures and options. The capital adequacy norms for banks in European Economic Community demand less capital to hedge or speculate through derivatives then to carry underlying assets. Derivatives are weighted lightly than other assets that appear on bank balance sheets. The size off-balance sheets

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assets which include derivatives is more than seven times as large as balance sheet items at some American banks causing concern to regulators.

LETS UNDERSTAND BETTER: Consider a hypothetical situation in which ABC trading company has to import a raw material for manufacturing goods. But this raw material is required only after 3 months. However in 3 months the prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the prices would go up or come down. Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material prices would be offset by profits on the futures contract and vice versa. Hence the company can hedge its risk through the use of derivatives With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b. contract which derives its value from the prices, or index of prices, of underlying securities.

Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns.

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FEATURES OF DERIVATIVES: The three key features of financial derivatives are: 1. Their value is derived from an underlying instrument such as stock index (futures and options based on them), currency or interest rates.

2. They are vehicles for transferring risks.

3. They are leveraged instruments.

Literally a derivative is an asset, which derives, i.e., takes its origin from another asset. As a matter of fact, the price of a derivative instrument contingent on the value of its underlying asset. Accordingly, derivatives are also sometimes called contingent claims. The simplest form of a derivative is a forward contract, “it is an agreement to buy or sell an asset at a certain future time for certain price” The value of an existing forward contract depends on the ruling spot rate and forward margin for the currency; in other words, the value is the cash flow that needs to exchanges if the contract is to be canceled now. Other form of derivatives includes futures, options, swaps, etc.

Derivative can be classified based on the following features : •

Nature of contact

•

Underlying asset

•

Market Mechanism.

1. Nature of contract: Based on the nature of the contract, derivatives can be classified in to three categories: •

Forward rates contracts and futures 13

•

Options

•

Swaps

2.

Underlying asset: Most derivatives are based on one of the

following four types of assets: •

Foreign exchange

•

Interest bearing financial assets

•

Commodities

•

Equities

A contract can be similar in all aspects for the underlying asset. Thus an option contract can exist in commodity or a currency.

3. Market Mechanism: •

OTC products

•

Exchanges traded products

Functions performed by derivatives markets: Price discovery: The futures and options markets serve an all important function of price discovery. The individuals with better information and judgment are inclined to participate in these markets to take advantage of such information.

When some new information arrives, perhaps some good news about the economy, for instance, the actions of speculators swiftly feed their information into the derivative markets causing changes in prices of the derivatives.

Risk Transfer: By their very nature, the derivative instruments do not themselves involve risk. Rather, they merely redistribute the risk between the market participants. In this sense, the whole derivatives market may be compared to a gigantic insurance company-providing means to hedge against adversities of unfavorable market movements in return for a premium, and providing means and opportunities to those who prepared to take risks and make money in the process.

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Market completion: The existence of derivative instruments adds to the degree of completeness of the market. A complete market implies that the number of independent securities (or instruments) is equal to the number of all possible alternative future states of the economy. To understand the idea, let us recall that the derivative instruments of futures and options are the instruments that provide an investor the ability to hedge against possible odds (or events) in the economy. A market would be said to be complete if instruments may be created which can, solely or jointly, provide a cover against all the possible.

Importance of derivatives: Derivatives have become very popular and because of their unique nature, they offer a combination of characteristic, which are not found in other assets.

There are four important features that distinguish derivative from underlying asset and make them useful for a variety of purposes: It is easier to take short position in derivative than in other assets: As all transactions in derivatives take place on future specific dates. It is easy for the investor to sell underlying assets. The short position means taking stand for selling the underlying asset, with or without possessing it. He can assess the market or product, which is otherwise not possible in any other asset.

Exchange traded derivatives are liquid and have low transaction cost: Exchange traded derivatives are more liquid and have lower transaction costs than other assets. They are more liquid because they have standardized terms and low credit risk. Furthermore, their transaction costs are low due to high volume in trade and high competition. In addition, margin requirement in the exchange-traded derivatives is relatively low, which reflects that the risk associated with this instrument is low It is possible to construct a portfolio, which is exactly needed, without having the underlying assets; Derivative can be constructed or combined to closely match specific portfolio requirement.

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Forward Contracts: Forward contract is an agreement between buyer and seller obligating the seller to deliver a specified quality and quantity to the buyer on specified date at a specified place and buyer in turn ready to pay to the seller prenegotiated price in exchange of delivery .

This mean in forward contract, the contracting parties negotiate not only the price at which commodity is to be delivered on a future date but also quality and quantity to be delivered at what place. No part of the contract is standardized. A forward contract is good means of avoiding price risk, but it entails an element of risk in that party to the contract may not honor its part of obligation. Thus, each party has the risk of default.

A forward contract is a simple derivative that involves an agreement to buy/sell an asset on a certain future date at an agreed price. This is a contract between two parties, one of which takes a long position and agrees to buy the underlying asset on a specified future date for a certain specified price. The other party takes short position, agreeing to sell the asset at the same date for the same price. Thus, when one orders a car, which is not in stock, from a dealer, one is in fact buying a forward contract for the delivery of a car. The price and description of the car are specified.

The mutually agreed price in a forward contract is known as the delivery price. The delivery price is chosen in such a way that the value of the forward contract to both the parties is zero, so that it costs nothing to take either a long or a short position. On maturity, the contract to the holder of the long position who in turn pays cash amount equal to the delivery price.

The value of a forward contract is determined, chiefly, by the market price of the underlying asset. As mentioned above, initially the value of such a contract is zero. But later, as the price of the underlying asset moves up or down, the contract assumes a positive underlying asset moves up or down, the contract assumes a positive or negative value. Thus, for instance, if the price of the asset increases substantially after the contract is entered in to, 16

the contract would have positive value for he holder of the long position while it would be negative for the one holding the short position.

For example, suppose A and B enter into a contract where by A agrees to deliver one kg of silver to B on April 15, 1998 at a price of Rs 7200.

Now, if the price of silver on that day is quoted at Rs 7800 per kg, who is short the contract would stand to lose Rs 600 on the contract and B, who is long, would gain the same amount.

INTRODUCTION TO FUTURE MARKET Futures markets were designed to solve the problems that exit 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. There is a multilateral contract between the buyer and seller for a underlying asset which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded.

PURPOSE The primary purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk. It is a derivative instrument and a type of forward contract The future contracts are affected mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has to pay the margin to trade in the futures market It is essential that both the parties compulsorily discharge their respective obligations on the settlement day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here both the parties face an equal amount of risk and are also required to pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in cash unlike futures on individual stocks which are very rare and yet to be launched even 17

in the US. Most of the financial futures worldwide are index based and hence the buyer never comes to know who the seller is, both due to the presence of the clearing corporation of the stock exchange in between and also due to secrecy reasons

Futures are considered to be better when compared to forwards because of the following reasons:  Standard Volume  Liquidity  Counterparty guarantee by exchange  Intermediate cash flows.

EXAMPLE Suppose the current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares.

Suppose the stock rises to 2200.

Profit

20 2200 10 0 1400 1500 1600 1700 1800 1900 -10 18

-20 Loss Unlimited profit for the buyer (Hitesh) = Rs.1,65, 000 [(2200-1650*3oo)] and notional profit for the buyer is 500.

Suppose the stock falls to Rs.1400 Profit

20 10 0 1400 1500 1600 1700 1800 1900 -10 -20 Loss Unlimited profit for the seller = Rs.75, 000.[(1650-1400*300)] and notional profit for the seller is 250.

Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some date in the future. Futures are often used by mutual funds and large institutions to hedge their positions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in proportion to the total value of contract.

Type of Future : Commodity futures: 19

A future contract, where the underlying asset is a commodity, is referred to as a commodity futures contract.

Agricultural commodities: Commodities such as corn, soybeans, sugar, cotton, coffee seeds, etc., which indeed form a part of daily consumption, are traded on the futures exchange.

Though all of them form a part of agricultural commodities, they are further segregated in to grains, soft commodities and meat futures.

Metallurgical commodities: The metallurgical category includes genuine metals and petro products. The metals are further grouped into precious and industrial metals. In general, the precious metals are in relative short supply and they retain value irrespectively of the conditions of the economy.

The single stock futures Single stock futures is a special type of deferral products, which allows traders to carry forward their positions while taking more long term view of the market. It can be used: ďƒ˜ As a straight substitute for the cash market when investigating or speculating. ďƒ˜ As a leverage instrument for hedging or speculative purposes and ďƒ˜ As a tool for price discovery However, it is different from badla system in Indian context, where whole transaction is carried forward up to 90 days by paying price difference at the end of each settlement period. While taking future position under the stock future it would involve fund outlay in the form of initial margin i.e., certain 20

value of transactions to be deposited with the exchange. This (Margin A/C) is needed for adjusting mark to market losses or gains. One can have margins calls everyday as and when it falls below maintenance level. Further extra balance above that level may be withdrawn but it should not be negative at any point of time. It is also different from the stick options. The buyer of the option pays upfront premium from the stock options. The buyer of the option pays upfront premium to acquire the right to buy or sell the underlying at a future date. The seller on the other hand, receives premium but assumes unlimited risks due to adverse price fluctuations for him.

Features: Leveraged product: Single stock future provides a way to gain access to the performance of stock without either owning the stock or paying full considerations. For instance, a particular stock trades at Rs. 1000 and onemonth future trades at Rs.1004. Suppose, an investor is required to buy 100 contracts and pay a margin of 30pc, i.e., Rs 30000(30pc*100*Rs.1000). Now when the stocks moves up Rs. 1010 and the futures converge with the spot at expiry, then he, the buyer stands to gain [100(1010-1004)] of Rs 600, i.e.,2pc {600/30000*100}. In the cash segment he happens to have purchased 100 contracts and paid 100*Rs.1000=Rs.100000. suppose he sold @ Rs. 1010, his gain will be 100*(1010-1000) =Rs.1000 and his percentage gain will be (1000/100000*100) 1 pc only.

Risk management tool: An investor in the cash segment can minimize both market risk and price risk of the underlying stock by taking contra position in the futures. For instance, Mr. X extremely bullish about a company over next three months. Thus he can buy stock futures of that company with three maturity. At the same time in order to hedge his possible downside he can buy a put option on that stock to limit his loss. This combination can help investors to take appropriate position with automatic cap on the loss in case of adverse trends.

Synthetic futures: Stock futures have special characteristics over the options. Combining two options synthetic futures can be obtained. For 21

instance, buying call option and selling out put option give returns similar to that of long future. Thus one can hedge his position combining both put and call option. However, pricing the options is a complicated as well as costly affair than of futures. Besides availability of both the products, options and futures, would allow hedging, arbitrage and efficient cost reduction by way of cross margining Arbitrage: It is a mechanism followed in the derivative segment in which a group of participants called arbitrageur lock themselves in a risk less profit by simultaneously entering on to the two transactions in two or more markets.

This facility would lead to the market buoyancy by introducing an efficient price discovery mechanism. When the futures are under valued or overvalued, one could take the advantage of carry cost by taking position in the cash market and counter position in the future market.

Advantages Opportunities for financiers: The investor having insufficient cash needs financiers to fund their purchases. In Indian context the badla financiers served the purpose. The cessation of the carry forward products however, led to sharp fall in trading volumes. More margin trading could not gain ground, as the bankers are shy away from the capital market. The stock futures, on the other hand would provide an opportunities to the financiers to return to the market. They can buy in the spot market and sell them on future basis leading to increase in total volume of trade in the whole market Boost to investors: The retail investors have virtually driven out from the market due to restriction imposed on the cash market. Further failure of margin trading owing to lack of active bank financing coup-pled with investors own weak resource base, the depth of market has declined. Besides, only a few investors have sophistication what is required in the option trading. The futures in this context are fairly simple to trade and their intricate are well understood

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Risk management: Risk management is a major issue of the stock market operation and the risk transfer has become the name of the game. Generally, futures are riskier than option as its buyer can cap the losses to the amount of upfront premium paid. However, several combinations of stock futures and options may be created to hedge one’s position. The option writers therefore, can take position in the future segment of the market Risk manipulation : The market participants may take the advantage of poor liquidity in the cash market to manipulate the underlying. However, the stock futures enable manipulators to fix prices in the cash market and to take advantage in the future segment, as the transactions are cash settled. This ultimately makes the cash market more liquid as well as deeper and ensures growth of market by reducing risks.

Contract specifications for futures: A Future contract between two parties should specify in some detail the exact nature of the asset, price, contract size, delivery arrangements, delivery months, tick size, limits on daily price fluctuation and trading unit.

The Asset: The delivery of the asset needs to be specified at the time of entering in to a contract. When the underlying asset is a commodity, there may be variations in the quality of what is available in the market; therefore, it becomes important to specify the grade of the commodity that is to be delivered.

The price: The price agreeable to the buyer and the seller at the time of delivery of the futures contract is specified at the time of agreement. The future prices quotes are convenient and easy to understand The contact size: This specifies the asset that has to be delivered under one contract. If the size of the contact is too large, many investors cannot use the exchange for hedging or for speculative purposes. This is because speculators may not wish to take large positions due to risk. However, if the 23

contract size is too small, trading becomes expensive due to the cost associated with trading Delivery agreements: The place for delivery needs to be specified at the time of the contract to avoid controversy. The location or place of delivery becomes a major issue when the transportation costs are significant.

However, if any alternative delivery location is specified, the price received by the seller is sometimes adjusted according to the place chosen by him.

Sometimes alternatives are specified for the grade of the asset that will be delivered or for the delivery locations Delivery months: A Future contract is referred to by its delivery month. For example, July corn means that the contract is due to for delivery in the month of July. The delivery months vary from one contract to another depending upon the underlying asset, and also on the needs of market participations.

For certain contracts the deliver period will be any time during the month.

Trading on contracts is generally ceases a few days before the last day on which the delivery can be made. The date on which the contract ceases to trade is specified by the exchanges.

Tick Size: The contract also specifies the minimum price fluctuation or tick size. For example, in soybean, one tick is1/4 cent per bushel as the minimum size of contract for soybean is 5000 bushels, which gives a tick of $ 12.50 per contract.

Limits on daily price movements: The daily price movement’s limits are specified by the exchange. If the price moves up by limit, it is referred to as limit up and if it moves down by a limit, it is referred to as limit down. The prime purpose of the daily price limits is to prevent large price fluctuations that may occur due to excessive speculations and also to safeguard the interests of genuine traders. The limits are set by the exchange authorities.

Trading unit: This specifies the minimum number of units that are traded on the exchange for example; the trading unit for soybean oil is 60,000pounds on 24

CBOT exchange apart from the above specifications there are certain definite specifications pertaining to each of the categories based on underlying assets STOCK INDEX FUTURES: DEFINITION Stock index futures contract is an agreement to buy or sell a specified amount of an underlying stock index traded on a regulated futures exchange for a specified price for settlement in future. The stock index futures have the following characteristics:  It is an obligation and not on option  Settlement value depends (a) on the value of stock index and the price of which the original contract is struck, and (b) on specified times the differences between the index value at the last closing day of the contract and the original price or contract.  Basis of stock index futures is the specified stock market index. No physical delivery of stock is made.

1. These contracts are cash settled; there is usually no delivery of the underlying stocks or stocks or stock certificates, as matching the physical stocks as per the index may be quite difficult and costlier than settling the contract by cash 2. An investor can either buy or sell an index future contract. When an investor goes long in the index futures contract, he will receive a cash settlement on the expiration date, if the closing price exceeds the contract price. On other hand, if the closing price is less than the contract price, the investor will be required to pay the difference.

For Example, if the investor has bought the S&P 500 index futures at 350 and on the expiration day the value of the contract is 360, the investor will receive $5,000 (360-350)*500). On the other hand, if the index closes at 340, on the expiration date the buyer will be required to pay the difference of $ 5,000.

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An investor going short on the index futures contract stands to gain (lose) if, on the expiration day, the value of the index is less (more) than the contracted value. In our example, the investor going short on S&P 500 index future at 350 will receive a sum o $ 5000, if the index closes at 340 on expiration day and will be required to pay $5,000, if the index closes at 360.

3. Since Index futures contracts are listed and traded on futures exchanges, the investor can offset his position on any day prior to the expiration day. For example, an investor who has gone long on an index futures contract can offset his position by going short on the contract and vice versa.

4. The performance of all index futures contracts are guaranteed by the exchange’s clearing house. As in case of options exchanges, the clearing house becomes the counterparty to both the buyer and the seller.

5. The index futures carry the margin requirements, which are applicable to both buyer and the seller. The purpose of maintaining margin money is to minimize the risk of default by either party. The payment of margin ensures that the risk is limited to the previous day’s price movement on each outstanding position. Margin money is a kind of security deposit or insurance against a possible future loss of value. The margin can be maintained either in the form of risk free sort dated government securities or in the form of cash. There can be different types of margins like initial margin, variation margin, maintenance margin and additional margin.

Stock index futures: Origin Trading in stock index based on value line index commenced on February 24, 1982 on Kanses City Board of trade previously known as the mart fir hard winter wheat, the staple of America’s bread baking industry. Two months later Chicago Mercantile Exchange’s began offering futures on S&P 500 and 26

NYSE followed with a contract on its composite index, offered on its subsidiary, the New York most successful one. Other future contract based on S&P 500 index is in U.S.A., London international financial futures Exchange (LIFFE), in 1997, German, Swiss and French (MAIF) financial exchange offered to develop a joint computer based European derivative market. They will do this by building electronic links between their stock market. This move has been abandoned by London and Frankfurt Exchange jointly together.

Merits of index based futures 1. Liquidity: Stock index futures enjoy distinctly greater popularity and are likely to be more liquid than all other types of equity derivatives 2. Cost-effective: An institutional and other large equity holder needs a portfolio hedging facility. Hence index based derivatives are more suited to them and more cost- effective than derivatives based on individual stocks.

Even pension funds in US are known to use stock futures for risk hedging purposes.

3. Manipulation: Stock index is more difficult to manipulate than individual stock prices, more so in India, and the possibility of concerning as reduced.

This is partly because the individual stock has limited supply, which can be concerned. Of course, the liquidity greater than all manipulation of stock index can be attempted by influencing the cash prices of its component securities.

While the possibility of such manipulation is not ruled out, it is reduced by designing the index appropriately. There is need for minimizing it further by undertaking cask market reforms.

4. Less-Volatile: Stock index being an average is much less volatile than individual stock prices, this implies much lower capital adequacy and margin requirements in case of index futures than in case of derivatives on individual stock. The lower margin will induce more players to join market.

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5.Benefit to Mutual fund:  Index futures can be sold immediately at much less cost  Purchase of stock index futures gives adequate time for planned purchase of equities.  Partial liquidation of securities in case of open-ended schemes may be difficult due to illiquid stock. Repurchase of units may create the need for funds. Stock index futures can help to overcome this problem by providing easy liquidity.  Sometimes entire equity portfolio value may fall substantially if event, say X-occurs sale of stock index futures can be used to provide an insurance against risk. The neutralizing effects of index futures keep the yearly results unaffected.

Motives behind futures Hedging: Futures markets were formed originally to meet the needs of farmer and merchants. One can take position solely for the purpose of establishing a known price level – weeks or months in advance –or for either going long or short in cash market to minimize the risk. An individual who hedges is called hedger and the activity of trading in futures to control or reduce risk is called hedging.

Example: How the futures market is used for hedging. Suppose it is now June and you are a manufacturer of cotton apparels and in need of 200,000 pound of cotton in October 20*2 and are of the opinion that the price would rise. Currently, on the new York cotton exchange (NYCE) the October cotton No.2futures are trading at 57.00 cents per pound. You enter in to a futures contract for 2,00,000 pounds, for which you need to buy 4 contracts (minimum contract size is 50,000 pounds an NYCE) and lock your price at 57.00 cents per pound( i.e. your total outflow in October will be $1,14,000).

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Assume that in October the cask market price of cotton is 58.55 cents per pound. You will have to pay the supplier $1, 17,100 to procure cotton.

However, the extra cost of 1.55 cents per pound ($3,100) which you will have to pay for procuring cotton will be offset by a profit of 1.55 cents per pound when the futures contract is sold at 58.55. In other words, hedging provides insurance against insurance in price. However, had the price of cotton declined instead of rising, you would have incurred a loss on your futures position but this would have been offset by the lower cost of acquiring cotton in the cash market.

Long hedging ad Short Hedging: Short hedging is also known as selling hedge and it happens when the futures are sod in order to hedge the cash commodity against declining prices.

Long hedging is also known as buying and it happens when the futures are purchased to hedge against the increase in the prices of a commodity to be acquired either in the spot or futures market.

Short and long hedges can be with or without risk. Depending on the extent of minimization of basis risks, four outcomes are possible.

1. Short hedge without basis risk 2. Short hedge with basis risk 3. Long hedge without basis risk 4. Long hedge with basis risk Purpose of future markets: Future markets are relevant because of various reasons: Quick and low transaction cost: Since these low cost instruments lead to a specified delivery of goods lead to a specified price on a specified date, it becomes easy for finance manager to take decision with regard to production, consumption and inventory.

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Advantage to inform individual: Individual who has better information regarding demand supply, market behavior, technology changes can operate in future markets in an efficient way Hedging advantage: Adverse price changes which may lead to looses, can be efficiently hedged against future contracts, e.g. a trader who has imported consignment of metal and the shipment is to reach within a month. He may sell metal if he foresees fall in metal price. On the contrary, if metal price rise, trader will honor the delivery of the Future contract through the imported metal stock already available with him.

Difference between Forwards and Futures Features

Financial Futures

Forwards

Location

Future exchange

No fixed location

Size of contract

Fixed

Depends on the terms

of contact Maturity/ payment date Central exchange floor Over the telephone with Valuation

with worldwide network worldwide network Marked to market No unique method of

Variation margins

everyday Daily

Regulations in trading

Regulated

Settlement

exchanges Concerned Through clearing house

Liquidation

contract Mostly by offsetting the Mostly settled by actual

valuation None by

the self regulated Depends on terms of

positions very few by delivery.

Transaction costs

Some

by

delivery cancellation at a cost Direct costs such as Direct costs are commission, charges,

clearing generally low, indirect exchanges costs are high in the

fees are high; indirect form of high bid-ask costs, bid-ask spreads spread 30

are low

SWAPS Swap contracts, in comparison to forwards, futures and options, are one of the more recent innovations in derivatives contract design. The first currency swap contract, between the World Bank and IBM, dates to August of 1981.

The basic idea in a swap contract is that the counterparties agree to swap two different types of payments. Each payment is calculated by applying some interest rate, index, exchange rate, or the price of some underlying commodity or asset to a notional principal. The principal is considered notional because the swap generally does not require the transfer or exchange of principal (except for foreign exchange and some foreign currency swaps). Payments are scheduled at regular intervals throughout the tenor or lifetime of the swap. When the payments are to be made in the same currency, then only the net amount of the payments are made.

Interest rate swaps are financial instruments used to create future price exposure in interest rates in order to allow hedging and speculation in interest rates. Payments in an interest rate swap contract are designed to match interest rate payments on bonds and loans. For instance, take the situation faced by a corporation that has borrowed through a variable interest rate loan or a floating rate note. That corporation is exposed to the risk that short-term interest rates will rise during the life of the loan or note. In order to hedge against this exposure, the corporation can enter into an interest rate swap of the same maturity so that the floating rate payments are swapped for fixed rate payments.A foreign exchange swaps differs from an interest rate swap because the principal is exchanged (due to the fact that the payments, which must be in currency, amount to the “principal� in the transaction). A typical foreign exchange swap begins with a start leg that is indistinguishable from a spot transaction in which one currency is exchanged for another at the present spot rate. The second, or close leg, is a forward transaction at the present forward 31

foreign exchange rate. Thus a foreign exchange swap is essentially the combination of a spot and forward foreign exchange transaction.

Swaps contracts are traded in over-the-counter (OTC) derivatives markets, and in the United States they are not subject, i.e. are excluded from, to the Commodity Exchange Act. Foreign exchange swap. A foreign exchange swap is simply the combination of a spot and forward transaction (or possibly two forwards). The start leg of the swap usually consists of a spot foreign exchange transaction at the current spot exchange rate, and the close leg consists of a second foreign exchange transaction at the contracted forward rate. For example, a local investor enters a foreign exchange swap of pesos against dollars in which it buys $100,000 today at an exchange rate of $0.050 per peso (thus paying 2,000,000 pesos), and contracts to sell $100,000 dollars (i.e. buy pesos) at $0.0475 in 180 days. The local investor first receives $100,000 in the start leg, and then upon the swap expiration date pays $100,000 in exchange for receiving 2,105,263 pesos in the closing leg. This 10.8% annual rate of return in pesos is due to the depreciation of the peso against the dollar (or appreciation of the dollar against the peso) and reflects the fact that the peso rate of return from investing in the local currency is higher than the U.S. dollar rate of return.

Foreign exchange forwards and swaps are used by both foreign and domestic investors to hedge foreign exchange risk. Foreign investors from advanced capital markets who purchase securities denominated in local currencies use foreign exchange forwards and swaps to hedge their long local currency exposure. Similarly, foreign direct investments in physical real estate, plant or equipment are exposed to the risk of local currency depreciation. Local developing country investors who borrowed in major currencies in order to invest in local currency assets are also exposed to foreign exchange risk, and they too use foreign exchange forwards and swaps – as well as futures and options where available – to manage their risks.

32

Of course foreign exchange forwards and swaps were also used for speculation in these local currencies. Derivatives enabled speculators to leverage their capital in order to take larger positions in the value of local currencies. It means that developing country central banks must watch the exchange rate in two markets, the spot and forward, in order to maintain their fixed exchange rates.

Structured notes. Structured notes contain features of both conventional credit securities and derivatives. The term “note” usually refers to a public or private credit instrument like a bond, and may have a maturity that ranges between two and ten years. The term “structured” refers to attached derivative or other contingent payment schedule. Structured notes are part of a broader class of financial instruments called “hybrid instruments” which contain features of both securities and derivatives. Examples of hybrid instruments include familiar instruments such as callable bonds, convertible bonds and convertible preferred stock.

One well known structured note is called a PERL — principal exchange rate linked note. These instruments are rated as investment grade and denominated in U.S. dollars, but their payments were linked to a long position in the value of a foreign currency. The compensation or premium for holding this exchange rate exposure was a higher than normal yield in comparison to a similarly rated dollar denominated notes. If the foreign currency exchange rate remained fixed, or did not decline too far in value, then the higher yield would be realized. A devaluation or a substantial depreciation, however, could cause the return of the note to fall below the norm and in the event of a major depreciation the structured note might realize a negative return.

MARGINS Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk of the stock/index

33

margins are calculated. In general margin ranges between 10-50% of the contract value.

PURPOSE The purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations.

TYPES OF MARGINS INITIAL MARGIN: This is just an initial amount that a trader must depend before trading in any futures contract. In some of the contacts, this margin will be equal to 5 percent approximately. The initial margin is returned to the party after due completion of all obligations associated with trades futures position.

If a party deposits a security as the margin, then the party earns the interest that accrues to the asset while keeping it as security for margins requirements. It is a amount that a trader must deposit before trading any futures. The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper completion of all obligations associated with a traders futures position, the initial margin is returned to the trader.

OBJECTIVE The basic aim of Initial margin is to cover the largest potential loss in one day.

Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction.

MAINTENANCE MARGIN The maintenance is generally 75 percent of initial margin. This margin is strictly maintained to ensure that the balance in the margin account will never become negative or zero. The investor can withdraw any amount in excess of the initial margin. When the balance in margin account falls below the margin, bringing the balance back to he initial level.

34

VARIATION MARGIN: The amount of additional or extra funds to be deposited by the trader is referred to as ‘variation margin’. If the investor fails to deposit variation margin, the broker closes out the position by selling the contract.

ADDITIONAL MARGIN: In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.

CROSS MARGINING: This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN: It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly script of SATYAM falls then the investor is required to pay the mark-to-market margin also called as variation margin for trading in the future contract

INTRODUCTION TO OPTIONS It is a interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity

stocks/

stock

index/

35

bonds

etc.

MONTHLY OPTIONS The exchange trade option with one month maturity and the contract usually expires on last Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS Investors often face a problem when hedging using the three-monthly cycle options as the premium paid for hedging is very high. Also the trader has to pay more money to take a long or short position which results into iiliquidity in the market. Thus to overcome the problem the BSE introduced WEEKLY OPTIONS

WEEKLY OPTIONS The exchange trade option with one or weak

maturity and the contract

expires on last Friday of every weak ADVANTAGES 

Weekly Options are advantageous to many to investors, hedgers and traders.



The premium paid for buying options is also much lower as they have shorter time to maturity.



The trader will also have to pay lesser money to take a long or short position.



the trader can take a larger position in the market with limited loss. On account of low cost, the liquidity will improve, as more participants would come in.



Weekly Options would lead to better price discovery and improvement in market depth, resulting in better price discovery and improvement in market efficiency

TYPES OF OPTION:  CALL OPTION A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation 36

to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract.

ILLUSTRATION Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market.

The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25 CALL BUYER Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660.

Profit

30 20 10 0 590 600 610 620 630 640 -10 -20 -30 Loss Unlimited profit for the buyer = Rs.35{(spot price – strike price) – premium} Limited loss for the buyer up to the premium paid.

37

1. CALL SELLER: In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option.

Profit 30 20 10 0 590 600 610 620 630 640 -10 -20 -30 Loss Profit for the Seller limited to the premium received = Rs.25 Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30 Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent Thus call option indicates two positions as follows: 

LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call option. 

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call option.

38

Call option

Right to buy

Obligation to sell

Long position

Short position

Buyer of call

Seller of call

Holder to call

Writer to call

 PUT OPTION A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

ILLUSTRATION Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit(put

seller) who is bullish in the

market.

The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0 1) PUT BUYER(Dinesh): Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be exercised once the price went below 800. The premium paid by the buyer is Rs.20.The buyer’s breakeven point is Rs.780(Strike price – Premium paid). The buyer will earn profit once the share price crossed below 39

to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the TISCO scrip from the market at Rs.700and sell to the seller at Rs.800 Profit 20 10 0 600 700 800 900 1000 1100 -10 -20 Loss Unlimited profit for the buyer = Rs.80 {(Strike price – spot price) – premium} Loss limited for the buyer up to the premium paid = 20 2). PUT SELLER(Amit): In another scenario, if at the time of expiry, market price of TISCO is Rs. 900.

The buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. profit 20 10 0 600 700 800 900 1000 1100 -10 -20 Loss Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = 780 - 750 = 30 Limited profit for the seller up to the premium received = 20 Thus Put option also indicates two positions as follows : 40



LONG POSITION

If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Put option. 

SHORT POSITION

If the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put option.

Option

buyer

CALL OPTIONS PUT OPTIONS or Buys the right to buy the Buys the right to sell the

option holder Option

underlying asset at the underlying asset at the

seller

specified price specified price or Has the obligation to sell Has the obligation to buy

option writer

the underlying asset (to the

underlying

asset

the option holder) at the (from the option holder) specified price

Put option

41

at the specified price.

Right to sell

Obligation to buy

Long position

Short position

Buyer of put

Seller of put

Holder to put

Writer to call

The positions of the buyer and seller in call and put options are given below.

Option type

Buyer option

Writer of call

(Long position) (Short position) Call

Right to buy asset

Obligations to sell asset

Put

Right to sell asset

Obligations to buy asset

FACTORS AFFECTING OPTION PREMIUM



THE PRICE OF THE UNDERLYING ASSET: (S)

Changes in the underlying asset price can increase or decrease the premium of an option. These price changes have opposite effects on calls and puts.

For instance, as the price of the underlying asset rises, the premium of a call will increase and the premium of a put will decrease. A decrease in the price of the underlying asset’s value will generally have the opposite effect



THE SRIKE PRICE: (K)

42

The strike price determines whether or not an option has any intrinsic value.

An option’s premium generally increases as the option gets further in the money, and decreases as the option becomes more deeply out of the money.



TIME UNTILL EXPIRATION: (T)

An expiration approaches, the level of an option’s time value, for puts and calls, decreases.



VOLATILITY:

Volatility is simply a measure of risk (uncertainty), or variability of an option’s underlying. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at- the- money options.



INTREST RATE: (R1)

This effect reflects the “COST OF CARRY” – the interest that might be paid for margin, in case of an option seller or received from alternative investments in the case of an option buyer for the premium paid.

Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET: a) Developmental institutions b) Mutual Funds c) Domestic & Foreign Institutional Investors d) Brokers e) Retail Participants

FUTURES V/S OPTIONS  RIGHT OR OBLIGATION : 43

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset.  RISK Futures Contracts have symmetric risk profile for both the buyer as well as the seller.While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.  PRICES: The Futures contracts prices are affected mainly by the prices of the underlying asset.

While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset.  COST: It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.  STRIKE PRICE: In the Futures contract the strike price moves while in the option contract the strike price remains constant.  LIQUIDITY: As Futures contract are more popular as compared to options. Also the premium charged is high in the options. So there is a limited Liquidity in the options as compared to Futures. There is no dedicated trading and investors in the options contract.  PRICE BEHAVIOR: The trading in future contract is one-dimensional as the price of future depends upon the price of the underlying only.

44

While trading in option is two-dimensional as the price of the option depends upon the price and volatility of the underlying.  PAY OFF: As options contract are less active as compared to futures which results into non linear pay off. While futures are more active has linear pay off .

PRICING OF AN OPTION 

DELTA

A measure of change in the premium of an option corresponding to a change in the price of the underlying asset.

Change in option premium Delta =

-------------------------------Change in underlying price

FACTORS AFFECTING DELTA OPTION: 

Strike price



Risk free interest rate



Volatility



Underlying price



Time to maturity

ILLUSTRATION The investor has buys the call option in the future contract for the strike price of Rs.19. The premium charged for the strike price of 19 at 0.80 The delta for this option is 0.5.Here if the price of the option rises to 20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30.

45

Here in the money call option will increase the delta by 1.which will make the value more and expensive while at the money option have the delta to 0.5 and finally out the money call option will have the delta very close to 0 as the change in underlying price is not likely to make them valuable or cheap and reverse for the put option Delta is positive for a bullish position (long call and short put) as the value of the

position increases with rise in the price of the underlying. Delta is

negative for a bearish

position (short call and long put) as the value of the

position decreases with rise in the price of the underlying.

Delta varies from 0 to 1 for call options and from –1 to 0 for put options. Some people refer to delta as 0 to 100 numbers.

ADVANTAGE The delta is advantageous for the option buyer because it can tell him much of an option and accordingly buyer can expect his short term movements by the underlying stock. This can help the option of an buyer which call/put option should be bought.

GAMMA A measure of change in the delta that may occur corresponding to the rise or fall in the price of the underlying asset. change in option delta Gamma =

__________________ change in underlying price

The gamma of an option tells you how much the delta of an option would increase or decrease for a unit change in the price of the underlying. For example, assume the gamma of an option is 0.04 and its delta is 0.5. For a unit change in the price of the underlying, the delta of the option would change to 0.5 + 0.04 = 0.54. The new delta of the option at changed underlying price is 0.54; so the rate of change in the premium has increased.

46

suppose the delta changed to 0.5-0.04 = 0.46 thus the rate of premium will decreased .

In simple terms if delta is velocity, then gamma is acceleration. Delta tells you how much the premium would change; gamma changes delta and tells you how much the next premium change would be for a unit price change in the price of the underlying.

Gamma is positive for long positions (long call and long put) and negative for short positions (short call and short put). Gamma does not matter much for options with long maturity. However for options with short maturity, gamma is high and the value of the options changes very fast with swings in the underlying prices

ď ą

THETA:

A measure of change in the value of an option corresponding to its time to maturity. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio.

Change in an option premium Theta = -------------------------------------Change in time to expiry Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases.

ILLUSTRATION Suppose the theta of Infosys 30-day call option with a strike price of Rs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% and the risk-free interest rate is 8%. This means that if the price of Infosys and the other parameters like volatility remain the same and one day passes, the value of this option would reduce by Rs.4.5.

ADVANTAGE 47

Theta is always positive for the seller of an option, as the value of the position of the seller increases as the value of the option goes down with time.

DISADVANTAGE Theta is always negative for the buyer of an option, as the value of the option goes down each day if his view is not realized.

In simple words theta tells how much value the option would lose after one day, with all the other parameters remaining the same.

ď ą

VEGA

The extent of extent of change that may occur in the option premium, given a change in the volatility of the underlying instrument.

Change in an option premium Vega = ----------------------------------------Change in volatility ILLUSTRATION Suppose the Vega of an option is 0.6 and its premium is Rs15 when volatility of the underlying is 35%. As the volatility increases to 36%, the premium of the option would change upward to Rs15.6. Vega is positive for a long position (long call and long put) and negative for a short position (short call and short put).

ADVANTAGE Simply put, for the buyer it is advantageous if the volatility increases after he has bought the option.

DISADVANTAGE For the seller any increase in volatility is dangerous as the probability of his option getting in the money increases with any rise in volatility.

48

In simple words Vega indicates how much the option premium would change for a unit change in annual volatility of the underlying.

Participant in derivative Market: Participant can be banks, FIIs, corporate, brokers, individual, etc; they can be classified in to three categories: •

Hedgers

•

Speculators

•

Arbitrageurs

Hedgers: A transaction in which an investor seeks to protect an anticipated position in the spot market by using an opposite position in derivatives is known as a hedger. A person who hedges is called a hedger. These are the people who are exposed to risk due to their normal business operations and would like to eliminate or minimize or reduce the risk.

Hedgers are the traders who wish to eliminate the risk of price change to which they are already exposed. It is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Hedgers are those persons who don’t want to take the risk therefore they hedge their risk while taking position in the contract. In short it is a way of reducing risks when the investor has the underlying security.

PURPOSE: “To reduce the volatility of a portfolio, by reducing the risk”

ADVANTAGES •

Availability of leverage

STRATEGY: The basic hedging strategy is to take an equal and opposite position in the futures market to the spot market. If the investor buys the scrip in the spot market but suddenly the market drops then the investor hedge their risk by taking the short position in the Index futures.

49

HEDGING AND DIVERSIFICATION: Hedging is one of the principal ways to manage risk, the other being diversification. Diversification and hedging do not have cost in cash but have opportunity cost.

Hedging is implemented by adding a negatively and

perfectly correlated asset to an existing asset. Hedging eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk). Diversification is affected by choosing a group of assets instead of a single asset (technically, by adding positively and imperfectly correlated assets).

ILLUSTRATION Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is completed.

COST

SELLING PRICE

PROFIT

400

1000

600

However, Ram fears that Shyam may not honor his contract. So he inserts a new clause in the contract that if Shyam fails to honor the contract he will have to pay a penalty of Rs.400. And if Shyam honors the contract Ram will offer a discount of Rs100 as incentive .

Shyam defaults

Shyam honors

400 (Initial Investment)

600 (Initial profit)

400 (penalty from Shyam

(-100) discount given to Shyam

- (No gain/loss)

500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and protected his initial investment.

50

Now let’s see how investor hedge their risk in the market Example: Say you have bought 1000 shares of XYZ Company but in the short term you expect that the market would go down due to some news. Then, to minimize your downside risk you could hedge your position by buying a Put Option.

This will hedge your downside risk in the market and your loss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achieved using hedging is the removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduce risk .

HEDGING WITH OPTIONS: Options can be used to hedge the position of the underlying asset. Here the options buyers are not subject to margins as in hedging through futures.

Options buyers are however required to pay premium which are sometimes so high that makes options unattractive.

ILLUSTRATION: With a market price of

ACC Rs.600 the investor buys the 50 shares of

ACC.Now the investor excepts that price will fall by 100.So he decided to buy the put Option by paying the premium of Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered Rs.75 a share by buying ACC put.

HEDGING STRATEGIES: ď ą

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount of Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position. Thus the position LONG SECURITY, SELL 51

NIFTY is a pure play on the performance of the security, without any extra risk from fluctuations of the market index. Finally the investor has “HEDGED AWAY” his index exposure.

EXAMPLE:



LONG SECURITY, SELL FUTURES

Here stock futures can be used as an effective risk –management tool. In this case the investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the risk the Hedger enters into a future contract and takes a short position. However the losses suffers in the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390 Market action = 350 Loss = 40 Strategy = BUY SECURITY, SELL FUTURES Two month Futures= 390 Premium = 12 Short position = 390 Future profit = 40(390-350) As the fall in the price of the security will result in a fall in the price of Futures.

Now the Futures will trade at a price lower then the price at which the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made on his short futures position.

52



HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price. Therefore the solution is buy put options on HLL. The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the investor has two possible scenarios three months later.

1) IF PRICE RISES Market action: 215 Loss : 17(232-15) Strike price : 240 Premium : 08 Profit : 17(240-215-8) Thus loss he suffers on the stock will be offset by the profit the investor earns on the put option bought.

2) IF PRICE RISES: Market share : 250 Loss : 10 Short position : 250(spot market) Thus the investor has a limited loss(determined by the strike price investor chooses) and an unlimited profit.



HAVE PORTFOLIO, SHORT NIFTY FUTURES: Here the investor are holding the portfolio of stocks and selling nifty

futures. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on 1st May, 2001.

53

Company

Beta

Amount of Holding ( in Rs)

Infosys

1.55

400,000.00

Global Tele

2.06

200,000.00

Satyam Comp

1.95

175,000.00

HFCL

1.9

125,000.00

Total Value of Portfolio

1,000,000.00

Trading Strategy to be followed The investor feels that the market will go down in the next two months and wants to protect him from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge.

Formula to calculate the number of futures for hedging purposes is Beta adjusted Value of Portfolio / Nifty Index level Beta of the above portfolio =(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000 =1.61075 (round to 1.61) Applying the formula to calculate the number of futures contracts Assume NIFTY futures to be 1150 on 1st May 2001 = (1,000,000.00 * 1.61) / 1150 = 1400 Units Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts.

54

Short Hedge

Stock Market

Futures Market

1st May

Holds Rs 1,000,000.00 in Sell 7 NIFTY futures stock portfolio contract at 1150.

25th June

Stock portfolio fall by 6% NIFTY futures falls by to Rs 940,000.00 4.5% to 1098.25

Profit / Loss

Loss: -Rs 60,000.00 Net Profit: 15,450.00

+

Profit: 72,450.00 Rs

SPECULATORS: A person who buys and sells a contract in the hope of profiting from subsequent price movements is known as a speculator. These people voluntarily accept what hedgers want to avoid. If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. speculators are those who do not have any position and simply play with the others money. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. Here if speculators view is correct he earns profit. In the event of speculator not being covered, he will loose the position. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions.

SPECULATION IN THE FUTURES MARKET •

Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:

•

Naked positions - Position in any future contract.

55

•

Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

ADVANTAGES 1)Greater Leverage as to pay only the premium.

2) Greater variety of strike price options at a given time.

ILLUSTRATION: Here the Speculator believes that stock market will going to appreciate.

Current market price of PATNI COMPUTERS = 1500 Strategy: Buy February PATNI futures contract at 1500 Lot size = 100 shares Contract value = 1,50,000 (1500*100) Margin = 15000 (10% of 150000) Market action = rise to 1550 Future Gain :Rs. 5000 [(1550-1500)*100] Market action = fall to 1400 Future loss: Rs.-10000 [(1400-1500)*100] Thus the Speculator has a view on the market and accept the risk in anticipating of profiting from the view. He study the market and play the game with the stock market

TYPES: 

POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days until their target is met . DAY TRADERS: 56

.Day traders square off the position during the curse of the trading day and book the profits. 

SCALPERS:

Scalpers in anticipation of making small profits trade a number of times throughout the day.

SPECULATING WITH OPTIONS: A speculator has a definite outlook about future price, therefore he can buy put or call option depending upon his perception about future price. If speculator has a bullish outlook, he will buy calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If speculator’s view is correct he earns profit. In the event of speculator not being covered, he will loose the position. A Speculator will buy call or put if his price outlook in a particular direction is very strong but if is either neutral or not so strong. He would prefer writing call or put to earn premium in the event of price situations.

ILLUSTRATION: Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE TELEFILMS stock will come down then he will buy put on the sale price until he can write either call or put.

Finally Speculators provide depth and liquidity to the futures market an in their absence; the price protection sought the hedger would be very costly.

STRATEGIES 

BULLISH SECURITY,SELL FUTURES:

Here the Speculator has a view on the market. The Speculator is bullish in the market. Speculator buys the shares of the company an makes the profit. At 57

the same time the Speculator enters into the future contract i.e. buys futures and makes profit.

Spot Price of RELIANCE = 1000 Value

= 1000*100shares = 1,00,000

Market action

= 1010

Profit

= 1000

Initial margin

= 20,000

Market action

= 1010

Profit

= 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes a profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%.Thus because of leverage provided security futures form an attractive option for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:



Under this strategy the speculator is bullish in the market. He could do any of the following: 

BUY STOCK:

ACC spot price

: 150

No of shares

: 200

Price

: 150*200 = 30,000

Market action

: 160

Profit

: 2,000

Return

: 6.6% returns over 2months



BUY CALL OPTION:

Strike price

: 150

Premium

: 8

Lot size

: 200 shares

Market action

:160 58

Profit

: (160-150-8)*200 = 400 Return

: 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a investment of 2months as compared to 6.6% returns over a investment in stocks. 

BEARISH SECURITY,SELL FUTURES:

In this case the stock futures is overvalued and is likely to see a fall in price.

Here simple arbitrage ensures that futures on an individual securities more correspondingly with the underlying security as long as there is sufficient liquidity in the market for the security. If the security price rises the future price will also rise and vice-versa.

Two month Futures on SBI = 240 Lot size

= 100shares

Margin

= 24

Market action

= 220

Future profit

= 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes a profit because the speculator is bearish in the market and all the future stocks need to sell in the market.



BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can “BUY OR SELL” the entire index trading on one single security. Once a person is LONG NIFTY using the futures market, the investor gains if the index rises and loss if the index falls.

1st July = Index will rise Buy nifty July contract = 960 Lot =200 59

14th July nifty risen= 967.35 Nifty July contract= 980 Short position

=980

Profit

= 4000(200*20)

ARBITRAGEURS: These are the third important participants in the derivative market. Arbitrage means to obtain risk- free profits by simultaneously buying and selling identical or similar instruments in different markets. For example, one could buy in the cash market and simultaneously sell in the future market. The person who arbitrages is called an arbitrageur.

Arbitrage is the concept of simultaneous buying of securities in one market where the price is low and selling in another market where the price is higher.

Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable person and ready to take the risk He is basically risk averse.

He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market.

JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where the investor buys the shares in the cash market and sell the shares in the future market.

ARBITRAGEURS IN FUTURES MARKET Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

Example: 60

Current market price of ONGC in BSE= 500 Current market price of ONGC in NSE= 510 Lot size = 100 shares Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES: 

BUY SPOT, SELL FUTURES: In this the investor observing that futures have been overpriced,

how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 1025.

This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.

•

On day one, borrow funds, buy security on the spot market at 1000

•

Simultaneously, sell the futures on the security at1025

•

Take delivery of the security purchased and hold the security for a month

•

on the futures expiration date, the spot and futures converge . Now unwind the position

•

Sa y the security closes at Rs.1015. Sell the security

•

Futures position expires with the profit f Rs.10

•

The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position

•

Return the Borrow funds.

61

Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash – and- carry arbitrage. 

BUY FUTURES, SELL SPOT: In this the investor observing that futures have been under priced,

how can the investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 965.

This shows that futures have been under priced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions.

•

On day one, sell the security on the spot market at 1000

•

Mae delivery of the security

•

Simultaneously, buy the futures on the security at 965

•

On the futures expiration date, the spot and futures converge . Now unwind the position

•

Sa y the security closes at Rs.975. Sell the security

•

Futures position expires with the profit f Rs.10

•

The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position

Finally if the returns get investing in risk less instruments is less than the return from the arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse cash – and- carry arbitrage. 

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price difference between two markets. An arbitrageur will buy at the cheaper market and sell 62

at the costlier market. It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the strategy to be followed is

CASE-1 Spot Price of INFOSEYS = 1650 Future Price Of INFOSEYS = 1675 In this case the

arbitrageur will buy INFOSEYS in the cash market at

Rs.1650 and sell in the futures at Rs.1675 and finally earn risk free profit Of Rs.25.

CASE-2 Future Price Of ACC = 675 Spot Price of ACC = 700 In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot at Rs.700 and finally earn risk free profit Of Rs.25.

EMERGING CHALLENGES: Minimum contract size to be reduced Investors at large would trade in the derivative markets when the contract size is equal to market lot of shares. In this regard the decision of the SEBI to reduce the minimum contract size in value terms from Rs 2.00 lakhs to Rs. 63

1.00 lakhs would make it attractive for retail investors thereby facilitating further liquidity Instructions are less active The derivatives contracts are cash settled as against delivery settlement operating elsewhere in the world. This probably is due to shortcomings of banking and depository systems. As such institutional investors are not participating. Once delivery settled trades are allowed, there would be voluminous growth in the trading.

Separate derivative membership Derivative membership at exchanges is required to be taken separately. This restricts the entry of those brokers who are otherwise qualified to enter the market.

Taxation treatment of gains The tax authorities consider derivative gain as speculative capital gains or losses. And the same is not allowed to be set off against the normal business profit/losses. Whereas the positions in cash market are treated as short term gains or losses. Due to this also, major players are refraining from using the derivatives market in a big way.

High margin in trade resulting from high transaction cost High transaction cost due to high margin in trade acts a deterrent for big funds and portfolio investors to participate in the market.

Miscellaneous Proliferation of NSF branches across the nation has marginalized BSE. In fact, there should be product differentiation among the products offered at two exchanges for keeping the spirit of competition and enhancing services to investors.

64

Yet another problem relates to the investors and brokers education. While the Indian investor is familiar with forward trading under badla system, the derivative strategies are not very familiar to him.

Moreover, due to lack of code of conduct among brokers and trading members, they poach investors from one another under discount rate temptation.

DERIVATIVES INHERENT RISKS: Credit risks: The exposure to the possibility of loss resulting from a counter party’s failure to meet the financial obligation also includes counter party risk.

Market risks: Adverse movements in the price of financial asset or commodity.

Legal risks: An action by a court or by regulatory body that could invalidate a financial contract.

Operational risks: inadequate controls, deficient procedures, human error, system failure or fraud

ORGANIZATION OF DERIVATIVE EXCHANGES : An exchange is a physical location where future trading (for that matter any financial instrument) takes place. It is a voluntary, non-profit association of its members. The trading of each commodity/asset takes place at specific location referred to as ‘pit’ through system of open outcry or screen based online system’ during official trading hours .The exchanges Memberships are also referred to as seats and are held by individuals. These seats are activity traded in the market like any other assets. Members have the right to trade on the exchanges operations, rules and regulations, public relations, legal and ethical conducts of the members.

Clearing House

65

A Clearing house is an institution, which clears all the transactions undertaken by a futures exchange. It could be a part of the same exchange or a separate entity. It computes the daily settlement amount due to from each of the members and from other clearinghouses and matches the same.

Members who execute trade on the exchange floor are:  Floor brokers  Floor traders Floor brokers: These brokers will execute the orders on others, account.

They are normally self-employed individual members of the exchange.

Floor traders : These traders execute the trades on their own account. Some floor traders may also execute the orders for the account of others. This mechanism is known as dual trading and such traders are known as dual traders. Some of the floor traders are classified as “scalpers”. Scalper is a person who stands ready either to buy or sell. Scalpers add to the liquidity of the market, as they are market makers. Some of the floor traders are classified as’ position traders’. These persons tend to carry the positions for longer periods of time.

They also add to the liquidity of the markets.

Clearing house mechanism As the futures are exchange-traded instruments, the contract obligation is not between the buyer and the seller of the contract even though the contract at the time of initiation is between two parties. Each contract is substituted by two contracts in such a way that clearing house becomes a buyer to every seller and seller to every buyer.

Figure 1: Transaction without Clearing House

66

Price

Buyer

Seller

Underlying asset

Figure 2: Transaction with clearing House

Price Buyer

Clearing house

Under lying asset

Price Seller Under lying asset

This mechanism effectively removes counterparty risk from the futures transaction. In a transaction where A sell futures to B and B is replaced by the clearing house the credit risk taken by A becomes insignificant. Same is the case for B as well. This means that the credit risk is now assumed by the clearinghouse instead of the individual. When this happens for all the transaction the credit risk is now assumed by the clearing house instead of individual. When this happens for all transaction the credit risk assumed by the clearing house becomes disproportionately high. It becomes necessary for the clearing

house to minimize the credit risk. The credit risk of the

clearing house is minimized by the imposition of margins. Margins are the amounts which buyers and sellers of futures contracts have to deposit as collateral for their positions. Margins levied on each contract reflect the volatility of the underlying instrument and these margins are adjusted everyday depending on the changes in the prices. If the price of a contract increases, then the buyer of the contract experiences a gain because the value of an asset increases. The gain will be credited to the buyer account.

67

Important functions of a clearing house: 1. Ensuring adherence to system and procedures for smooth trading.

2. Minimizing credit risk by being counterparty to all trades.

3. Accounting for all the gains/losses on daily basis.

4. Monitoring the speculation margins.

5. Ensuring delivery of payment for the assets on the maturity date for the outstanding contracts.

Liquid net worth & Balance sheet Net worth Requirement of clearing members Liquid net worth: It is the total liquid assets deposited with the clearing corporation less than the initial margin applicable to the gross open positions of a clearing member at any point of time. SEBI has prescribed that every clearing member (both clearing member and self-clearing members) has to maintain at least Rs. 50 lakh as liquid net worth with the exchange/clearing corporation. These may be in cash, fixed deposit, bank guarantee, T-bills, Gsecs, unit of money market, mutual funds and gilt funds, units of mutual funds. A minimum of 50 percent liquid asset to be in cash equivalent cash, bank guarantees, fixed deposits, T-bills and dated government securities.

Balance sheet net worth is defined as capital plus free reserves less nonallowable assets. The non-allowable assets are fixed assets, pledged securities, value of member’s card, unlisted securities, doubtful debts and advances, prepaid expenses and losses, intangible assets and 30 percent of the marketable securities. Further, the balance sheet net worth requirements for the various categories are discussed below: Clearing members are those members who are permitted to settle their own trades as well the trade of the other non-clearing members known as trading members who have agreed to settle the trades through them. As per the 68

Gupta

Committee

recommendations,

SEBI

prescribed

a

net

worth

requirement of Rs. 3 crore for clearing members. The clearing members are required to furnish an auditor’s certificate for the net worth every 6 months to the exchange.

Self-clearing members, on other hand, are permitted to clear their own trades only. SEBI has also prescribed a net worth requirement of Rs 1 crore for self-clearing members. Like clearing members, the self-clearing members are required to furnish an auditor certificate for the net worth every 6 months to the exchange.

Major World Derivatives Exchanges in World  CHICAGO MERCNTILE EXCHANGE (CME).  EUREX (GERMANY).  HONGKONG FUTUR EXCHANGE (HKFE).  THE

LONDON

INTERNATIONAL

FINANICIAL

FUTURE

OPTIONS EXCHNGES (LIFFR).  SINGAPORE EXCHANGE.  SYDENY FUTURE EXCHANGE.  IDEM (ITALY).  CME (U.S).  MONEP (FRANCE).

POULAR INDEX FUTURES IN WORLD INDEX

COUNTRY

 S&P FUTURES

USA

 DAX CASH OPTIONS

GERMANY

 CAC FUTURES

FRANCE

 OMX FUTURES

SWEDEX

 IBEX

SPAIN 69

AND

 NIKKIE 225 FUTURES

JAPAN

 HANG SANG FUTURES

HONG KONG

 FTSE 100 FUTURES

U.K

 DAX FUTURES

GERMANY

 MIB 30 FUTURE

ITALY

 NASDAQ

U.S

OTHER POPULAR INDEX IN THE WORLD  NYSE COMPOSITE  VALUE LINE  DOW JONES INDUSTRIAL AVERAGE  DOW JONES INDUSTRIAL AVERAGE  S&P MID CAP  MIB 30  IBEX 35  OMX  FTSE

Cash VS derivative Market  In cash market tangible assets are traded where as in derivative markets contracts based on tangible assets or intangible like index or rates are traded.  In cash market, we can purchase even one share where as in Futures and options minimum lots are fixed  Cash market, we can purchase even one share whereas in futures and options minimum lots are fixed.

70

 Cash assets may be meant for consumption or investment. Derivative contracts are for hedging arbitration or speculation.  The value of derivative contract is always based on and linked to the underlying security. Though his linkage may not be point-to-point basis.  Small investors cannot go for futures and options because of more risk.  Trading volume of Futures and options is more in comparison to cash market.  In cash market, a customer must open security trading account with a securities broker and a Demat account with securities depository where as trade futures a customer must open a future trading account with a derivative broker.  Buyer securities involve putting up all the money upfront whereas buying futures simply involves putting up the margin money.

71

Review of Literature

72

1.The

study

conducted

by

Debdas

Rakshit

and

Chanchal

Chatterjee(University of Burdwan) under the title “Financial derivatives”.

This paper attempts to indicate various new financial instruments which are assumed to be significant in Indian economy. Financial derivatives are most important as well as significant among them. After their introduction in India in June 2000, financial derivatives have gained a significant ground in the Indian stock market. But till date no specific accounting standard has been formulated for accounting as well as disclosure of the results of derivative trading in India.

2. The study conducted by Gautam Vivek Gupta of ICFAI Center for Management Research, India under the title “Introduction and growth of the derivatives market in India”.

In this research he discussed the reasons that led to the introduction of derivatives trading in India and why it faced opposition by a section of industry analysts and media. The study also describes the issues that still remain to be addressed by the regulatory authorities to accelerate the long-term growth of the derivatives market. Finally, the research mentions a few steps taken by the concerned authorities in early 2004.

3.The Study conducted by

Dr. A Sudhakar & D G Praveen under the

title “Efficiency of the Indian Derivatives Market – An Empirical Study”.

This paper attempts to examine the level of efficiency of the Indian Derivatives Market, focusing on the prevalence of arbitrage opportunities. The existence of arbitrage opportunities signifies the level of market inefficiency.

Using the put-call parity (implied volatility) theory, the authors arrive at a conclusion that Indian derivatives markets provide immense arbitrage opportunities through strategies like cash-and-carry arbitrage, reverse cash73

and-carry arbitrage, and synthetic futures. However, there are some constraints to easy arbitrage in the Indian market such as short selling regulations, tax system, absence of hedge funds, unfamiliarity with derivatives, reluctance of banks to lend funds for arbitrage purposes etc.

4.The

study

conducted

by

Henk

Berkman

&

Michael

E.

BradburyEmpirical under the title “Evidence on the corporate use of derivatives”.

This paper attempts to

indicate that hedging can increase firm value by

reducing expected taxes, expected costs of financial distress, and other agency costs. Prior research, based on survey data, has found only weak evidence consistent with theory. This study provides evidence on the corporate use of derivative instruments from the 1994 audited financial statements of 116 firms. We use the fair and contract values scaled by the market value of each firm to measure the extent of derivatives usage. The results are largely insensitive to our measure of derivatives usage and generally in line with theoretical models of corporate risk management.

5.According to Prof. Alan Reichert & Yih-Wen Shyu under the title”Derivative activities and the risk of international banks: A market index and VaR approach” The paper attempts to indicate the results of a comparison of international banks using a three-factor multi-index model and a modified value-at-risk (VaR) analysis indicate that the use of options increases the interest rate beta for all banks, while both interest rate and currency swaps generally reduce risk. The results are the strongest and the most consistent for U.S. dealer banks, followed by European banks, and then Japanese banks. Furthermore, the evidence suggests that the VaR approach to risk management can effectively be used by both domestic as well as international banks, although

74

the results appear to be somewhat sensitive to the regulatory environment in which the bank operates.

Research Methodology

75

Research Design Research design is a base for every systematic study. It is an arrangement of the conditions for collection and analysis of data in a manner that aims to combine relevance to the research purpose with the economy in procedure.

The aim of the research in this project is to study the derivatives market, particularly in India and acceptability of Derivatives among various investors.

In order to study the objectives, questionnaire method is adopted.

The research methodology of the study has been explained as under: Methodology adopted: To observe and to probe the knowledge level and awareness of the investors about derivative trading, a questionnaire have been prepared containing 10 questions.

Sampling plan: The selection of the respondents is done purely on the basis of convenience sampling.

Sample size : The study involves 60 investor those who are investing in share market .

Sources of data: The study includes both primary and secondary data resources.

Primary data is collected by structured questionnaire.

Secondary data was collected from various books, magazines, previous reports and Internet.

Statistical tools: ďƒ˜ Proportionate test ďƒ˜ Z- test 76

 Correlation  Mean

LIMITATATION OF THE STUDY

No study is complete in itself however good it may be and every study has some limitations. The limitation of the study is as follows:  The Primary data was collected form investors those who are investing in share , but other investor those who are investing in share market are not covered.  Some of the respondent of the survey were unwilling to share information.  The survey was conducted during daytime, when most of the investors were busy in dong their work. As such, the respondents sometimes filled the questionnaire very quickly.

77

ANALYSIS

78

1. From how long you have been investing in share market.

Less than 2 year 2-4 year 4-6 year More than 6 year

Total 14 18 23 8

Percentage 22 29 36 13

Total

13%

22% Less than 2 year 2-4 year 4-6 year

36%

29%

More than 6 year

Observation: From the above it can be inferred that investor hold share for 4-6 year to get higher returns from their investments in shares . They are using delivery basis more rather than intra day basis.

79

2.

How much percentage of your saving have you invested.

Frequency 29 11 12 8

Less than 25% 25% to 50% 50%to 75% More than 75%

Percentage 48.3 18.33 20 13.3

48.3

50 40

29

Less than 25%

0

12 50%to 75%

11

10

20 13.3 Frequency

8 More than 75%

18.33

20

25% to 50%

30

Frequency

Percentage

Observation: It is clear from above figure that large number of investors invest small % percentage of their saving in share market because of high volatility and high risk. But there are some investors those invest 50% or more in shares to get higher return in short period. 29 investors have invested less than 25 % of their saving and 11 investor invests between 25% to 50 %.

3. Have you ever used (Future’s, Option’s) or any other Derivative.

Views

Total

80

Percentage

Yes NO

38 22

63.33 36.66

70 63.33

60 50

36.66

38

40

22

30

Yes NO

20 10

NO

0

Yes Total

Percentage

Observation: Study reveals that only (38) numbers of investors are aware about derivative. Some investors have awareness about derivatives but they are not using derivatives because of large lot size and high margin requirement.

4. Which Derivative (Future’s, Option’s), have you used.

Index Future Stock Future Interest rate Future Index Option Stock Option

frequency 19 10 0 3 5

81

Percentage 50 26.31 0 10.52 13.15

50

50 40 30 20

26.31 19

10

10 0

0

0

10.52

13.15

4

5

Index Stock Future Future Interest Index Stock rate Option Option Future

frequency percentage percentage frequency

Observation: Out of 38 investor those who are using derivative, higher number of investor are dealing in future than options. Interest rate futures are not prevalent in India It is also noted that options are less popular in India.

Index future is used by 19 i.e. 50 % and stock future is used by 10 investor (26.31%)and options are used only by 8 investors.

5. Which time horizon do you prefer for dealing in derivatives?

Time period 1 Month 2 Month 3 Month

Frequency 18 13 7

82

Percentage 47.36 34.21 18.42

Total

7, 18%

1 Month

18, 48%

2 Month 3 Month

13, 34%

Observation: It is noted that (47.36%) investors preferred 1 month contract period where as 3 months period is less prevalent. Availability of short selling and hedging encourages the investor to deal in 1-month contract.

6. In your opinion, which factor has influenced you as an investor to deal with Derivatives. a) Availability of Hedging and Short Selling X 5 4 3 2 1

f 10 12 8 7 1

Fx 50 48 24 14 1

250 192 72 28 1

Total

38

137

543

fx 2

Population Mean = 4 Sample Mean

=

ÎŁ fx =

3.605 83

Percentage 26.31 31.57 21.05 18.42 2.63

Σf Assumption: Availability of Hedging and Short Selling has high influence as reported by majority of respondents i.e.31.57 %. To test whether this factor is applicable to all investors.

1. It is parametric in nature.

2. Sample size n=38 and as Small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = 1.29 ∑ƒ 4. Standard Error:

(∑ƒ )² =

5. Level of Significance : Level of Confidence

σ samplesize

= 1.29/√38= 0.209

5% : 95 %

6. Two Tail Test is applied.

7. Hypothesis setting

8.

Ho :

Xs = Xp

Ha :

Xs ≠ Xp

where Xs is Sample Mean and Xp is Population mean

Zc = Sample mean – Population mean 

 3.605 - 4  =

Standard Error

Inference: Zc = 1.975 >

= 1.975 .20

Zt = 1.96

84

 So null hypothesis is rejected.  Alternate is accepted.  The difference in two means is significant.  We can interpret that of Hedging and Short Selling has high influence as reported by majority of respondents. b) Minimum cash requirement

X 5 4 3 2 1 Total

f 9 15 7 4 3 38

Fx 45 60 21 8 3 137

fx 2

225 240 63 16 3 547

Percentage 23.68 39.47 18.42 10.52 7.89

Population Mean = 4 Sample Mean

Σ fx

=

=

3.605

Σf

Assumption

: Minimum cash requirement factor has high influence as

reported by majority of respondents i.e.39.47 %. To test whether this factor is applicable to all investors.

1. It is parametric in nature.

2. Sample size n=38 and as Small n > 30. Therefore z test is applicable.

3. Standard deviation

σ = √ ∑ ƒ x² - (∑ƒx )² = √14.39 – 12.99= 1.4 ∑ƒ

(∑ƒ )² 85

σ

4. Standard Error: = samplesize

= 0.22

5. Level of Significance : 5% Level of Confidence

: 95 %

6. Two Tail Test is applied.

7. Hypothesis setting Ho :

Xs = Xp

where Xs is Sample Mean and

Ha :

Xs ≠ Xp

Xp is Population mean

8. Zc =  Sample mean – Population mean 

 3.605 - 4  =

Standard Error

= 1.795 0.22

Inference: Zc =1.795 < Zt =1.96  So null hypothesis is accepted.  Alternate hypothesis is rejected.  The difference in two means is insignificant.  We can interpret that Minimum cash requirement factor has almost insignificant influence as reported by majority of respondents.

c) Higher return by investing small amount of Capital X 5 4 3 2 1

f 9 4 12 7 6 38

Fx 45 16 36 14 6 117 86

fx 2

225 64 108 28 6 431

Percentage 23.68 10.52 31.57 18.42 15.78

Total

Population Mean = 3 Sample Mean

Σ fx

=

=

3.07

Σf Assumption: Investors were indifferent about higher return by investing small amount of Capital factor. To test whether this factor is applicable to all investors.

1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation Standard deviation, σ = √ ∑ ƒ x² - (∑ƒx )² = √ 11.34 – 9.47 = 1.87 ∑ƒ

σ

=

4. Standard Error:

samplesize

5. Level of Significance: Level of Confidence

(∑ƒ)²

= .303

5% : 95 %

6. Two Tail Test is applied.

7. Hypothesis setting Ho :

Xs = Xp

Ha :

Xs ≠ Xp

8. Zc =

where Xs is Sample Mean and Xp is Population mean

 Sample mean – Population mean 

 3.07 - 3  =

87

= 0.23

Standard Error Inference: Zc =0.23

<

.30

Zt =1.96

 So null hypothesis is accepted.  Alternate hypothesis is rejected.  The difference in two means is insignificant.  We can interpret that investors are indifferent towards the factor of Higher return by investing small amount of Capital . d) Liquidity X 5 4 3 2 1 Total

f 4 6 2 15 11 38

Fx 20 24 6 30 11 91

fx 2

100 96 18 60 11 285

Percentage 10.52 15.78 5.26 39.47 28.94

Population Mean = 2 Sample Mean

=

Σ fx =

2.39

Σf Assumption : Liquidity has low influence as reported by majority of respondents i.e.39.47%. To test whether this factor is applicable to all investors.

1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = √ 7.5 – 5.73 = 1.34 88

∑ƒ

(∑ƒ )² σ

=

4. Standard Error:

samplesize

= 0.217

5. Level of Significance : 5% Level of Confidence

: 95 %

6. Two Tail Test is applied.

7. Hypothesis setting Ho :

Xs = Xp

where Xs is Sample Mean and

Ha :

Xs ≠ Xp

Xp is Population mean

8. Zc =  Sample mean – Population mean 

 2.39- 2  =

Standard Error

Inference: Zc =1.797

<

= 1.797 0 .217

Zt =1.96

 So null hypothesis is accepted.  Alternate hypothesis is rejected.  The difference in two means is insignificant.  We can interpret that liquidity has significant influence upon the respondents.

7. To what extent following factors discouraged the investor to deal with derivatives. a)

Lot size X 5

f 13

Fx 65 89

fx 2

325

Percentage 34.2

4 3 2 1 Total

14 4 4 3 38

56 12 8 3 144

224 36 16 3 604

36.84 10.52 10.52 7.89

Population Mean = 4 Sample Mean

Σ fx

=

=

3.78

Σf Assumption

: Lot size has a high impact on investor which

discouraged the investor

highly

to use derivative as reported by majority of

respondents i.e.36.84 %. To test whether this factor is applicable to all investor 1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = √ 15.89 – 14.36 = 1.23 ∑ƒ

(∑ƒ )²

σ

=

4. Standard Error:

samplesize

= 0.199

5. Level of Significance : 5% Level of Confidence

: 95 %

6. Two Tail Test is applied.

7.Hypothesis setting Ho :

Xs = Xp

Ha :

Xs ≠ Xp

where Xs is Sample Mean and Xp is Population mean 90

8. Zc =

 Sample mean – Population mean   3.78 - 4  = Standard Error

Inference:

Zc = 1.157

<

= 1.157 0.199

Zt = 1.96

 So null hypothesis is accepted.  Alternate hypothesis is rejected.  The difference in two means is insignificant.  We can interpret that Lot size has a high impact on investor which highly discouraged the investor to use derivative.

91

b) Taxation treatment of gains and losses

X 5 4 3 2 1

f 3 9 15 6 5 38

Fx 15 36 45 12 5 113

fx 2

75 144 135 24 5 383

Percentage 7.89 23.68 39.47 15.78 13.15

Total Population Mean = 3 Sample Mean

Σ fx

=

=

2.97

Σf Assumption: Investor those who are using derivatives, indifferent about taxation treatment of gains and losses as reported by majority of respondents i.e. 39.47 %. To test whether this factor is applicable to all investor

1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = √ 10.07 – 8.84 = 1.23 ∑ƒ

(∑ƒ )²

4. Standard Error:

=

σ samplesize

5. Level of Significance : 5% Level of Confidence

: 95 %

92

= 0.199

6. Two Tail Test is applied.

7. Hypothesis setting Ho :

Xs = Xp

Ha :

Xs ≠ Xp

8. Zc =

where Xs is Sample Mean and Xp is Population mean

 Sample mean – Population mean 

 2.97 - 3  =

Standard Error

=0.150 0.199

Inference: Zc =0.150 <

Zt =1.96

 So null hypothesis is accepted.  Alternate hypothesis is rejected.  The difference in two means is insignificant.  We can interpret that Investor those who are using derivatives, indifferent about taxation treatment of gains and losses.

93

c) Margin requirement X 5 4 3 2 1

f 8 11 6 9 4 38

fx 40 44 18 18 4 124

fx 2

200 176 54 36 4 470

Percentage 21.05 28.94 15.78 23.68 10.52

Total

Population Mean = 4 Sample Mean

Σ fx

=

=

3.26

Σf Assumption

: Margin requirement has a high impact on investor which

discouraged the investor to use derivative as reported by majority of respondents i.e.28.94 %. To test whether this factor is applicable to all investor.

1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = √ 12.36 – 10.64 = 1.72 ∑ƒ

(∑ƒ )²

=

4. Standard Error:

σ samplesize

5. Level of Significance : 5% Level of Confidence

: 95 %

6. Two Tail Test is applied.

94

= 0.274

7. Hypothesis setting Ho :

Xs = Xp

Ha :

Xs ≠ Xp

where Xs is Sample Mean and Xp is Population mean

Zc =  Sample mean – Population mean



 3.26 - 4  =

Standard Error Inference:

Zc = 2.74 >

=2.74 0.27

Zt = 1.96

 So null hypothesis is rejected.  Alternate hypothesis is accept.  The difference in two means is significant.  We can interpret that Margin requirement doen not bear much impact on investor which discouraged the investor to use derivative

95

d)

Brokerage

X 5 4 3 2 1

f 3 6 10 15 4 38

Fx 15 24 30 30 4 103

fx 2

75 96 90 60 4 325

Percentage 7.89 15.78 26.31 39.47 10.52

Total Population Mean = 2 Sample Mean

Σ fx

=

=

2.71

Σf Assumption: Brokerage has a low impact on investor which discouraged him/her to use derivative as reported by majority of respondents i.e.39.47 %.

To test whether this factor is applicable to all investor.

1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = √ 8.55 – 7.34 = 1.1 ∑ƒ

(∑ƒ )²

4. Standard Error:

σ

=

samplesize

5. Level of Significance : 5% Level of Confidence

: 95 %

6. Two Tail Test is applied.

96

= 0.178

7. Hypothesis setting Ho :

Xs = Xp

Ha :

Xs ≠ Xp

8. Zc =

where Xs is Sample Mean and Xp is Population mean

 Sample mean – Population mean 



2.71 - 2 

= Standard Error Inference:

Zc=3.98

>

= 3.98 0.178

Zt = 1.96

 So null hypothesis is rejected.  Alternate hypothesis is accept.  The difference in two means is significant.  We can interpret that Brokerage doe not have low impact on investor which discouraged him/her to use derivative.

8. To what extent are you satisfied with your investment in Future’s and Option’s?

Total

Percentage

8 21 4 2 3

21.05 55.26 10.52 5.26 7.89

Very Satisfied Satisfied Indifference Dissatisfied Very Dissatisfied

97

55.26

60 50 40 30

Total 21.05 21

Percentage

20 10

10.52 5.26 4 2

8

7.89 3

fie d In di ffe re nc D e is sa V tis er fie y d D is sa tis fie d

at is S

V

er y

S

at is f ie d

0

Observation : Study reveals that 21.05 % investors are very satisfied and 55.26% are satisfied whereas 7.89 % of the respondents come into the category of very dissatisfied. Investors are more satisfied after using derivatives because derivatives are liquid and have low transaction cost and it is easier to take short position in derivative than in other assets.

X 5 4 3 2 1

f 8 21 4 2 3 38

fx 40 84 12 4 3 143

Total

Population Mean = 4 Sample Mean

=

ÎŁ fx =

3.76 98

fx 2

200 336 36 8 3 583

Percentage 21.05 55.26 10.52 5.26 7.89

Σf Assumption : Investors are satisfied by investing their money in Futures & Options as reported by majority of respondents i.e. 55.26. To test whether this factor is applicable to all investor.

1. It is parametric in nature.

2. Sample size n=38 and as small n > 30. Therefore z test is applicable.

3. Standard deviation σ = √ ∑ ƒ x² - (∑ƒx )² = √ 15.34 – 14.16 = 1.08 ∑ƒ

(∑ƒ )²

4. Standard Error:

=

σ samplesize

= 0.175

5. Level of Significance : 5% Level of Confidence

: 95 %

6. Two Tail Test is applied.

7. Hypothesis setting Ho :

Xs = Xp

Ha :

Xs ≠ Xp

8. Zc =

where Xs is Sample Mean and Xp is Population mean

 Sample mean – Population mean 

 3.76 - 4  =

Standard Error

Inference:

Zc = 1.371 <

= 1.371 0.175

Zt =1.96

 So null hypothesis is accepted.

99

 Alternate hypothesis is rejected.  The difference in two means is insignificant.  We can interpret that Investors are satisfied by investing their money in Futures & Options 9. How much importance would you assign to each of the following factors at the time of investing your money in Future’s and Option’s?

FACTORS

Very important

IMPORTANT

Not important

Risk

17

15

6

Rate of return

20

15

3

Time horizon

8

12

18

Tax benefit

5

12

21

Company and

6

22

10

its Growth

25 20 15

20

22

20 18

17 15

15 12

10

very important

12

8 6

5

3

important

10

not important

6

5

gr ow th

of re tu rn t im e ho riz on ta x be ne fit

ra te

ris k

0

10. Please rate the following statements

Strongl

Agree

100

Undeci

Disagree

Strongly

y Agree

There is a need to 14 reduce/revise

ded

Disagree

11

7

4

2

14

7

4

4

13

3

5

1

9

6

2

1

14

6

7

4

lot

size.

In India, Futures are 9 used

more

comparison

in to

optionâ&#x20AC;&#x2122;s There is an increase 16 in

volume

derivative

of trading

(future and options) as compared to cash market since 2000.

Volatility in share 20 market has led to gaining popularity of derivative instrument like

hedging

and

short selling.

Derivative helps in 7 bringing

FIIâ&#x20AC;&#x2122;s

investment.

Respondents view about statements: ď&#x192;&#x2DC; There is a need to reduce/revise lot size: It is clear from the result that investor are in favor to reduce /revise the lot size because lots are available in lakhs due to which small investors are not using derivative.

101

 In India, Futures are used more in comparison to option’s : It is observed form studies that futures are used more as compare to options in India .investor also agree with the statement .  There is an increase in volume of derivative trading (future and options) as compared to cash market since 2000: Study reveals that turnover in derivative segment of NSE is about 307 percent of cash market turnover and investors are also strongly agreed with this statement.  Volatility in share market has led to gaining popularity of derivative instrument like hedging and short selling: It is also strongly agreed by the investor those who are using derivatives.  Derivative helps in bringing FII’s investment. Availability of hedging and short selling in derivative market encourages the FIIs to invest in Indian stock market. Respondents also agree with the statement which is clear from the response of maximum number of respondents

.

SUGGESTIONS  There is a need to bring awareness among the general public about derivative trading.

102

 Generally, Derivative contract are settled on T+1 system but our banking sector is not so advanced. So there is a need to improve the banking sectors.  Other than Futures and Options, other instrument like Swaps, Swaptions have to be introduced in order to expand the area of derivative in India.  Government should open a separate Derivative exchange, completely dedicated to derivative trading.

 Contract size to be reduced. For Example, SEBI to reduce the minimum contract size in value terms from Rs 2.00 lakh to Rs. 1.00 lakh would make it attractive for retail investors thereby facilitating further liquidity.  Taxation treatment of gains and losses should be changed: The tax authorities consider derivative gain as speculative capital gains or losses. And the same is not allowed to be set off against the normal business profit/losses. Whereas the positions in cash market are treated as short term gains or looses. Due to this also, major players are refraining from using the derivatives market in a big way

Emerging challenges: Minimum contract size to be reduced Investors at large would trade in the derivative markets when the contract size is equal to market lot of shares. In this regard the decision of the SEBI to reduce the minimum contract size in value terms from Rs 2.00 lakhs to Rs. 103

1.00 lakh would make it attractive for retail investors thereby facilitating further liquidity Instructions are less active The derivatives contracts are cash settled as against delivery settlement operating elsewhere in the world. This probably is due to shortcomings of banking and depository systems. As such institutional investors are not participating. Once delivery settled trades are allowed, there would be voluminous growth in the trading.

Separate derivative membership Derivative membership at exchanges is required to be taken separately. This restricts the entry of those brokers who are otherwise qualified to enter the market.

Taxation treatment of gains The tax authorities consider derivative gain as speculative capital gains or losses. And the same is not allowed to be set off against the normal business profit/losses. Whereas the positions in cash market are treated as short term gains or losses. Due to this also, major players are refraining from using the derivatives market in a big way.

High margin in trade resulting from high transaction cost High transaction cost due to high margin in trade acts a deterrent for big funds and portfolio investors to participate in the market.

Miscellaneous Proliferation of NSF branches across the nation has marginalized BSE. In fact, there should be product differentiation among the products offered at two exchanges for keeping the spirit of competition and enhancing services to investors.

104

Yet another problem relates to the investors and brokers education. While the Indian investor is familiar with forward trading under badla system, the derivative strategies are not very familiar to him.

Moreover, due to lack of code of conduct among brokers and trading members, they poach investors from one another under discount rate temptation.

CONCLUSION Derivatives products initially emerged as hedging device against fluctuation in commodity prices and commodity-linked derivatives remained the sole form of 105

such products. The financial derivative came in the spotlight in post 1970 due to growing instability in financial market. The derivative market performs a number of important economic functions. The prices of various instruments in a well-developed market reflect the market perception about the future.

A need was felt in India to start derivatives trading, as the derivative products became important instruments if price discovery, portfolio diversification and risk hedging in stock markets all over the world. Introduction of derivatives have made substantial improvement in market quality on underlying equity market. It was felt that liquidity and efficiency of Indian equity market will improve the introduction of stock market derivatives.

Foreign investors would be attracted more too Indian capital market hedging vehicles is worldwide available. The well functioning derivative market will improve the market efficiency and revive the primary market. It will improve markets ability to direct resources towards the projects and industries with consistent returns. These factors have encouraged Indian capital market consistent returns.

The derivative market segment growth pattern is a phenomenon in itself. The market of F&O segment at a very good rate. Over years from May 2001 to May 2002 growth rate is near about 200%. In 2005-06, the turnover in the derivative segment of NSE is about 307 percent of cash segment turnover.

The part of Future in F&O segment shows a more preference of future than option. On the same track in stock and stock future turnover are more than index option and index futures.

No doubt it is growing day by day but the problems confronting the derivative market segment is giving it a low customer base. The main problems are lack of knowledge, lot size. These problems can be overcome easily by revising the lot size and there should be seminar on derivatives at different places to aware the investors about Derivative Market. Derivative membership at

106

exchanges is required to be taken separately. This restricts the entry of those brokers who are otherwise qualified to enter the market.

107

Annexure QUESTIONNAIRE I am Gaurav parmar pursuing MBA from Gian Jyoti institute of management and technology, Mohali. As a part of the curriculum I am doing research on “STUDY OF DERIVATIVES IN THE FINANCIAL MARKETS”. Kindly help me in the same by filling the Questionnaire. Your response would be kept strictly confidential and would be used only for academic research.

1. From how long you have been investing in share market?

• • • •

Less than 2 year 2-4 year 4-6 year More than 6 year

2. How much percentage of your saving have you invested?

• • • •

Less than 25% ( ) 25% to 50% 50%to 75% More than 75%

3. Have you ever used (Future’s, Option’s) or any other Derivative?

Yes ( )

No ( )

4. Which Derivative (Future’s, Option’s), have you used?

Index Future ( )

Stock Future ( )

Index Option ( )

Stock Option ( )

Interest rate Future ( )

5. Which time horizon do you prefer for dealing in derivatives? one month ( )

two month ( )

108

three month ( )

6. In your opinion, which factor has influenced you as an investor to deal with Derivatives. a) Availability of Hedging and Short Selling strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

b) Minimum cash requirement strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

c) Higher return by investing small amount of Capital strongly agree ( )

agree ( )

disagree ( )

neutral ( )

strongly disagree ( )

d) Liquidity strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

7. To what extent following factors discouraged the investor to deal with derivatives. a)

Lot size Very strongly ( )

strongly ( )

Lightly ( )

neutral ( )

very lightly ( )

b) Taxation treatment of gains and losses Very strongly ( ) Lightly ( )

strongly ( )

neutral ( )

very lightly ( )

c) Margin requirement Very strongly ( ) Lightly ( )

strongly ( )

neutral ( )

very lightly ( )

d) Brokerage Very strongly ( ) Lightly ( )

strongly ( )

very lightly ( ) 109

neutral ( )

8. To what extent are you satisfied with your investment in Future’s and Option’s?

Very Satisfied ( ) Dissatisfied (

Satisfied ( )

)

Indifference ( )

Very Dissatisfied ( )

9. How much importance would you assign to each of the following factors at the time of investing your money in Future’s and Option’s?

Very important ( )

IMPORTANT (

)

Not important (

)

10. Please rate the following statements a) There is a need to reduce/revise lot size. strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

b) In India, Futures are used more in comparison to option’s strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

c)There is an increase in volume of derivative trading (future and options) as compared to cash market since 2000 strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

d) Volatility in share market has led to gaining popularity of derivative instrument like hedging and short selling strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( )

e) Derivative helps in bringing FII’s investment. strongly agree ( ) disagree ( )

agree ( )

neutral ( )

strongly disagree ( ) 110

Bibliography:  www.nseindia.com  www.bseindia.com  www.derivativesindia.com  www.icmrindia.org

 www.eurojournals.com  www.sebi.gov.in/faq/derivatives  Financial Derivatives Theory Concepts And Problems

111