A Derivative is a financial instrument whose value depends on other

8/7/2019 A Derivative is a financial instrument whose value depends on other

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A Derivative is a financial instrument whose value depends on other, more basic,

underlying variables. The variables underlying could be prices of traded securities

and stock, prices of gold or copper. Derivatives have become increasingly

important

in the field of finance, Options and Futures are traded actively on many exchanges,

Forward contracts, Swap and different types of options are regularly traded outside

exchanges by financial intuitions, banks and their corporate clients in what are

termed

as over-the-counter markets in other words, there is no single market place

organized exchanges. Interpretation

NEED OF THE STUDY

The study has been done to know the different types of derivatives and also to

know

the derivative market in India. This study also covers the recent developments in

the

derivative market taking into account the trading in past years.

Through this study I came to know the trading done in derivatives and their use in

the stock markets.

SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better

understanding various strategies with different situations and actions have been

given. It includes the data collected in the recent years and also the market in thederivatives in the recent years. This study extends to the trading of derivatives

done in the National Stock Markets.


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3. INTRODUCTION TO DERIVATIVES

DERIVATIVES

The origin of derivatives can be traced back to the need of farmers to protect

themselves against fluctuations in the price of their crop. From the time it was

sown to the time it was ready for harvest, farmers would face price uncertainty.

Through the use of simple derivative products, it was possible for the farmer to

partially or fully transfer price risks by locking-in asset prices. These were simple

contracts developed to meet the needs of farmers and were basically a means of

reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he

would receive for his harvest in September. In years of scarcity, he would probably

obtain attractive prices. However, during times of oversupply, he would have to

dispose off his harvest at a very low price. Clearly this meant that the farmer and

his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too

would face a price risk that of having to pay exorbitant prices during dearth,

although favorable prices could be obtained during periods of oversupply. Under

such circumstances, it clearly made sense for the farmer and the merchant to cometogether and enter into contract whereby the price of the grain to be delivered in

September could be decided earlier. What they would then negotiate happened to

be futures-type contract, which would enable both parties to eliminate the price

risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers

and merchants together. A group of traders got together and created the to-arrive

contract that permitted farmers to lock into price upfront and deliver the grain later.

These to-arrive contracts proved useful as a device for hedging and speculation on

price charges. These were eventually standardized, and in 1925 the first futures

clearing house came into existence.


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Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also

exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.


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HISTORICAL ASPECT OF DERIVATIVES:

The need for derivatives as hedging tool was first felt in the commodities

market. Agricultural F&O helped farmers and PROCESSORS hedge against

commodity price risk. After the fallout of BRITAIN WOOD AGREEMENT, the

financial markets in the world started undergoing radical changes, which give rise

to the risk factor. This situation led to development of derivatives as effective

"Risk Management tools".

Derivative trading in financial market started in 1972 when "Chicago

Mercantile Exchange opened its International Monetary Market Division (IIM).

The IMM provided an outlet for currency speculators and for those looking to

reduce their currency risks. Trading took place on currency. Futures, which were

contracts for specified quantities of given currencies, the exchange rate was fixed

at time of contract later on commodity future contracts was introduced then

followed by interest rate futures.

Looking at the liquidity market, derivatives allow corporate and institutional

investors to effectively manage their portfolios of assets and liabilities throughinstruments like stock index futures and options. An equity fund e.g. can reduce its

exposure to the stock market and at a relatively low cost without selling of part of

its equity assets by using stock index futures or index options. Therefore the stock

index futures first emerged in U.S.A. in 1982.


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3.1DERIVATIVES DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can be

equity, forex, commodity or any other asset. In our earlier discussion, we saw thatwheat farmers may wish to sell their harvest at a future date to eliminate the risk of

change in price by that date. Such a transaction is an example of a derivative. The

price of this derivative is driven by the spot price of wheat which is the

underlying in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the Forward

Markets Commission (FMC) continues to have jurisdiction over commodityfutures contracts. However when derivatives trading in securities was introduced in

2001, the term security in the Securities Contracts (Regulation) Act, 1956

(SCRA), was amended to include derivative contracts in securities. Consequently,

regulation of derivatives came under the purview of Securities Exchange Board of

India (SEBI). We thus have separate regulatory authorities for securities and

commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivatives

is governed by the regulatory framework under the SCRA. The Securities

Contracts (Regulation) Act, 1956 defines derivative to include-

A security derived from a debt instrument, share, loan whether secured or

unsecured, risk

instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of underlyingsecurities


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There are various derivative products traded. They are;

1.Forwards

2.Futures

3.Options

4.Swaps

A Forward Contract is a transaction in which the buyer and the seller agree upon

a delivery of a specific quality and quantity of asset usually a commodity at a

specified future date. The price may be agreed on in advance or in future.

A Future contract is a firm contractual agreement between a buyer and seller fora specified as on a fixed date in future. The contract price will vary according to

the market place but it is fixed when the trade is made. The contract also has a

standard specification so both parties know exactly what is being done.

An Options contract confers the right but not the obligation to buy (call option) or

sell (put option) a specified underlying instrument or asset at a specified price the

Strike or Exercised price up until or an specified future date the Expiry date. The

Price is called Premium and is paid by buyer of the option to the seller or writer of

the option.

A call option gives the holder the right to buy an underlying asset by a certain

date for a certain price. The seller is under an obligation to fulfill the contract and

is paid a price of this, which is called "the call option premium or call option

price".

A put option, on the other hand gives the holder the right to sell an underlying

asset by a certain date for a certain price. The buyer is under an obligation to fulfill

the contract and is paid a price for this, which is called "the put option premium or

put option price".


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Swaps are transactions which obligates the two parties to the contract to exchange

a series of cash flows at specified intervals known as payment or settlement dates.

They can be regarded as portfolios of forward's contracts. A contract whereby twoparties agree to exchange (swap) payments, based on some notional principle

amount is called as a SWAP. In case of swap, only the payment flows are

exchanged and not the principle amount


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Types of Derivatives

FORWARD CONTRACTS:

A forward contract is an agreement to buy or sell an asset on a specified date for

a specified price. One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specified future date for a certain

specified price. The other party assumes a short position and agrees to sell the

asset on the same date for the same price. Other contract details like delivery

date, price and quantity are negotiated bilaterally by the parties to the contract.

The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are:

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the asset.

If the party wishes to reverse the contract, it has to compulsorily go to the same

counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized, as

in the case of foreign exchange, thereby reducing transaction costs and increasing

transactions volume. This process of standardization reaches its limit in the

organized futures market. Forward contracts are often confused with futures

contracts. The confusion is primarily because both serve essentially the same

economic functions of allocating risk in the presence of future price uncertainty.However futures are a significant improvement over the forward contracts as they

eliminate counterparty risk and offer more liquidity.

Features:

c an be of any agreed amount and hence offer flexibility


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c ontract dates available for two years and hence better than interest rate

futures which have specific periods and commence on standardised dates.

Good volumes and finer spreads

Provide opportunity to hedge interest rate exposures without recourse to

cash markets.

Are off balance sheet items and have no margin requirements

Relate only to interest rate movements and not the underlying amount.T

herefore counterparty credit risk is smaller.

Uses:

Manage or hedge interest rate risk

C an be used to eliminate the interest rate risk of a bank in funding

relatively long term fixed rate loans with short term or variable rate deposits

C an be used by a C orporate borrower to convert a variable rate loan to afixed rate loan

C an be used for speculation on interest rates in future

(ii)

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in the

future, at a pre-set price. The future date is called the delivery date or final

settlement date. The pre-set price is called the futures price. The price of the

underlying asset on the delivery date is called the settlement price. The settlement

price, normally, converges towards the futures price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which

differs from an options contract, which gives the buyer the right, but not the

obligation, and the option writer (seller) the obligation, but not the right. To exit

the commitment, the holder of a futures position has to sell his long position or buy

back his short position, effectively closing out the futures position and its contract


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obligations. Futures contracts are exchange traded derivatives. The exchange acts

as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:Futures contracts ensure their liquidity by being highly standardized, usually by

specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a

short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the

notional amount of bonds, a fixed number of barrels of oil, units of foreign

currency, the notional amount of the deposit over which the short term interest rate

is traded, etc.

OPTIONS -

A derivative transaction that gives the option holder the right but not the obligation

to buy or sell the underlying asset at a price, called the strike price, during a period

or on a specific date in exchange for payment of a premium is known as option.

Underlying asset refers to any asset that is traded. The price at which the

underlying is traded is called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION: A contract that gives its owner the right but not the obligation to

buy an underlying asset-stock or any financial asset, at a specified price on or

before a specified date is known as a Call option. The owner makes a profit

provided he sells at a higher current price and buys at a lower future price.

PUT OPTION: A contract that gives its owner the right but not the obligation to

sell an underlying asset-stock or any financial asset, at a specified price on or

before a specified date is known as a Put option. The owner makes a profit


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provided he buys at a lower current price and sells at a higher future price. Hence,

no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally

preference shares, bonds and warrants become the subject of options.

Uses of options :

When one is not sure of the direction of exchange rates, options limit

losses and provide access to unlimited profits.

When market is stable writing options is profitable as premium is earned

without much risk.

When one is not sure of winning a tender, it comes as a handy hedging tool.Useful in hedging exposure to uncertain amounts and timing.

Best answer to hedging translation exposure as that is not real exposure.

Very useful in hedging on account of foreign currency loans as the amounts

are relatively large

SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange

a series of cash flows at specified intervals known as payment or settlement dates.

They can be regarded as portfolios of forward's contracts. A contract whereby two

parties agree to exchange (swap) payments, based on some notional principle

amount is called as a SWAP. In case of swap, only the payment flows are

exchanged and not the principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his

series of fixed rate interest payments to a party in exchange for his variable rate

interest payments. The fixed rate payer takes a short position in the forward

contract whereas the floating rate payer takes a long position in the forward

contract.


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CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the

interest on loan in one currency are swapped for the principle and the interest

payments on loan in another currency. The parties to the swap contract of currency

generally hail from two different countries. This arrangement allows the counter

parties to borrow easily and cheaply in their home currencies. Under a currency

swap, cash flows to be exchanged are determined at the spot rate at a time when

swap is done. Such cash flows are supposed to remain unaffected by subsequent

changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to access

one market and then exchange the liability for another type of liability. It alsoallows the investors to exchange one type of asset for another type of asset with a

preferred income stream.

Other forms of Swaps

C ross currencySwap:Is a combination of currency and interest rate

swap wherein two parties having borrowings in different currencies with

different interest profiles agree to service the principal and interest liability of

the counter party.

Asset Swap: In an Interest RateS wap, if the interest streams being exchanged

are funded with interest received on a specific asset . It is named on the

account of the purpose it serves.

T erm swap: If swap is for more than two years.T he fixed interest paid is

yield on fixed income bonds of the same tenor

Money market swap:Swaps having a tenor upto two years. Also

known as IMM swaps

Uses of Swaps:

Swaps are used for:

1. Raising finance at cheaper cost


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2. Obtaining high yield assets

3. Hedging against interest rate exposure

4. Hedging against exchange rate exposures

5. Raising resources abroad which mayotherwise not be allowed by authorities6. Used as a tool ofAsset Liability Management especially in the short term

7. Arbitraging in different countries

8.S peculation

Interest Rate - Caps,Floors, Collars :

T hese instruments are used to hedge interestrate risk.They protectC orporates

from interest rate volatility.T hey are also used to fund medium term projects

with short term money.

Interest Rate cap:

T his is an agreement between a bank and a corporate borrower with floating

rate debt,whereby the bank, in return for a premium,undertakes to bear the

extra cost on interest rate going up beyond the agreed rate during an agreed

premium.T his caps the interest payment of the borrower as any rise will be

borne by the bank.

Interest rate floor:T his is an agreement under which the bank and a corporate lender on

floating basis agree that thebank, for a premium ,will set a floor on the

interest income to be earned by the lender.

Interest Rate collar:

If a corporate takes a view that the interest rates will remain in a range (band),

it can combine a capand a floor, thus protecting its upside risk at a

very low cost.


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OTHER KINDS OF DERIVATIVES:

The other kind of derivatives, which are not, much popular are as follows:

BASKETS - Baskets options are option on portfolio of underlying asset. Equity

Index Options are most popular form of baskets.

LEAPS - Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years.

These long-term option contracts are popularly known as Leaps or Long term

Equity Anticipation Securities.

WARRANTS - Options generally have lives of up to one year, the majority ofoptions traded on options exchanges having a maximum maturity of nine months.

Longer-dated options are called warrants and are generally traded over-the-counter.

SWAPTIONS - Swaptions are options to buy or sell a swap that will become

operative at the expiry of the options. Thus a swaption is an option on a forward

swap. Rather than have calls and puts, the swaptions market has receiver swaptions

and payer swaptions. A receiver swaption is an option to receive fixed and pay

floating. A payer swaption is an option to pay fixed and receive floating.

Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few

years, which has accompanied the modernization of commercial and investment

banking and globalisation of financial activities. The recent developments in

information technology have contributed to a great extent to these developments.

While both exchange-traded and OTC derivative contracts offer many benefits, the

former have rigid structures compared to the latter. It has been widely discussedthat the highly leveraged institutions and their OTC derivative positions were the

main cause of turbulence in financial markets in 1998. These episodes of

turbulence revealed the risks posed to market stability originating in features of

OTC derivative instruments and markets.


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The OTC derivatives markets have the following features compared to exchange-

traded derivatives:

1.The management of counter-party (credit) risk is decentralized and

located within individual institutions,

2.There are no formal centralized limits on individual positions, leverage, or

margining,

3.There are no formal rules for risk and burden-sharing,

4.There are no formal rules or mechanisms for ensuring market stability and

integrity, and for safeguarding the collective interests of market

participants, and

5.The OTC contracts are generally not regulated by a regulatory authority and the

exchanges self-regulatory organization, although they are affected indirectly by

national legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.

The following features of OTC derivatives markets can give rise to instability in

institutions, markets, and the international financial system:

(i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii)

the effects of OTC derivative activities on available aggregate credit; (iv) the high

concentration of OTC derivative activities in major institutions; and (v) the centralrole of OTC derivatives markets in the global financial system. Instability arises

when shocks, such as counter-party credit events and sharp movements in asset

prices that underlie derivative contracts, occur which significantly alter the

perceptions of current and potential future credit exposures. When asset prices

change rapidly, the size and configuration of counter-party exposures can become

unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However,

the progress has been limited in implementing reforms in risk management,

including counter-party, liquidity and operational risks, and OTC derivatives

markets continue to pose a threat to international financial stability. The problem is

more acute as heavy reliance on OTC derivatives creates the possibility of


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systemic financial events, which fall outside the more formal clearing house

structures. Moreover, those who provide OTC derivative products, hedge their

risks through the use of exchange traded derivatives. In view of the inherent risks

associated with OTC derivatives, and their dependence on exchange tradedderivatives, Indian law considers them illegal.

INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where pricesfluctuate every day. The introduction of risk management instruments in India

gained momentum in the last few years due to liberalisation process and Reserve

Bank of Indias (RBI) efforts in creating currency forward market. Derivatives are

an integral part of liberalisation process to manage risk. NSE gauging the market

requirements initiated the process of setting up derivative markets in India. In July

1999, derivatives trading commenced in India

Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Today, derivatives have

become part and parcel of the day-to-day life for ordinary people in major part

ofthe world.

Until the advent of NSE, the Indian capital market had no access to the latest

trading methods and was using traditional out-dated methods of trading. There

was a huge gap between the investors aspirations of the markets and the

available means of trading. The opening of Indian economy has precipitated the

process of integration of Indias financial markets with the international financial

markets. Introduction of risk management instruments in India has gained

momentum in last few years thanks to Reserve Bank of Indias efforts in allowing


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forward contracts, cross currency options etc. which have developed into a very

large market.

Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Financial derivatives came into

the spotlight along with the rise in uncertainty of post-1970, when US announced

an end to the Bretton Woods System of fixed exchange rates leading to

introduction of currency derivatives followed by other innovations including stock

index futures. Today, derivatives have become part and parcel of the day-to-day

life for ordinary people in major parts of the world. While this is true for manycountries, there are still apprehensions about the introduction of derivatives. There

are many myths about derivatives but the realities that are different especially for

Exchange traded derivatives, which are well regulated with all the safety

mechanisms in place.

What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose.

Indian Market is not ready for derivative trading.

Disasters prove that derivatives are very risky and highly leveraged instruments.

Derivatives are complex and exotic instruments that Indian investors will find

difficulty in understanding.

Is the existing capital market safer than Derivatives?


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Derivatives increase speculation and do not serve any economic purpose:

Numerous studies of derivatives activity have led to a broad consensus, both in the

private and public sectors that derivatives provide numerous and substantial

benefits to the users. Derivatives are a low-cost, effective method for users to

hedge and manage their exposures to interest rates, commodity prices or exchange

rates. The need for derivatives as hedging tool was felt first in the commodities

market. Agricultural futures and options helped farmers and processors hedge

against commodity price risk. After the fallout of Bretton wood agreement, the

financial markets in the world started undergoing radical changes. This period is

marked by remarkable innovations in the financial markets such as introduction of

floating rates for the currencies, increased trading in variety of derivativesinstruments, on-line trading in the capital markets, etc. As the complexity of

instruments increased many folds, the accompanying risk factors grew in gigantic

proportions. This situation led to development derivatives as effective risk

management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities through

instruments like stock index futures and options. An equity fund, for example, can

reduce its exposure to the stock market quickly and at a relatively low cost

without selling off part of its equity assets by using stock index futures or index

options.

By providing investors and issuers with a wider array of tools for

managing risks and raising capital, derivatives improve the allocation of credit

and the sharing of risk in the global economy, lowering the cost of capital

formation and stimulating economic growth. Now that world markets for trade and

finance have become more integrated, derivatives have strengthened these

important linkages between global markets, increasing market liquidity and

efficiency and facilitating the flow of trade and finance.


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FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the

financial theories.

A. PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects having

value maybe commodities, local currency or foreign currencies. The concept of

price is clear to almost everybody when we discuss commodities. There is a price

to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays

for use of a unit of another persons money is called interest rate. And the price one

pays in ones own currency for a unit of another currency is called as an exchange

rate.

Prices are generally determined by market forces. In a market, consumers have

demand and producers or suppliers have supply, and the collective interaction

of demand and supply in the market determines the price. These factors are

constantly interacting in the market causing changes in the price over a short

period of time. Such changes in the price are known as price volatility. This has

three factors: the speed of price changes, the frequency of price changes and the

magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The break down of the

BRETTON WOODS agreement brought and end to the stabilising role of fixed

exchange rates and the gold convertibility of the dollars. The globalisation of themarkets and rapid industrialisation of many underdeveloped countries brought a

new scale and dimension to the markets. Nations that were poor suddenly became

a major source of supply of goods. The Mexican crisis in the south east-Asian

currency crisis of 1990s has also brought the price volatility factor on the surface.

The advent of telecommunication and data processing bought information very


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quickly to the markets. Information which would have taken months to impact the

market earlier can now be obtained in matter of moments. Even equity holders are

exposed to price risk of corporate share fluctuates rapidly.

These price volatility risks pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against adverse

price changes in commodity, foreign exchange, equity shares and bonds.

B. GLOBALISATION OF MARKETS

Earlier, managers had to deal with domestic economic concerns; what happened in

other part of the world was mostly irrelevant. Now globalisation has increased the

size of markets and as greatly enhanced competition .it has benefited consumers

who cannot obtain better quality goods at a lower cost. It has also exposed the

modern business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis--vis depreciated currencies. Export of certain

goods from India declined because of this crisis. Steel industry in 1998 suffered its

worst set back due to cheap import of steel from south East Asian countries.

Suddenly blue chip companies had turned in to red. The fear of china devaluing its

currency created instability in Indian exports. Thus, it is evident that globalisationof industrial and financial activities necessitates use of derivatives to guard against

future losses. This factor alone has contributed to the growth of derivatives to a

significant extent.


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STRENGTH OF INDIAN CAPITAL MARKET FOR INTRODUCTION OF

DERIVATIVES:

1.LARGE MARKET CAPITALIZATION:

India is one of the largest market capitalized country

in Asia with a market capitalization of more than 7,65,000 corers.

2.HIGH LIQUIDITY : In the underlying securities the daily average traded volume

in Indian capital market today is around 7,500 crores. Which means on an average

every month 14% of the country market capitalization gets traded, shows high

liquidity.

3.TRADER GUARANTEE: The first "clearing corporation" (CCL) guaranteeing

trades has become fully functional from July 1996 in the form of National

Securities Clearing Corporation (NSCCL) for which it does the clearing.

4.STRONG DEPOSITORY : A strong depository National Securities Depositories

Ltd.(NSDL), which started functioning in the year 1997, has strengthen the

securities settlement in our country.

5.A GOOD LEGAL GUARDIAN : SEBI is acting as a good legal guardian for

Indian Capital market


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DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern trading

of derivatives. SEBI set up a 24member committee under the Chairmanship of

Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework

for derivatives trading in India. The committee submitted its report on March 17,

1998 prescribing necessary preconditions for introduction of derivatives trading

in India. The committee recommended that derivatives should be declared as

securities so that regulatory framework applicable to trading of securities couldalso govern trading of securities. SEBI also set up a group in June 1998 under the

Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in

derivatives market in India. The report, which was submitted in October 1998,

worked out the operational details of margining system, methodology for charging

initial margins, broker net worth, deposit requirement and realtime monitoring

requirements. The Securities Contract Regulation Act (SCRA) was amended in

December 1999 to include derivatives within the ambit of securities and theregulatory framework were developed for governing derivatives trading. The act

also made it clear that derivatives shall be legal and valid only if such contracts are

traded on a recognized stock exchange, thus precluding OTC derivatives. The

government also rescinded in March 2000, the three decade old notification, which

prohibited forward trading in securities. Derivatives trading commenced in India in

June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI

permitted the derivative segments of two stock exchanges, NSE and BSE, and their

clearing house/corporation to commence trading and settlement in approved

derivatives contracts. To begin with, SEBI approved trading in index futures

contracts based on S&P CNX Nifty and BSE30 (Sense) index. This was followed

by approval for trading in options based on these two indexes and options on

individual securities.


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The trading in BSE Sensex options commenced on June 4, 2001 and the trading in

options on individual securities commenced in July 2001. Futures contracts on

individual stocks were launched in November 2001. The derivatives trading on

NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. Thetrading in index options commenced on June 4, 2001 and trading in options on

individual securities commenced on July 2, 2001. Single stock futures were

launched on November 9, 2001. The index futures and options contract on NSE are

based on S&P CNX Trading and settlement in derivative contracts is done in

accordance with the rules, byelaws, and regulations of the respective exchanges

and their clearing house/corporation duly approved by SEBI and notified in the

official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all

Exchange traded derivative products.

The following are some observations based on the trading statistics provided in

the NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the F&O

segment. It constituted 70 per cent of the total turnover during June 2002. A

primary reason attributed to this phenomenon is that traders are comfortable with

single-stock futures than equity options, as the former closely resembles the

erstwhile badla system.

y On relative terms, volumes in the index options segment continue toremain poor. This may be due to the low volatility of the spot index.

Typically, options are considered more valuable when the volatility of

the underlying (in this case, the index) is high. A related issue is that

brokers do not earn high commissions by recommending indexoptions to their clients, because low volatility leads to higher waiting

time for round-trips.

y Put volumes in the index options and equity options segment haveincreased since January 2002. The call-put volumes in index options


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have decreased from 2.86 in January 2002 to 1.32 in June. The fall in

call-put volumes ratio suggests that the traders are increasingly

becoming pessimistic on the market.

Farther month futures contracts are still not actively traded. Trading inequity options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as a less

risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. If calls and puts are not looked as just substitutes for spot trading,

the intra-day stock price variations should not have a one-to-one impact on the

option premiums.

The spot foreign exchange market remains the most important segment but the

derivative segment has also grown. In the derivative market foreign exchange

swaps account for the largest share of the total turnover of derivatives in India

followed by forwards and options. Significant milestones in the development of

derivatives market

have been (i) permission to banks to undertake cross currency derivative

transactions subject to certain conditions (1996) (ii) allowing corporates to

undertake long term foreign currency swaps that contributed to the development of

the term currency swap market (1997) (iii) allowing dollar rupee options (2003)

and (iv) introduction of currency futures (2008). I would like to emphasise that

currency swaps allowed companies with ECBs to swap their foreign currency

liabilities into rupees. However, since banks could not carry open positions the risk

was allowed to be transferred to any other resident corporate. Normally such risks

should be taken by corporates whohave natural hedge or have potential foreign

exchange earnings. But often corporate assume these risks due to interest ratedifferentials and views on currencies.

This period has also witnessed several relaxations in regulations relating to forex

markets and also greater liberalisation in capital account regulations leading to

greater integration with the global economy.


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Cash settled exchange traded currency futures have made foreign currency a

separate asset class that can be traded without any underlying need or exposure and

on a leveraged basis on the recognized stock exchanges with credit risks being

assumed by the central counterparty

Since the commencement of trading of currency futures in all the three exchanges,

the value of the trades has gone up steadily from Rs 17, 429 crores in October 2008

to Rs 45, 803 crores in December 2008. The average daily turnover in all the

exchanges has also increased from Rs871 crores to Rs 2,181 crores during the

same period. The turnover in the currency futures market is in line with the

international scenario, where I understand the share of futures market ranges

between 2 3 per cent.

BENEFITS OF DERIVATIVES:

Derivative markets help investors in many different ways:

1. RISK MANAGEMENT Futures and options contract can be used for altering

the risk of investing in spot market. For instance, consider an investor who owns

an asset. He will always be worried that the price may fall before he can sell the

asset. He can protect himself by selling a futures contract, or by buying a Put

option. If the spot price falls, the short hedgers will gain in the futures market, as

you will see later. This will help offset their losses in the spot market. Similarly, if

the spot price falls below the exercise price, the put option can always be

exercised.

2. PRICE DISCOVERY Price discovery refers to the markets ability to

determine true equilibrium prices. Futures prices are believed to contain

information about future spot prices and help in disseminating such information.

As we have seen, futures markets provide a low cost trading mechanism. Thus

information pertaining to supply and demand easily percolates into such markets.Accurate prices are essential for ensuring the correct allocation of resources in a

free market economy. Options markets provide information about the volatility or

risk of the underlying asset.


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3.OPERATIONAL ADVANTAGES As opposed to spot markets, derivatives

markets involve lower transaction costs. Secondly, they offer greater liquidity.

Large spot transactions can often lead to significant price changes. However,

futures markets tend to be more liquid than spot markets, because herein you can

take large positions by depositing relatively small margins. Consequently, a large

position in derivatives markets is relatively easier to take and has less of a price

impact as opposed to a transaction of the same magnitude in the spot market.

Finally, it is easier to take a short position in derivatives markets than it is to sell

short in spot markets.

4. MARKET EFFICIENCY The availability of derivatives makes markets more

efficient; spot, futures and options markets are inextricably linked. Since it is easier

and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities

quickly and to keep prices in alignment. Hence these markets help to ensure thatprices reflect true values.

5. EASE OF SPECULATION Derivative markets provide speculators with a

cheaper alternative to engaging in spot transactions. Also, the amount of capital

required to take a comparable position is less in this case. This is important

because facilitation of speculation is critical for ensuring free and fair markets.

Speculators always take calculated risks. A speculator will accept a level of risk

only if he is convinced that the associated expected return is commensurate with

the risk that he is taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying at the

expiration of derivative contract. Thus derivatives help in discovery of future as

well as current prices.

An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of activity.


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NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was promotedby Central Warehousing Corporation (CWC), National Agricultural Cooperative

Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation

Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB),

National Institute of Agricultural Marketing (NIAM), and Neptune Overseas

Limited (NOL). While various integral aspects of commodity economy, viz.,

warehousing, cooperatives, private and public sector marketing of agricultural

commodities, research and training were adequately addressed in structuring the

Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took

equity of the Exchange to establish that linkage. Even today, NMCE is the only

Exchange in India to have such investment and technical support from the

commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by

CMC. It has robust delivery mechanism making it the most suitable for theparticipants in the physical commodity markets. It has also established fair and

transparent rule-based procedures and demonstrated total commitment towards

eliminating any conflicts of interest. It is the only Commodity Exchange in the

world to have received ISO 9001:2000 certification from British Standard

Institutions (BSI). NMCE was the first commodity exchange to provide trading

facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The contracts are

marked to market on daily basis. The system of upfront margining based on Value

at Risk is followed to ensure financial security of the market. In the event of high

volatility in the prices, special intra-day clearing and settlement is held. NMCE

was the first to initiate process of dematerialization and electronic transfer of


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warehoused commodity stocks. The unique strength of NMCE is its settlements via

a Delivery Backed System, an imperative in the commodity trading business.

These deliveries are executed through a sound and reliable Warehouse Receipt

System, leading to guaranteed clearing and settlement.

NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a

technology driven commodity exchange. It is a public limited company registered

under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in

Mumbai on April 23,2003. It has an independent Board of Directors and

professionals not having any vested interest in commodity markets. It has been

launched to provide a world-class commodity exchange platform for market

participants to trade in a wide spectrum of commodity derivatives driven by best

global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures

trading in commodities. Besides, NCDEX is subjected to various laws of the land

like the Companies Act, Stamp Act, Contracts Act, Forward Commission

(Regulation) Act and various other legislations, which impinge on its working. It is

located in Mumbai and offers facilities to its members in more than 390 centres

throughout India. The reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil,

Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags,

Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed

,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, silk,

silver, soyabean, sugar, tur,etc


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RECOMMENDATIONS & SUGGESTIONS:

RBI should play a greater role in supporting derivatives. Derivatives market should be developed in order to keep it at par with

other derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

After study it is clear that Derivative influence our Indian Economy up to much

extent. So, SEBI should take necessary steps for improvement in Derivative

Market so that more investors can invest in Derivative market.

There is a need of more innovation in Derivative Market because intoday scenario even educated people also fear for investing in

Derivative Market Because of high risk involved in Derivatives.


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CONCLUSION

On the basis of overall study on derivatives it was found that derivative

products initially emerged as hedging devices against fluctuation and commodity

prices and commodity linked derivatives remained the soul form of such products.

The financial derivatives came in spotlight in 1972 due to growing in stability in

financial market.

I was really surprised to see during my study that a layman or a simple

investor does not even know how to hedge and how to reduce risk on his

portfolios. All these activities are generally performed by big individual investors,

institutional investors, mutual funds etc.

No doubt that derivative growth towards the progress of economy is positive. But

the problems confronting the derivative market segment are giving it a low

customer base. The main problems that it confronts are unawareness and bit lot

sizes etc. these problems could be overcome easilyby revising lot sizes and also

there should be seminar and general discussions on derivatives at varied places.


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BIBLIOGRAPHY

1. BOOKS AND ARTICLES

NCFM on derivatives core module by NSEIL.

The Indian Commodity-Derivatives Market in Operations

2. MAGAZINES

The Dalal Street

LSE Bulletin

3. INTERNET SITES

www.nseindia.com www.derivativeindia.comwww.bseindia.com


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PROJECT ON

CORPORATE GOVERNANCE IN BANKS

BACHELORS OF COMMERCE-

BANKING AND INSURANCE

SEMESTER V

{2010-2011}

SUBMITTED

IN PARTIAL FULLFILLMENT OF THE REQUIREMENTS FOR THE

AWARD OF THE DEGREE OF BACHELORS OF COMMERCE-

BANKING AND INSURANCE

BY

KAILASH CHUGH

ROLL NO: 12

SMT. MITHIBAI MOTIRAM KUNDNANI COLLEGE

OF COMMERCE AND ECONOMICS

32nd

Road, T.P.S III Bandra, Mumbai- 400050


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DECLARATION

I KAILASH CHUGH the student of B.Com(Banking & Insurance) Semester

V (2010-2011) herby declare that I have completed the Project on

CORPORATE GOVERNANCE IN BANKS.

The information submitted is true and original to the best of my

knowledge.

KAILASH CHUGH.

Roll No.12


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CERTIFICATE

This is to certify that KAILASH CHUGH of B.Com (Banking &

Insurance) Semester V (2010-2011) has successfully completed the

project on CORPORATE GOVERNANCE IN BANKS under the guidance

of Prof. A.C VANJANI

Project Guide: Prof. A.C VANJANI

CourseCo-ordinator:-

Dr A.C VANJANI

Principal:-

Dr A.C Vanjani

Internal Examiner

External Examiner


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ACKNOWLEGDEMENT

It is indeed a moment of great pleasure to express my sense of profound gratitude

& indebtedness to all the people who have been instrumental in making my

research a rich experience.

First of all I would like to thank Mumbai University for having projects as a part of

B.B.I. curriculum. This project is a result of efforts of several people, who have

affected its shape and content.

At the outset I would like to thank our principal, project guide and course

coordinator Mr. Ashok Vanjani. It was my privilege to be trained under him, as I

have gained corporation & valuable guidance from him, throughout the preparation

of the project.

I would also like to thank especially my parents and my entire family and friends,

without whose corporation and understanding this wouldnt have been possible.

Eventually I would like the divine intervention who backed me at all times.


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INDEX

Sr No. Particulars Page No.

1. Executive summary 12. Introduction 23. Meaning& Definitions 3-44. What is corporate governance 55. Impact of Corporate Governance 66. Parties to corporate governance 6-77. Internal & External corporate governance controls 7-88. Corporate governance and its development 9-109. Corporate governance in bank 11-1710. Corporate governance in Banks Overview 1811. Importance of good corporate governance 1912. Concept of transparency (its crystal clear) 2013. Specialty & what corporate implies 21-2414. Birla committee (SEBI) recommendations(2000) 25-2615. Narayana Murthy committee (SEBI) Recommendation (2003) 26-2716. Corporate governance and world bank: 28-2917. Case study: HDFC BANK 30-3318 Conclusions 34-35


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www.sebi.gov.in

Documents

A Derivative is a financial instrument whose value depends on other