DECLARATION

I, Khushboo Agrawal, hereby declare that the project work has been carried
out through my own efforts and under the guidance of Mr. Taral Pathak and
Mr. Mayank Joshipura, faculty of AES PGIBM, Ahmedabad.

This project has been submitted as a part of study curriculum of MBA

program. The report has not been submitted to any other university.

Signature

1
ACKNOWLEDGEMENT

It is my great pleasure to present this report. I thank all those people who
helped me to make this project, by providing necessary information.

I would like to express my gratitude towards Mr. Nayan Thakkar of Kunvarji

group who spent his most valuable time and provided with all the necessary
details regarding the company.

I would also like to thank Ms. Sheetal Panchal and Mr. Kunal Shah, who
shared their knowledge and expertise.

I would also like to thank Mr. Taral Pathak and Mr. Mayank Joshipura of
AESPGIBM for their guidance throughout the preparation of the project and
for their valued suggestion.

At last I would like to thank all those people who helped me bring this
project to fruitism.

Date:

Place: Signature

2
EXECUTIVE SUMMARY

This project mainly focuses on Share market as a whole, its history and
development.

Herein, I discuss the basic concepts of the share market, what is equity
market, commodities market and derivatives market, how they function.

It discusses Kunvarji as a stock broking company, and its services.

Lastly, it includes an analysis on The Historic Market Crash of May 2006.

3
 KUNVARJI COMMODITIES & FINSTOCK PVT LTD.

The group is doing the business activities in the field of Shares and Stock
for more than 10 years and in the field of Commodities for more than 2 year.

The activities include those of trading as well as broking.

The company's sister concern, Kunvarji Commodities Brokers Pvt. Ltd. is a

member of NCDEX, MCX, NMCE and ACEL.

Kunvarji Commodities Brokers Pvt. Ltd. (India) a company which is pioneer

service provider in the field of an organized commodities and derivatives
sector with wide range of clients at large.

The trading in commodity futures and derivatives has an immense potential

in India and worldwide. In the international market, the commodity future
trading holds a big part of total turnover in the allied markets.

Kunvarji Commodities Brokers Pvt. Ltd. having wide business with 24

branches spread across the state of Gujarat, Maharashtra and Rajasthan.

It is an active member of Multi Commodity Exchange of India Ltd. (MCX)

and National Commodities & Derivatives Exchange Ltd. (NCDEX), and
Ahmedabad Commodities Exchange Limited (ACEL) which are totally
professional and since they work with the best technology, they can adopt
the best international practices for trading in the commodities and
derivative

The Kunvarji Fin stock Pvt. Ltd. is acting as a Member of National Stock
Exchange of India, NSE FO, BSE and ASE.

The KFPL is hopeful to take benefits of existing clients and can develop the
business of broking in shares and stock with the help of its rich experience.

In nut shell, Kunvarji are very well established enterprises with wide
coverage to host the investors.

4
 SPREAD OF BUSINESS:

Date of Incorporation: 28th, August 2003

No. of Branches: 24Branches across the state of Gujarat,

Maharashtra & Rajasthan

Active Trading Users: 164

Avg. Daily Volume: Rs. 950 crores (Approx 200 Million US $)

ASSOCIATE CONCERNS:

¾ Kunvarji Finance Pvt. Ltd.

¾ Kunvarji Fin stock Pvt. Ltd.

¾ Kunvarji Financial Brokers Pvt. Ltd.

¾ Kunvarji Brokers Pvt. Ltd.

¾ Kunvarji international commodities Pvt. Ltd. (DMCC) Dubai.

¾ Kunvarji Commodities Brokers Pvt. Ltd.

REGISTERED OFFICE:

310/311 SHYAMAK COMPLEX

OPP. SAHJANAND COLLEGE,
NEAR ‘L’ COLONY,
AMBAWADI,
AHMEDABAD – 380 0015
PH NO: 079-30089130-42

5
Track Record:

KCBPL stands for service quality and Innovation. Its share in the overall
commodity activity as improved over the years.

KCBPL enjoys pioneer position in broking business in India in commodity

futures and derivatives.

Infrastructure

• Office Area - 16000 Sq. Ft

• Number of Branches -24
• Qualified employees -134

Client Network

• Corporate Clients - 35
• Individual Clients - 3500

Coverage Of Business

• Ahmedabad – 3 Branches – 14 Users

• Mehsana – 3 Users
• Patan – 4 Users
• Deesa – 5 Users
• Bhabhar – 6 Users
• Bhuj – 4 Users
• Rajkot – 4 Users
• Baroda – 2 Users
• Bhavnagar – 3 Users
• Surendranagar – 3 Users
• Single Users:
• Mansa, Jetpur, Gondal, Surat, Nadiad

6
Technology & Connectivity

Number of V-Sat - 26
Total V-Sat Users - 108

Internet Connections - 2000

Total Users - 350

Services Offered

• Information for Trading and Arbitrage opportunities in various

commodities
• Daily Market Outlook
• Online Accounting Position on Website
• 14 Hours a day, Trading Opportunities
• Dematerialization of Commodities Stock

7
¾ MEMBERSHIP:

• National Commodity & Derivatives Exchange Ltd.

• Multi Commodity Exchange of India Ltd.

• Ahmedabad Commodities Exchange Ltd.

• Dubai (DGCX)

• NMCE

¾ Kunvarji’s Bankers & DPS

Bankers:

• HDFC Bank Ltd.

• ICICI Bank Ltd.
• UTI Bank Ltd.
• Central Bank of India
• The Bhuj Mercantile Bank Ltd.
• Bhabhar Vibhag Nagrik Sahakari Bank Ld.
• Sardar Ganj Nagrik Bank - Patan

¾ DPS

• HDFC Bank Ltd.

• UTI Bank Ltd

8
At present the firm has above 8000 registered clients, 24 V-sats, 350 user
ids. Average daily volume of over 950 crores (200 $ mn approx) for the group
branches and dealing offices spread across whole Gujarat.

The group has all the ingredients for providing best services viz.
professionally qualified work force, pin point guidance and most
professional advice, transparency, advanced technical support to cope up
with the entire changing scenario.

The two guiding regulation to success till now have been :

Regulation 1 Maximization of wealth of clients with true integrity.

Regulation 2 Always remember Regulation 1.

9
Turnover At NCDEX

Consistent increase in turnover along with trade increase in commodities is

shown in the graph.

November 9.13
December 9.92
January 12.13
February 12.36
March 17.68
April 20.43
May 26.15

percentage share at NCDEX

nov
26.15 9.13
9.82 dec
12.13 jan
feb
mar
20.43 12.36 apr
17.68
may

10
TURNOVER AT MCX:

Consistent increase in the turnover along with the increase in commodities

of the firm is shown in the chart below

November 4.13
December 5.12
January 9.03
February 21.45
March 29.63
April 32.63
may 38.05

4.13 5.12 november

9.03
38.05
december
21.45
january
february
march
april
32.63 29.63 may

11
INTRODUCTION TO COMMODITY MARKET

WHAT IS A COMMODITY?

The dictionary defines commodities as ‘Something useful that can be turned

to commercial or other advantage’ or ‘an article, of trade or commerce,
especially an agricultural or mining product that can be processed and
resold’

Therefore commodities really refer to things which in day to day life, we

simply take for granted. Like the wheat in our bread, the cotton in our
clothes, the gold in our ornaments, the petrol in our cars and so on.
However, shat many don’t know is that these very ordinary items are also
one of the finest investment avenues available.

WHAT ARE COMMODITIES FUTURES?

The commodity futures are the part and parcel of the commodity market,
but it does form a distinctive market within the wider commodity market.

The risks that will be dealt with are risks that originate in the commodity
markets. The tool that will be used to manage that risk is commodity
futures contracts.

The futures markets trade huge numbers of contracts daily. Many futures
contracts are thus extremely liquid. If the number and size of contracts are
taken into account, future market trades greater quantity (volume) than the
cash or spot markets.

The futures markets do not really fulfill the role of acting as a conduct for
the cash commodity. They are financial markets that play a financial role.

12
WHAT ARE COMMODITY FUTURES USED FOR?

It is estimated that around 60 to 70 percent of all trades transacted on

futures exchanges are done for the purpose of hedging. Although hedging is
the most important use of futures contracts, their use is obviously not
limited to that. They are there to take risk for profit.

That is why speculators are drawn to the futures markets like bees to a
honey jar. Speculators play a very important role in the whole market
mechanism. They bring liquidity to the markets.

Commodity futures contracts are also used to diversify portfolios.

Producers and their representatives (cooperatives, govt organizations) of

commodities use commodity futures to protect the selling price of their
commodity. Consumers and their representatives of the commodity use
commodity futures to fix their purchasing price within an acceptable level.

Other than the actual producers and consumers, there are participants with
investment interest in commodities. These participants seek to capitalize on
the profit opportunity and assume higher risks. Generally, these investors
are called ‘SPECULATORS’

There is a kind of participant who looks at imperfection in pricing of the

commodity between different markets. These imperfections are often short
lived and caused by restrictions in the markets, flow of capital, or physical
asset. These participant, called “arbitrageurs” assume relative low level of
risk compared with “speculators”

13
ACCESSIBILITY OF THE COMMODITY FUTURES
MARKET

What may not be so generally known is that the futures markets are
extremely accessible and can be utilized by virtually every business. They
are often more accessible than other derivatives, simply because they offer
risk management possibilities for much smaller quantities. This opens the
door to effective risk management even for the smaller business.

THE ORIGIN OF COMMODITY FUTURES TRADING

Futures trading must have originated from the execution of a pre-harvest

agreement between the farmer and the person who needs the grain.

The practice of buying futures contracts for a lower price and selling them
at higher price and buying for lower prices become a part of the futures
market.

Agriculture started with food crops. Futures trading must have originated
from the execution of a prior to harvest agreement between the farmer and
the person who needs the grain. What first started as oral agreements later
grew to be contracts. Then came advancing amounts for contracts surety.
When contracts became a normal practice, they were assigned the value of
the commodities themselves.

Also, these contracts started getting to be sold and bought like commodities.
That is, if the person who got into a agreement with the farmer didn’t need
the commodity anymore he could exchange the contracts with someone who
needed the grain.

Likewise, the farmer who reached the agreement and did not want to sell his
grain that moment could assign the contact to some other farmer ready to
sell. In the meantime, owing to some other farmer ready to sell his grain at
that moment could assign the contract to some other farmer ready to sell. In
the meantime to change in market and weather, there could be an increase
or decrease in the price.
If due to any reason there is a shortage in the availability of the commodity
then the selling price increases.

14
However if the supply increases the buying contract price decreases. It is
this situation that has attracted people to the future markets, bringing in
people who do not have their own commodity to sell or even those who do
not really need to buy. Thus the practice of buying for lesser prices has
become a part of the futures market. Seeing this opportunity to make bigger
profits when compared to common investment methods, many people, even
non-farmers, non buyers and even those who didn’t have a real requirement
are lured to the future market.

HOW TRADING BEGAN INTERNATIONALLY?

Though it is said that commodity trading formally started in Japan in the

17th century, there is evidence to suggest that a form of futures trading in
commodities existed in china 6000 years earlier. In the US, the futures
markets were developed initially to help agricultural producers and
consumers manage the price risks they faced while harvesting, marketing
and processing food crops each year. The modern futures industry still
serves those markets.

The world’s oldest established futures exchange, the Chicago Board of

Trade, was founded in 1848 by 82 Chicago merchants. The first of what
were then called ‘to arrive’ contracts were flour, timothy seed and hay,
which came into use in 1849. “Forward” contracts on corn came into use in
1851 and gained popularity among merchants and food processors.

Meanwhile, what is now the largest futures exchange in the US – the

Chicago Mercantile Exchange, was founded as the Chicago Butter and Egg
Board in 1898. At that time, trading was offered in-you guessed it-butter
and eggs.

15
COMMODITIES MARKET WORLD WIDE PICTURE

Commodities unlike stock/share, which mostly have an impact on the

country in which it is being listed or traded, can leave a long lasting
impression in almost all the countries in which it is traded. A group of
traders can never be in command of influencing a large price fluctuations
in commodities, as the prices are not determined by that particular sect/ or
group but by other factors i.e. international demand, supply, total
production, consumption expected, international regulation and
international state of affairs etc.

The cost of living index/wholesale price is determined by the price

variations in the commodities which are consumed by the general public
and the industries. The inflation or deflation are mostly linked with the
commodity price instability, they have epitomized themselves as a very
sturdy force in the international state of affairs.

Now almost all type of commodities are being traded that too in a more
organized manner, for instance CBOT has switched over to electronic
trading platform in the year 2000 and very recently it has switched over its
clearing operations to the same mode, at NYMEX the trading takes place
both in Open Out Cry and Electronic Mode, at TOCOM (Tokyo Commodity
Exchange) the trading is computerized and like wise all the international
exchanges the following the suit.

16
 LEADING EXCHANGES AROUND THE WORLD:
EXCHANGES
CBOT (Chicago Board of
Trade)
CME (Chicago Mercantile
Exchange)
NYBOT (New York Board of
Trade)
LME (London Metal
Exchange)
TOCOM (Tokyo Commodities Tokyo – Japan
Exchange)
LIFFE (London International
Financial Futures and
Options Exchange)
SICOM (Singapore
Commodity Exchange)
KITCO
NYMEX (New York
Mercantile Exchange)
PLACE TRADED COMMODITIES
Chicago – USA Soya (Bean, Oil and Meal),
Corn, Wheat, Rice, Gold
and Silver.
Chicago – USA Milk, Live cattle, Butter,
Urea, Ammonium Nitrate,
and Phosphate.
New York – USA Cocoa, Coffee, Cotton,
Sugar, and Citrus (Frozen
Orange Juice) Crop.
London – UK Aluminum and its alloys,
Copper, Lead, Nickel, Tin
and Zinc.
Gold, Silver, Platinum,
Palladium, Aluminum,
Gasoline, Kerosene, Crude
and Rubber.
London – UK Cocoa, Coffee (Robusta),
Sugar (White), Wheat,
Corn and Rapeseed.
Singapore Rubber and Coffee.
New York – USA Gold, Silver, Palladium
Quebec – Canada and Platinum.
New York – USA Crude oil (Brent and
Sweet), Heating oil,
Natural Gas, Electricity,
Propane, Coal, Gold,
Silver, Palladium,
Platinum, Copper and
Aluminum.
17
THE EVOLUTION OF COMMODITY TRADING IN INDIA

THE BEGINNING OF COMMODITY FUTURES TRADING IN INDIA

Commodity futures markets in India have a long history. The first organized
futures market appeared in 1921, when the Cotton Exchange, which dealt
in various types of cotton, was created in Bombay. A second exchange, the
Seeds Traders Association Ltd, also in Bombay was created in 1926. This
exchange traded oilseeds and their products – like castor seeds, groundnuts
and groundnut oil.

Many other exchanges followed, trading in commodities such as raw jute,

jute products, black pepper, turmeric, potatoes, sugar, food grains and
silver. Several exchanges traded in the same commodities and some of these
had formal trading links.

A complete regulatory framework for futures was drafted, including rules for
trading in futures, a system for the licensing of brokers and a clearing
house structure. Not only futures, but also options on a number of
commodities were traded on the exchanges; for example, options on cotton
were traded up to one year out, until all options were banned in 1939.

18
In the 1940s, forward and futures contracts as well as options were
outlawed as part of the governments drive to contain inflation or trading in
these contracts was made impossible through price controls.

This situation prevailed until 1952, when the government passed the
Forward Contract (Regulation) Act, which controls all transferable forward
contracts and futures up to this day. The Act again allowed futures trade in
a number of commodities (but excluded some essential foods like sugar and
food grains).

It provided that forward and futures markets should normally be self-

regulating – through governing bodies of recognized associations in which
the government has the right to place representatives.

During the 1960s, the central government banned or suspended futures

trading in several commodities including cotton, raw jute, edible oil seeds
and their products. In the 1970s, futures trading in non-edible oil seeds like
castor seed and linseed were forbidden. The reason for this crackdown in
futures markets was that government felt that these markets helped drive
up prices for commodities, by giving free reign to speculators.

Restrictive measures were directed at combating speculation, which affected

the activities of 31 ‘recognized associations’, which were supposed to
regulate trade and commodities futures.

The government policies softened somewhat in the late 1970s when futures
trade in jaggery was allowed. Two government appointed comities – the
Datwala Committee in 1966 and the Khusro Committee in 1979 –
recommended the revival of futures trading in a wide range of commodities,
but little action resulted.

Contracts in most commodities are actively traded for periods up to six

months out and as should be the case for mature future markets, most
contracts are used for hedging purposes and not for physical trade. This
means that a large majority of positions are closed out before maturity and
physical delivery is relatively rare.

The Indian economy is going through a process of liberalization and is

opening up to the world market. Partly, as a result, Indian exporters are
increasingly confronted with highly competitive world markets in which they
are forced not only to work on slimmer margins but also to sell further
forwards in order not to lose markets.

19
The rupee gas becomes fully convertible for commercial purposes. Against
this background, the role of commodity futures market is being recognized
by the government, through the Forward Market Commission (FMC) to
assist them in this internationalization process.

India has recently seen three National Level Electronic Exchanges

facilitating commodity trading.

¾ National Commodity Exchange ( www.ncdex.com)

¾ Multi Commodity Exchange (www.mcxindia.com)
¾ National Multi Commodity of India (www.nmce.com)

Besides this, there are at least 20 other Regional Commodity Exchanges

also in India.

¾ Rajdhani Oils and Oilseeds Exchange Ltd., Delhi (www.roel.com)

¾ Ahmedabad Commodity Exchange Ltd. (www.acecastorfuture.com)
¾ Bhatinda Om and Oil Exchange Ltd.
¾ Bikaner Commodity Exchange Ltd. (www.bcel.org)
¾ Esugarindia Ltd. (www.esugarindia.com)
¾ First commodity Exchange of India Ltd, Kochi (www.fceikochi.com)
¾ Haryana Commodities Ltd. (www.hissarcommodities.com)
¾ India pepper and Spices Trade Association., Kochi (www.ipsta.com)
¾ National Board of Trade; Indore (www.nbotind.org)
¾ Surendranagar Cotton Oil and Oilseeds Association Ltd.
¾ The Bombay Commodity Exchange Ltd. (www.booe.com)
¾ The Central India Commercial Exchange Ltd; Gwalior
¾ The Chamber of Commerce ; Hapur
¾ The Coffee Futures Exchange India ltd; Bangalore (www.cofei.com)
¾ The East India Cotton Association; Mumbai (www.eicaexchange.com)
¾ The Meerut Agro Commodities Exchange Co. Ltd.
¾ The Rajkot Seeds Oil and Bullion Merchant’s Association Ltd.
(www.rajkotexchange.com)
¾ The Spice and Oilseeds Exchange Ltd; Sangli
¾ Vijay Beopar Chamber Ltd; Muzaffarnagar.

20
THE FUTURES EXCHANGES

(MCX)- MULTI COMMODITY EXCHANGE OF INDIA

Highlights

¾ Key Shareholders
• Financial Technologies (India) Ltd.
• State Bank of India
• State Bank of Indore
• State Bank of Hyderabad
• Bank of Baroda
• Bank of Saurashtra
• Union Bank of India
• Bank of India
• Canara Bank
• Corporation Bank
• HDFC Bank
• SBI Life Insurance Co.

¾ Strategic Alliance with Prominent Industry Associations

• Bombay Bullion Association

• Bombay metal Exchange
• Solvent Extractors Association and
• Pulses Importer Association
• UPSAI
• IPSTA

¾ International Alliances

• MOUs with the Tokyo Commodity Exchange (TOCOM) and the

Baltic Exchange, London. The New York Mercantile Exchange
(NYMEX)
• Joint Venture to set up The Dubai Gold and Commodity
Exchange

21
¾ Daily mark to market, real time price and trade information
dissemination

¾ MCX presently has over 1000 trading members spread in more than
275 centers in India.

22
(NCDEX) – THE NATIONAL COMMODITY AND
DERIVATIVES EXCHANGE LTD.

NCDEX is a public limited company

incorporated on April 23, 2003 under the
Companies Act, 1956.

It obtained its Certificate for Commencement

of Business on May 9, 2003. It has commenced
its operations on December 15, 2003

NCDEX is located in Mumbai and offers

facilities to its members in more than 550
centers throughout India the reach
will gradually be expanded to more centers.

NCDEX is the only commodity exchange in the country promoted by

national level institutions. This unique parentage enables it to offer a
bouquet of benefits, which are currently in short supply in the
commodity markets. The institutional promoters of NCDEX are
prominent player

NCDEX is a nation-level, technology driven de-mutualized on-line

commodity exchange with an independent Board of Directors and
professionals not having any vested interest in commodity markets. It is
committed 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.

23
NCDEX currently facilitates trading of 48 commodities –

Cashew, Castor Seed, Chana, Chili, Coffee - Arabica,

Coffee - Robusta, Common Parboiled Rice,
Common Raw Rice, Cotton Seed Oilcake,
Crude Palm Oil, Expeller Mustard Oil,
Groundnut (in shell), Groundnut Expeller Oil,
Grade A Parboiled Rice, Grade A Raw Rice,
Guar gum, Guar Seeds, Gur, Jeera,
Jute sacking bags, Indian 28 mm Cotton,
Indian 31 mm Cotton, Lemon Tur,
Maharashtra Lal Tur, Masoor Grain Bold,
Medium Staple Cotton, Mentha Oil,
Mulberry Green Cocoons, Mulberry Raw Silk, Rapeseed - Mustard Seed,
Pepper, Raw Jute, RBD Palmolein, Refined Soy Oil, Rubber, Sesame
Seeds,
Soy Bean, Sponge Iron, Sugar, Turmeric, Urad (Black Matpe),
V-797 Kapas, Wheat, Yellow Peas, Yellow Red Maize,
Yellow Soybean Meal, Electrolytic Copper Cathode, Aluminium Ingot
Nickel Cathode, Zinc Ingot, Mild Steel Ingots, Sponge Iron,
Gold, Silver, Brent Crude Oil, Furnace Oil.

At subsequent phases trading in more commodities would be facilitated.

24
Highlights

¾ Key Shareholders.

• NSE (National Stock Exchange)

• Canara Bank
• Punjab National Bank
• ICICI Bank Ltd.
• CRISIL (Credit Rating Information Service of India Ltd.)
• IFFCO (Indian Farmers Fertilizers Co-operative Ltd.)
• LIC (Life Insurance Corporation of India)
• NABARD (National Bank for Agricultural and Rural
Development)

¾ Strategic Alliance with prominent industry associations

• In talks with GAIL & BPCL to promote gas futures

¾ International Alliances

• MOUs with The Dalian Commodity Exchange, The International

Petroleum Exchange (IPE) & The Tokyo Grain Exchange

¾ Daily mark to market, real time price and trade information

dissemination

¾ NCDEX presently has over 720 trading members spread in more than
450 centers in India.

25
LIKELY PLAYERS IN THE COMMODITY MARKET

At the Indian commodity exchanges, where futures trading is currently

ongoing, half of the trade is estimated to be speculative, half of which is
conducted by traders or what the international trading community calls as
the ‘scalpers’ (day traders buy and sell during same day, trying not to keep
any positions overnight). These scalpers earn through their daily trading
transactions and contribute significantly to the liquidity of the exchange.
The remaining half of the trade is by way of hedging, with traders being the
most active.

The various categories of users of these commodity exchanges in India are

discussed below:

Farmers in India rarely use futures markets directly. Indian farmers benefit
indirectly from using co-operatives or other intermediaries or simply from
better deals with traders using futures markets.

Traders, both large and small are the main users of futures contracts in
India. For oil seeds, pepper and gur, there is an active participation of town
dealers. Castor seeds and pepper, exporters are active in the exchanges.

Virtually, all speculators in these exchanges are relatively small –either they
are day-traders as explained above or are individuals placing their deals
through brokers. Large institutional investors such as banks and NBFCs
are absent. Their participation in commodity exchanges is not allowed
under the Reserve Bank of India regulations, which stipulates prudential
norms for banks and non banking financial institutions.

Processors and manufacturers use the exchanges to a limited extent for two
reasons:

First, some manufacturers, especially in the oil sector, are so large that they
are unable to lay off a significant part of their risks on domestic exchanges,
which suffer from chronic illiquidity.

Secondly, the range of the commodity futures contracts offered is too small
resulting in incomplete risk management. For example, many firms do not

26
find castor seeds contract useful as few manufacturers use castor oil and it
is an imperfect risk management instrument for other oils.

Foreign trading firms participated in some of the commodity exchanges until

their participation was banned. But, the current scenario of development in
commodity futures trading will bring the issue of allowing them to
participate in this field too. This will result in commodity linked mutual
funds to spring up across the country.

ADVANTAGES OF THE FUTURES MARKET FOR

VARIOUS PLAYERS

¾ Farmers

• Get an extensive market opened for them

• Can decide the market even before harvest
• Can sell the commodity to the customer without any agents
• Get an opportunity to trade, knowing the national and
international trends and standards
• Get an opportunity to gain by leveraging the futures market
• There is an opportunity to keep the commodity in the
warehouse and use the warehouse receipts to deal with
financial needs as it is an extensive document
• Can avoid deliberate in price in the name of quality
• Farmers can trade even if they are computer illiterate by the
help of renown broking house

¾ Traders / Stockiest

• Can trade by parking only the margin amount

• Can hedge their underlying by selling the same in the futures
market and save from any losses from the price fluctuation
• For those who have kept their commodity in the Central
Warehouse, loans are available on the basis of stock. The
benefit is that you can keep the commodity somewhere without
blocking the working capital

27
 ¾ Corporates / Exporters

• Can get a better price discovery

• Can buy goods without agents
• Can hedge themselves by offsetting their exposure in the future
market and minimize their risk
• Can take positions by paying only the margin value instead of
whole value of the contract
• Can assure the quality of the goods because of standardized
future contacts.

¾ Arbitrageurs / Speculators

Can get benefit by an arbitrage between

• Spot to Future
• Inter Commodity Exchanges (MCX & NCDEX)
• Spread Trading

FUTURES MARKET V/S FORWARD MARKET

FORWARD CONTRACTS

Forward contracts are agreements to purchase or sell a specified amount of

a commodity on a fixed future date at a pre determined price. Physical
delivery is expected. If, at maturity (the future date has been agreed to in
the contract), the actual price (the spot price) is higher than the price in the
forward contract, the buyer makes a profit and the seller suffers a
corresponding loss.

28
FUTURES CONTRACT

Future contracts are exchange traded agreements to purchase or sell a

given quantity of a commodity at a predetermined price at a predetermined
time. But, unlike forward contracts, physical delivery in fulfillment of this
agreement is not necessarily implied, the contract can be used to make or to
take physical delivery, but usually, it is offset on or before maturity (the
closing date of the contract) by an equivalent reverse transaction.

On organized commodity exchanges, where most futures contracts are

traded, this involves the buying at different times of two identical contracts
for the purchase and sale of the commodity in question, each canceling
the other out. This is called the closing out of the position and is possible
because all transactions are guaranteed through a central organism, the
clearing house, which automatically assumes the position of the
counterpart to both sides of the transaction. Thus, a producer who wishes
to hedge has an obligation not Vis-a Vis a consumer or a speculator, but
vis-a vis a clearing house. Likewise, consumers obtain a position Vis-a Vis
the clearing house.

FOUR IMPORTANT FEATURES THAT DISTINGUISH FUTURES

CONTRACT FROM A FORWARD CONTRACT:

¾ Contract terms (amounts, grades and delivery terms) are

standardized
¾ Transactions are almost always handled by organized exchanges
through clearing house systems.
¾ Most futures contracts are ‘marked to market’ everyday, using the
settlement price of the day. Hence, if the futures price moves
adversely for a holder of a futures contract, that holder is obliged to
pay into the clearing house a sum equal to the value of the adverse
movement (a margin call). This prohibits users of the market from
carrying large unrealized losses over a long period, and thus reduces
the risk of default. In the case of profitable price movements,
clearing members (including intermediaries such as brokerages), but
not necessarily their clients, receive the profits of the day’s futures
trading
¾ Futures contracts require depositing small amounts of ‘initial
margin’ money in the exchange as collateral. Due to this, futures
contacts significantly reduce the credit of default risk contained in
the forward transactions.

29
MECHANICS OF FUTURES TRADING

Essentially, futures contracts try to predict what the value of an index or

commodity will be at some date in the future. Speculators in the futures
market can use different strategies to take advantage of rising and
declining prices. The most common are known as “Going Long”, “Going
Short” and “Spreads.”

GOING LONG

When an investor goes long i.e. enters a contract by agreeing to buy the
underlying at a set price it means that he or she is trying profit from an
anticipated future price increase.

GOING SHORT

A speculator, who goes short, i.e. enters into a futures contract by ageing
to sell the underlying at a set price is looking to make a profit from
declining price levels. By selling high now, the contract can be
repurchased in the future at a lower price, thus generating a profit for the
speculator.

SPREAD TRADING

Going long and going short are positions that involve the buying or selling
of a contract now in order to take advantage of rising or declining prices in
the future. Another common strategy used by futures traders is called
“spreads.”

Spreads involve taking advantage of the price difference between two

different contracts of the same commodity. Spreading is considered to be
one of the most conservative forms of trading in the futures market
because it is much safer than the trading of long/short futures contracts.

Spread-trading is a more sophisticated trading tool than just purchasing

or selling futures or option contracts.

There are mainly three different types of spreads:

• Calendar Spreads

30
 • Inter-Exchange Spreads

• Inter Commodity Spreads

It is important that you understand that when you are trading a spread,
you are speculating on the price difference or spread between the two
contracts. Spreaders are focused on the price relationship between the two
contracts. A spread position is not to be looked at as two separate
trades, but rather as one trade.
The success or failure of the trade is determined by the change in the price
difference between the two contracts or commodities. It is much obvious
for one side of the trade to make money, and the other side to lose money.
It is much obvious for one side of the trade to make money, and the other
side to lose money. It is the perception of the spread trader that the
winning side makes more than the losing side.

One might ask,” Why don’t you just put on the wining side forget about
spreading with the losing side?” The answer is simple “the spread trader
does not know which side of the trade will be the prime mover and impact
the spread value.”

CALENDER SPREADS

The calendar spread is perhaps the easiest to understand and the most
commonly used type of spread in the industry. A spread trader in a
calendar attempts to profit from the price difference between two futures
contracts of the same commodity, traded on the same exchange, but with
different expiry dates. The trader putting on this spread believes that the
price differences are too close or too close or too far apart to suggest
further expansion or contraction in the prevailing spread:

EXAMPLE:

Mr. X bought a March contract of sugar at Rs.2100 and sold April sugar at
Rs.2125 with a spread of Rs.25 for March over the April contract.

At the expiry, March sugar was at Rs. 2115, and April sugar was at Rs.
2130 spread has narrow down to Rs. 15

Hence, sold March sugar Rs. 2115 and bought April sugar Rs. 2130,
resulting into a net profit of Rs. 10

31
Why would a spreader put on the trade? Because he would have reason to
believe that the price of March sugar would gain on or get closer to the
April price.

As you can see in this example the above mentioned trade was profitable,
but one side of the spread lost money.

INTER EXCHANGE SPREAD (ARBITRAGE)

It is a spread or arbitrage in prices for the same commodity in two different

exchanges. The spread may be into existence due to the factors of :

• Price difference: during volatile market situations due to price

elasticity the prices may go either side of the equation. Arbitrageurs,
enters to take positions in opposite direction i.e. buy in one
exchange and a simultaneous sell in the other exchange. As and
when the market stabilizes, the prices return to the normal parity
levels where in the arbitrageur reversed their respective exposures in
the two exchanges to leave them with risk less profit from the series
of transactions.

• Distance: globalization have erased the international boundaries of

trade though, but primarily at the market levels price differences
remain due to duties, freight, insurance and other levies as per the
rules of trade. Very often it is observed by the traders that even after
the loading of these factors, the prices in the futures market are over
or under valued from the price parity levels. Immediately the
arbitrageurs steps in to take advantage of the situation and keeps a
doing this till the time market returns to the existing norms of
parity.

• Time: operational hour’s differences between two exchanges located

on two geographical parts of the world lend opportunity for the
investors to move their trades profitably in both the exchanges.
Typically this is the case with the Crude oil, Gold and Silver futures
contracts. Whilst the Indian exchanges close their session by 23:55
hours IST, US markets are open till 01:30 hours IST followed by
Japanese markets which start trading by 07:00 hours IST.
Movements in the price during this intermediate time is chased by
the Indian market in the opening session align itself with the

32
 international market scenario and thus portraying a spread
opportunity between two exchanges till they finally coverage to a
parity level in existence.

INTER COMMODITY SPREADS

Inter commodity spreads are the most difficult to understand and the most
risky to trade, therefore not used as much as the inter market spread. A
spreader of inter commodity spreads is spreading two different but related
commodities, in the same or different delivery months. Examples of inter
commodity spreads are

• Cattle / Hogs
• Gold / silver
• Heating oil / Crude oil
• T-Bills / T- Bonds
• Canadian Dollar / Swiss Franc

This is just a small example of the inter commodity spreads available to

trade

33
Risk Free Returns

¾ Hedging

¾ arbitrage

Hedging

• Hedging in futures contracts provides an effective tool to manage price

risks and it is always associated with an opposite transaction that
involves physical cash transaction.

What Makes Hedge Works?

Spot and Futures price for the same commodity tend to go up and down
together. Losses in one side are cancelled out by gains on the other.

EXAMPLE:

Let Us Take Example of Client-A, which is seller of the gold

Client-B, buyer of Gold.

Client-A Plans to sell 1 Kg. Gold in December 2005. It expects futures prices
to be lower and feels that Rs. 7000 per 10 gm will be a good price to get in
December.

So, Client-A decides to lock in 1kg. At a price of Rs. 7000 on the future
market for December contract.

34
Scenario-1:

The prediction of Client-A come true. The spot price for December 1st is Rs.
6980 per 10 gm.

SPOT MARKET FUTURES MARKET

PRICE Rs. 6980 Locked in atRs.7000/-

for 1 kg
Current price @ Rs.
6980/-

SALE Sold 1 kg. in the spot @ Squares off 1 kg. @ Rs.

Rs. 6980/- 6980/-

RESULT Loss of Rs. 20/- against Gain of Rs. 20/- per kg.
budget from spot against the
budget. Bought @ Rs.
6980 and sold @ Rs.
7000/-

Scenario-2:

The predictions of Client-A has gone wrong. Spot prices for December 1st
are Rs. 7020 per 10 gm.

SPOT MARKET FUTURE MARKET

PRICE Rs. 7020/- Locked in at Rs. 7000/-

for 1 kg.

SALES Sold entire 1 kg. in the Squared off 1 kg. @ Rs.

spot market @ Rs. 7020/-
7020/-
RESULT Books Rs. 20/- profit Bought at Rs. 7020/-
against the budget and sold at Rs. 7000/-
therefore books a loss of
Rs. 20/-

35
By a stockiest – using futures market

SPOT MARKET FUTURES MARKET

01/01/2006 A stockiest purchases, To hedge price-risk, he

say, 10 tones of Castor would simultaneously
seed in the physical sell 10 contracts of one
market @ Rs. 1600/- tone each in the futures
p.q. market at the prevailing
price. Assuming the
ruling price in June
2006 contract is Rs.
1750/- p.q.

01/05/2006 The stockiest sells his The stockiest liquidates

stock in the month of his contract in the
May when the spot futures market by
price is Rs. 1500/- p.q. entering into purchase
contract @ Rs.1625/-
p.q.

RESULT Loss = Rs. 25 + Loss on A/c gain = Rs.

125/- of carrying
Stocks.

The stockiest is able to lock in a spread/ “Badla” of Rs. 150/- p.q. i.e. about
9% for about 6 months.

Looking at the gain / loss in the two segments, we find that the stockiest is
able to hedge his price by operating simultaneously in the two markets and
taking opposite positions.
He gains in the futures market if he loses in the spot market; but would lose
in futures market if he gains in the spot market. Similarly, processors,
exporters, and importers can also hedge their price risks.

36
FOR IMPORTER

When spot prices decreases faster than the future price.

SPOT GOLD GOLD FUTURE

OCT 2005 The spot gold is @ Rs. Sell gold Future @ 5900
5850 per 10 gms per 10 gms

JAN 2006 Sell spot gold @ 5750 Buy back gold future @
per 10 gms Rs. 5850 per 10 gms

RESULT Loss Rs. 50 per 10 gms Gain Rs. 50 per 10 gms

If the importer had not hedged his position, he would have, had to sell the
gold at Rs. 5750 per 10 gms, accounting for a loss for Rs. 100 per 10 gms
By cover his position at the futures market he minimized his losses.

FUTURES TRADING – A LUCRATIVE BUSINESS

Futures trading in castor seed have been going on for a long time in India.
In this context, it would be best to understand futures trading taking castor
seed contracts as an example.

XYZ mill sells castor oil in the export market for December shipment at
Rs.100 per kilo.

Their cost sheet is as follows:

Sale price Rs.100

Cost of castor seed Rs. 60
(Present spot price)
Labour Rs. 20
Overheads Rs. 10
Profit Rs. 10

37
They are unable to find a castor seed supplier who would offer them the
required quantity for the December delivery.

They therefore hedge their castor seed moves up to Rs. 80 per kilo by
December.

Spot price of castor seed moves up to Rs. 80 per kilo by December.

XYZ mill buys physical castor seed in the spot market at Rs.80 per kilo and
settles in the futures market at a price of Rs. Per kilo.

Thus their cost sheet would now be as follows:

Sale price Rs. 100

Cost of castor seed Rs. 80
(Present spot price)
Labour Rs. 20
Overheads Rs. 10
Loss Rs. 10
Add: profit on futures Rs. 20
Net profit Rs. 10

Due to hedging in the futures market, the profit of the mills remains intact.

38
ARBITRAGE

• The simultaneous purchase and selling of an asset in order to profit

from a differential in the price. This usually takes place on different
exchanges or marketplaces. Also known as a "risk less profit".

• Say a domestic stock trades also on a foreign exchange in another

country, where it hasn't adjusted for the constantly changing
exchange rate. A trader purchases the stock where it is
undervalued and short sells the stock where it is overvalued, thus
profiting from the difference. Arbitrage is recommended for
experienced investors only.

Market Arbitrage

Purchasing and selling the same security at the same time in different
markets to take advantage of a price difference between the two separate
markets.

An arbitrageur would short sell the higher priced stock and buy the lower
priced one. The profit is the spread between the two assets.

EXAMPLE:

If we buy Jeera from NCDEX at rate Rs. 6488and than Sell it in MCX at
rate Rs. 6589.85, that is arbitrage. The Rs. 101.85 we gain that represents
an arbitrage profit.

39
NEED OF COMMODITIES IN A PORTFOLIO:

¾ COMMODITIES AS A HEDGING TOOL

• Hedge against inflation

• Hedge against a currency fluctuation
• Hedge against event risk

¾ COMMODITIES AS AN INVESTMENT AVENUE

• Growing popularity as an investment tool

• Global underlying broadly difficult to manipulate
• Pure play demand/supply/inventory/trading pattern driven
• High degree of cyclicality/seasonality
• Extremely high leverage instrument due to low margins (4-5%)
• Established as an asset class world wide
• option to invest direct in commodities than investing in
commodities stocks

¾ INDIAN EXPERIENCE / COMMODITY STOCKS

• Commodities account for about 38% (ask) of Nifty Market Cap.

(as on 31/03/2006)

40
COMMODITY GROUPS

COMMODITY GROUPS AVAILABLE FOR TRADING

BULLION

BASE
ENERGY METAL

OIL CEREALS
SEEDS COMMOD
ITY
FUTURES
MARKET

PLANTATI
ONS,
PULSES FIBRES &
PETRO
CHEMICAL

SPICES OTHERS

41
COMMODITY FUTURE TRADING REGULATIONS

REGULATORY FRAMEWORK

The ministry of consumers affairs, food and public distribution governs all
commodity exchanges in India through the forwards markets commission
(FMC).

The FMC is a regulatory body set up under the forward contracts

(regulation) act, 1952 (‘FCRA’). The FCRA lays down the general provisions
in relation to the administration of the commodity exchanges and other
regulatory provisions pertaining to commodity trading in India. All
exchanges dealing in trading of commodities are required to obtain
registration from FMC.

PERMISSIBLE BUSINESS ACTIVITIES

Only futures trading in commodity is permitted on the exchange. Options in

goods are presently prohibited under the FCRA. Further, only the
commodities notified under the FCRA can be traded on the commodity
exchange. Presently, futures trading is permitted in all the commodities.
These commodities can be broadly classified under the following categories:

¾ Agro products
¾ Precious metals and base metals
¾ Energy

At present there are 22 commodity exchanges in India providing futures

trading in commodities. However currently only 4 exchanges have been
accorded a national commodity exchange status as under:

¾ National Commodity and Derivatives Exchange Limited (NCDEX)

¾ Multi commodity Exchange of India Limited (MCX)
¾ National Multi Commodity Exchange (NMCE)
¾ National Board of Trade (NBOT)

42
The aforesaid exchanges are entitled to commence trades in all permitted
commodities prescribed under the FCRA.

NCDEX & MCX are located in Mumbai and provide active platforms for
metals and agro commodities futures. NMCE is located in Ahmedabad and
presently the trading volumes of commodities at NMCE are limited to
NCDEX & MCX.

These exchanges are expected to be role model to other exchanges and are
likely to compete for trade not only among them but also with the existing
exchange.

MEMBERSHIP OF THE COMMODITY EXCHANGE

Any person desiring to trade over the commodity exchange, is required to

register with the exchange as a member. Unlike the stock broking
regulations, in case of commodity trading membership, no SEBI
registrations are required and the relevant commodity exchange is the sole
authority to sanction registration. However, recently there has been news
articles proposing that as application would also required to be made to the
FMC for seeking trading membership registration with the exchange; the
procedures for registration with the FMC is however not clarified.

In order to regulate the activities of its members, each of the stock

exchanges have formulated its own bye-laws, rules and regulations.
Presently, the following memberships are offered by the commodity
exchanges:

Trading cum clearing membership entitling a member to execute

transactions on the exchange and also a right to clear the trades on its own.

Professional clearing membership providing only clearing rights to the

members

43
ENTITLEMENT TO MEMBERSHIP:

Stock broker

A stock broker registered with NSE/BSE can also obtain membership

of the commodity exchange. However, the SCRA does not permit a stock
broker to undertake business in commodity derivatives in the same entity in
which stock broking is carried out. For this purpose the SCRA prescribes
setting up a separate company for undertaking commodities trades.

NBFC

As regards trading in commodities by NBFC, RBI would not permit a

NBFC to undertake any activities which would result in the NBFC being
governed by multiple regulators (i.e. the commodities exchanges and the
FMC).

BANKS

Banks are currently not permitted to engage in buying or selling or

bartering of goods except engaging in bullion trades.

FDI IMPLICATIONS ON ESTABLISHING THE NEW ENTITY

From a FDI perspective, currently commodity broking unlike stock broking

is not specifically covered under the list of nineteen permitted NBFC
activities wherein investment is permitted under the automatic route
subject to adherence to the stipulated minimum capitalization norms.
Based on informal talks the regulatory authorities have informed that
commodity broking would nor form part of stock broking for FDI purposes
and not subjected to minimum capitalization norms.

44
PROSPERING INDIAN COMMODITIES MARKET (PRESENT SCENARIO)

The exchange, National Commodity and Derivative Exchange which is just

two and a half years old, is Asia's third-largest commodities exchange after
Tokyo and Shanghai and the 14th-largest in the world. It is unlisted and
trades $1.2 billion worth of products daily.

Goldman Sachs Group, the large U.S. securities firm, plans to buy a stake
in the National Commodity & Derivatives Exchange, reflecting growing
interest in the surge in commodity trading in India.

Among its institutional shareholders are four state-owned companies, the

National Stock Exchange, ICICI Bank and Crisil, a rating agency. ICICI
Bank, which owns 15 percent of the exchange, is selling less than half its
stake to Goldman Sachs.

Strong economic growth and rising income levels in India have bolstered
investments in commodities, making the country attractive for investors in
the trading exchanges.

Earlier this year, Fidelity International paid $49 million for 9 percent in the
Multi Commodity Exchange of India, which is primarily a metals-trading
operation.

About 80 percent of the trades in the National Commodity & Derivatives

Exchange are currently in agricultural commodities like sugar, wheat and
vegetables.

But the share of energy commodities, like Brent blend crude oil, natural
gas, coal and electricity is rising significantly.

With India one of the world's largest consumers of energy, the rising energy
commodities trade has undoubtedly been an attraction.

There is also significant potential in bullion. India is the world's largest

consumer of gold and is expected to soon turn into a price-setter in the
commodity.

Currently, foreign investors and overseas institutions are not allowed to

trade on the commodities exchanges but there are indications that
regulators might relax the rules for some commodities.

45
COMMODITY MARKET V/S. EQUITY MARKET

¾ Commodity trading

• Three national platforms for screen based trading

• Upfront margin between 5-10%
• Low downside risk
• Less volatile, providing an efficient portfolio diversification
option.
• Short selling is allowed across the board

¾ Equity trading

• Two national platforms for screen based trading

• Upfront margin between 25-30%
• High downside risk
• More volatile
• Short selling is restricted to a few scripts where futures are
there.

46
BOMBAY STOCK EXCHANGE (BSE)

For the premier Stock Exchange that pioneered the stock broking activity in
India, 125 years of experience seem to be a proud milestone. A lot has
changed since 1875 when 318 persons became members of what today is
called "Bombay Stock Exchange Limited" by paying a princely amount of
Re1.

Since then, the stock market in the country has passed through both good
and bad periods. The journey in the 20th century has not been an easy one.
Till the decade of eighties, there was no measure or scale that could
precisely measure the various ups and downs in the Indian stock market.
Bombay Stock Exchange Limited (BSE) in 1986 came out with a Stock Index
that subsequently became the barometer of the Indian Stock Market.

SENSEX, first compiled in 1986 was calculated on a "Market Capitalization-

Weighted" methodology of 30 component stocks representing a sample of
large, well-established and financially sound companies. The base year of
SENSEX is 1978-79. The index is widely reported in both domestic and
international markets through print as well as electronic media. SENSEX is
not only scientifically designed but also based on globally accepted
construction and review methodology. From September 2003, the SENSEX
is calculated on a free-float market capitalization methodology. The "free-
float Market Capitalization-Weighted" methodology is a widely followed index
construction methodology on which majority of global equity benchmarks
are based.

The growth of equity markets in India has been phenomenal in the decade
gone by. Right from early nineties the stock market witnessed heightened
activity in terms of various bull and bear runs. More recently, the bourses in
India witnessed a similar frenzy in the 'TMT' sectors. The SENSEX captured
all these happenings in the most judicial manner. One can identify the
booms and bust of the Indian equity market through SENSEX.

The launch of SENSEX in 1986 was later followed up in January 1989 by

introduction of BSE National Index (Base: 1983-84 = 100). It comprised of
100 stocks listed at five major stock exchanges in India at Mumbai,
Calcutta, Delhi, Ahmedabad and Madras. The BSE National Index was
renamed as BSE-100 Index from October 14, 1996 and since then it is
calculated taking into consideration only the prices of stocks listed at BSE.
The Exchange launched dollar-linked version of BSE-100 index i.e. Dollex-
100 on May 22, 2006.

47
With a view to provide a better representation of the increased number of
companies listed, increased market capitalization and the new industry
groups, the Exchange constructed and launched on 27th May, 1994, two
new index series viz., the 'BSE-200' and the 'DOLLEX-200' indices. Since
then, BSE has come a long way in attuning itself to the varied needs of
investors and market participants.

In order to fulfill the need of the market participants for still broader,
segment-specific and sector-specific indices, the Exchange has continuously
been increasing the range of its indices. The launch of BSE-200 Index in
1994 was followed by the launch of BSE-500 Index and 5 sectoral indices in
country's first free-float based index - the BSE TECk Index.

The Exchange shifted all its indices to a free-float methodology (except BSE
PSU index) in a phased manner.

The Exchange also disseminates the Price-Earnings Ratio, the Price to Book
Value Ratio and the Dividend Yield Percentage on day-to-day basis of all its
major indices.

48
NATIONAL STOCK EXCHANGE:

The trading on stock exchanges in India used to take place through open
outcry without use of information technology for immediate matching or
recording of trades. This was time consuming and inefficient. this imposed
limits on trading limits on trading volumes and efficiency.

In order to provide efficiency, liquidity and transparency, NSE introduced a

nation wide on line fully automated screen based trading system (SBTS)
where a member can punch into the computer quantities of securities and
the prices at which he likes to transact and the transaction is executed as
soon as it finds a matching sale or buy order from a counter party.

NSE was incorporated in 1992 and was given recognition as a stock

exchange in April 1993. It started operations in June 1994, with trading on
the Wholesale Debt Market Segment. Subsequently it launched the Capital
Market Segment in November 1994 as a trading platform for equities and the
Futures and Options Segment in June 2000 for various derivative
instruments.

NSE became the leading stock exchange in the country, impacting the
fortunes of other exchanges and forcing them to adopt SBTS also. Today
India can boast that almost 100% trading take place through electronic
order matching. Technology was used to carry the trading platform from the
trading hall of stock exchanges to the premises of brokers. NSE carried the
trading platform further to PCs at the residence of investors. This made a
huge difference in terms of equal access to investors through the internet
and to handheld devices through WAP for convenience of mobile investors.

This made a huge difference in terms of equal access to investors in a

geographically vast country like India.

Trading volumes in the equity segment have grown rapidly with average
daily turnover increasing from Rs.17 crores during 1994-95 to Rs.4, 328
crores during 2003-04. During the year 2003-04, NSE reported a turnover
of Rs.1, 099,535 crores in the equities segment accounting for 68.60% of
the total Indian securities market.

49
CLEARING AND SETTLEMENT

The clearing and settlement mechanism in Indian securities market has

witnessed significant changes and several innovations during the last
decade.

Till recently, the stock exchanges in India were following a system of

account period settlement for cash market transactions. T+2 rolling
settlement have now been introduced for all securities.

Due to setting up of Clearing Corporations, the market has full confidence

that settlements will take place on time and will be completed irrespective of
possible default by isolated trading members. Two depositories viz.,

¾ National Securities Depositories Ltd. (NSDL)

¾ Central Depository Services Ltd. (CDSL)

Provide electronic transfer of securities and more than 99% of turnover is

settled in dematerialized form. The pay-in and pay-out of securities is
affected on the same day for all settlements.

Partners

CLEARING
MEMBERS

CLEARING
DEPOSITORIES
BANKS

PROFESSIONAL
CLEARING CUSTODIANS
MEMBERS

50
TRANSACTION CYCLE

PLACING DECISIO
ORDER N TO
TRADE

TRADE FUNDS/
EXECUTI SECURITI
ON ES

SETTLEM
CLEARIN ENT
G OF OF
TRADES TRADES

A person holding assets (securities/funds), either to meet his liquidity needs

of to reshuffle his holding in response to changes in his perception about
risk and return of the assets, decides to buy or sell the securities. He selects
a broker and instructs him to place buy/sell order on an exchange. The
order is converted to a trade as soon as it finds a matching sell/buy order.

51
At the end of the trade cycle, the trades are netted to determine the
obligations of the trading members to deliver securities/funds as per
settlement schedule.

Buyer/seller deliveries funds/securities and receives securities/funds and

acquires ownership of the securities. A securities transaction cycle is
presented in the above figure

SETTLEMENT CYCLE:

At the end of each trading day, concluded or locked-in trades are received
from NSE by NSCCL. NSCCL determines the cumulative obligations of each
member and electronically transfers the data to Clearing Members (CMs). All
trades concluded during a particular trading period are settled together.

52
NORMAL MARKET

In a rolling settlement, trade day is T day, T+1 day and T+2 day for NSCCL.

At NSE, trades in rolling settlement are settled on a T+2 basis i.e. on the 2nd
working day. Typically trades taking place on Monday are settled on
Wednesday, Tuesday’s trades settled on Thursday and so on. A tabular
representation of the settlement cycle for rolling settlement is given below:

ACTIVITY DAY

TRADING Rolling settlement T

trading

CLEARING Custodial confirmation T+1 working days

Delivery generation T+1 working days

SETTLEMENT Securities and funds T+2 working days

pay in

Securities and funds T+2 working days

pay out

Valuation of shortages At T+1 closing prices

based on closing prices

POST SETTLEMENT Auction T+3 working days

Bad delivery reporting T+4 working days

Auction settlement T+ 5 working days

Rectified bad delivery T+6 working days

pay in and pay out

Re-bad delivery T+8 working days

reporting and pick up

Close out of re-bad T+9 working days

delivery and funds pay-
in and pay-out

53
INTRODUCTION TO DERIVATIVES:

Inroduction of derivatives in the Indian capital market is beginning of an

exciting era. Index futures were introduced as the first exchange traded
derivatives product in the Indian capital markets in june 2000. the trading
and risk management systems set up by SEBI are today international
benchmarks. With introduction of index options, individuals stock futures
and options and interest rate futures, the Indian derivatives market has
become a vibrant and dynamic part of the capital markets.

Derivatives worldwide are recognized as risk management products. These

products have a long history in India in the unorganized sector, especially in
currency and commodity markets. The availability of these products on
organized exchange have provided the market participants with a safe
efficient and transparent market.

Derivatives have been a key factor in creation of new and innovative

financial products. These products by unbundling and bundling various
risks and return parameters are meeting the specific and growing needs of
investors and issuers.

MEANING:

Derivative is a product which derives its value from some underlying. This
underlying can be securities, currency, commodities or even another
derivative. The derivative does not have indepent of the underlying.
Forwards, futures, options and swaps are amongst the more popular of
derivatives products today used across the financial markets. Following is a
brief introduction to various derivative contracts.

FORWARD CONTRACTS:

A forward contract is a bi-partite contract, to be performed in the future at

the terms decided at the time of entering into the contracts. These terms are
in respect of value of transaction, place of settlement, date and time of
settlement, what is being bought/sold etc.

54
Forward contracts offer tremendous flexibility to the parties to design the
contract in terms of the price, quantity, quality (in case of commodities).
Delivery time and place, in some markets some markets some of the terms
are decided by convention though the parties have the flexibility to adjust
the terms to suit their requirements. For example in markets a spot
transaction is settled after two working days. However parties free to decide
free to decide any other delivery date also.

Forward contracts suffer from relatively poor liquidity as compared to

actively traded futures. As the contract is bi-partite, the closing of the
position requires a party to approach the same party with whom the original
contract was entered into. Sometimes as the choices are limited this may
limited this may result in not getting the best price. This alternate is to
enter into an equal and opposite contract with another party. While this
closes the price risk, the counter party risk goes up.

FUTURES CONTRACTS:

Futures contracts are organized which are traded on the exchanges. The
terms like quantity, quality (in case of commodities) delivery time and place,
value of one contract etc. are standardized and traded on the exchanges are
very liquid in nature. In futures market, clearing corporation house reduces
the credit risk by either it self becoming the counter party to every trade
(through novation) or by giving a guarantee to do settlement in case any
counter party fails to honor the contract.

Also each contract is seetled with the clearing corporation. This enables the
clearing corporation to do net settlement, cancelling all equal and opposite
contracts for each party thereby further reducing the credit risk as well the
size of settlement.

55
Forward / Future contracts

Features Forward contract Future contract

Trading Not traded on Traded on exchange

exchange
Settlement Directly between the Through the clearing
two parties system of the exchange

Contract specifications May differ from trade Contracts are specified

to trade. High
flexibility in deciding
the terms

Counterparty risk of Each party takes credit The counterparty risk

credit risk risk on the other is transferred to
clearing system.
Clearing system takes
credit risk on the
clearing system.

Liquidity Poor liquidity as High liquidity as

contracts are tailor contracts are
made standardized. And
traded on the
exchange.

Price discovery Poor, as markets are Better, as traded on a

fragmented transparent exchange

56
SWAPS:

A swap represents an exchange of obligations. The two most common types

of swaps are “interest rate swaps” and “currency swaps”. Lately “credit
swaps” are also becoming popular.

EQUITY DERIVATIVES IN INDIA _ AN OVERVIEW

DERIVATIVES TRADING

Derivatives trading broadly can be classified into two categories, those that
are traded on the exchange and those traded one to one or ‘over the
counter’. They are hence known as

¾ Exchange traded derivatives

¾ OTC (Over The Counter) Derivatives

OTC equity derivatives

• Traditionally equity derivatives have a long history in India in the OTC

market.
• Options of various kinds (called Teji and Mandi and Fatak) in
unorganized markets were traded as early as 1900 in Mumbai.
• The SCRA however banned all kind of options in 1956.

DERIVATIVE MARKETS TODAY

• The prohibition on options in SCRA was removed in 1995. foreign

currency options in currency pairs other than Rupee were the first
options permitted by RBI.
• The Reserve Bank of India has permitted options, interest rate swaps,
currency swaps and other risk reductions OTC derivative products.
• Besides the Forward Markets Commission has allowed the setting up
of commodities futures exchanges. Today they have 18 commodity
exchanges most of which trade futures e.g. the Indian Pepper and
Spice Traders Association (IPSTA) and the Coffee Owners Futures
Exchange of India (COFEI).
• In 2000 an amendment to the SCRA expanded the definition of
securities to included derivatives thereby enabling stock exchanges to
trade derivative products

57
 • The year 2000 heralded the introduction of exchange traded equity
derivatives in India for the first time.

EQUITY DERIVATIVES EXCHANGES IN INDIA

• IN THE EQUITY MARKETS BOTH THE National Stock Exchange of

India Ltd. (NSE) and The Stock Exchange, Mumbai (BSE) have set up
their derivative segments.
• Both the exchanges have set up an in house segment instead of
setting up a separate exchange for derivatives.
• BSE’s derivatives segment, started with Sensex futures as its first
product.
• NSE’s Futures and Options segment was launched with Nifty futures
as the first product. The market share of NSE is very large compared
to that BSE.

MEMBERSHIP:

• Membership for the new segment in both the exchanges is not

automatic and has to be separately applied for.
• All members have to be separately registered with SEBI before they
can be accepted.
• Both the exchanges have specified certain Net worth, deposit and
annual membership requirements for both Clearing and Trading
members.

TRADING SYSTEMS

• NSE’s trading system for its futures and options segment is called
NEAT F&O. it is based on the NEAT system for the cash segment.
• BSE’s trading system for its derivatives segment is called DTSS. It is
built on a platform different from the BOLT system though most of the
features are common.

58
SETTLEMENT AND RISK MANAGEMENT SYSTEMS

• Systems for settlement and risk management are required to satisfy

the conditions specified by L.C. Gupta Committee and the J.R. Verma
committee subject to modifications made by SEBI from time to time.
• These include upfront margins, daily settlement, online surveillance
and position monitoring and risk management using the Value-at
Risk concept (VAR).

OPTIONS BASICS:

Options are one of the widely used derivative tools just like the futures
markets and it is the integral part of Risk Management. Options demand
broad based understanding of the derivatives segment.

OPTION TERMINOLOGY

Option is a contract giving the buyer the right, but not the obligation, to buy
or sell an underlying asset at a specific price on or before a certain date. An

59
option, just like a stock or bond, is a security. It is also a binding contract
with strictly defined terms and properties.

CALLS

The right to sell a stock or a commodity future at a given price before a

given date. Calls are similar to having long positions on stock. The owner of
the call option is speculating that the rice of the underlying will go up and is
therefore bullish.

PUTS

The right to sell a stock or a commodity at a given price before a given date
is defined as a Put option. Puts are similar to having short positions on the
stock. The owner of the Put option is speculating that the price of the stock
will go down and is therefore bearish.

PLAIN VANILLA OPTIONS

The simple calls and Puts discussed above are referred to as plain vanilla
options. They are termed so since are standardized options available for
trading on the exchange.

OPTION PRICE

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

EXPIRATION DATE

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

STRIKE PRICE

The price specified in the Options contracts is known as the strike price or
the exercise price.

AMERICAN OPTIONS

60
American options are options that can be exercised at any time up to the
expiration date. Most exchange traded options are American.

EUROPEAN OPTIONS

European options are options that can be exercised only on the expiration
date itself. European options are easier to analyze than American options,
and properties of an American options are frequently deduced from those of
its European counterpart.

IN THE MONEY OPTION

An in-the-money (ITM) option is an option that would lead to a positive cash

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

AT THE MONEY OPTION

An at-the-money (ATM) option is an option that would lead to zero cash-flow

if it were exercised immediately. An option on the index is at-the-money
when the current index equals the strike price (i.e. spot price=strike price).

OUT OF THE MONEY OPTION

An out-of-money (OTM) option that would lead to a negative cash flow if it

were exercised immediately. A call option on the index is out-of-the-money
when the current index stands at a level which is less than the strike price
(i.e. spot price < strike price). If the index is much lower than the strike
price, the call is said to be deep OTM. In the case of a Put, the put is OTM if
the index is above the strike price.

61
PARTICIPANTS OF OPTION MARKET

There are four types of participants in Options markets depending on the

position they take:

¾ Buyers of calls
¾ Sellers of calls
¾ Buyers of puts
¾ Seller of puts

People who buy options are called holders and those who sell options are
called writers; furthermore, buyers are said to have long positions, and
sellers are said to have short positions.

Here is an important distinction between buyers and sellers

Call holders and put holders (buyers) are not obliged to buy or sell. They
have the choice to exercise their rights if they choose.

Call writers and put writers (sellers) however are obliged to buy or sell. This
means that a seller may be required to make good on their promise to buy
or sell.

The European option can be exercised only on the maturity date, while
American option can be exercised before or on the maturity date.

In most exchanges trading starts with European options, as they are easy to
execute and keep track of. This is the case in the BSE and the NSE.

Cash settled options are those where the buyer is paid the difference
between stock price and exercise price (call) or between exercise price and
stock price (put).

Delivery settled options are those where the buyer takes delivery of
undertaking (calls) or offers delivery of undertaking (puts)

62
CALL OPTIONS

The following example would clarify the basics on call options

Example:

An investor buys one European call option on one share of Reliance

Petroleum at a premium of Rs. 2 per share on 31st July. The strike price is
Rs. 60 and the contract matures on 30th September. The “payoffs” for the
investor, on the basis of fluctuating spot prices at any time are shown by
the payoff table. It may be clear from the graph that even in the worst case
scenario; the investor would only lose a maximum of Rs. 2 per share which
he/she had paid for the premium. The upside to it has an unlimited profits
opportunity.

On the other hand the seller of the call option has a payoff chart completely
reverse of the call option buyer. The maximum loss that he can have is
unlimited though a profit of Rs. 2 per share would be made on the premium
payment by the buyer.

Payoff from Call Buying / Long (Rs.)

S XT C PAYOFF NET
PROFIT
57 60 2 0 -2
58 60 2 0 -2
59 60 2 0 -2
60 60 2 0 -2
61 60 2 1 -1
62 60 2 2 0
63 60 2 3 1
64 60 2 4 2
65 60 2 5 3
66 60 2 6 4

A European call option gives the following payoff to the investor: max (S –
XT, 0).
The seller gets a payoff of: max (S – XT, 0) or min (XT – S, 0)

63
S = stock price
XT = exercise price at time “T”
C = European call option premium payoff – Max (S – XT, 0)

Payoof
Payoff fromFrom Call Bying
Call Buying / Long/ Long

6
4
Profit / Loss

2 65
PL
0 63
-2 1 2 3 4 5
61 6 7 8 9 10
57 59
-4
Spot Price

Exercising the call option and what are its implications for the buyer
and the seller?

The call option gives the buyer a right to buy the requisite shares on a
specific date at a specific price. This puts the seller under the obligation to
sell the shares on that specific date and specific price. The call buyer
exercises his option only when he/she feels it is profitable. This process is
called “Exercising the Option”. This leads us to the fact that if the spot price
is lower than the strike price then it might be profitable for the investor to
buy the share in the open market and forgo the premium paid.

The implications for a buyer are that it is his/her decision whether to

exercise the option or not. In case the investor expects prices to rise far
above the strike price in the future then he/she would surely be interested
in buying call options.

On the other hand, if the seller feels that his shares are not giving the
desired returns and they are not going to perform any better in the future, a

64
premium can be charged and returns from selling the call option can be
used to make up for the underlying asset.

In the real world, most of the deals are closed with another counter or
reverse deal. There is no requirement to exchange the underlying assets
then as investor gets out of the contract just before its expiry.

65
PUT OPTIONS:

The European Put option is the reverse of the call option deal. Here, there is
a contract to sell a particular number of underlying assets on a particular
date at a specific price. An example would help understand the situation a
little better

Example:

An investor buys one European Put option on one share of Reliance

Petroleum at a premium of Rs. 2 per share on 31st July. The strike price is
Rs. 60 and the contract matures on 30th September. The payoff table shows
the fluctuations of net profit with a change in the spot price.

Payoff from Put buying/Long (Rs.)

S XT P PAYOFF NET
PROFIT
55 60 2 5 3
56 60 2 4 2
57 60 2 3 1
58 60 2 2 0
59 60 2 1 -1
60 60 2 0 -2
61 60 2 0 -2
62 60 2 0 -2
63 60 2 0 -2
64 60 2 0 -2

The payoff for the put buyer is max (XT – S, 0)

The payoff for a put writer is max (XT – S, 0) or minus (S – XT, 0)

66
These are the two basic options that from the whole gamut of transactions
in the options trading. These in combination with the other derivatives
create a whole world of instruments to choose from depending on the kind
of requirement and the kind of market expectations.

Exotic Options are often mistaken to be another kind of option. They are
nothing but non-standard derivatives and are not a third type of option.

67
MARKET PLAYERS

¾ HEDGERS

The objective of these kinds of traders is to reduce the risk. They are not in
the derivatives market to make profits. They are in it to safeguard their
existing positions. Apart from equity markets, hedging is common in the
foreign exchange markets where fluctuations in the exchange rate have to
be taken care of in the foreign currency transactions or could be in the
commodities market where spiraling oil prices have to be tamed using the
security in derivative instruments.

¾ SPECULATORS

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

¾ ARBITRAGEURS

Risk less profit making is the prime goal of Arbitrageurs. Buying in one
market and selling in another, buying two products in the same, market are
common. They could be making money even without putting their own
money in and such opportunities come up in the market but last for very
short time frames. This is because as soon as the situation arises
arbitrageurs take advantage and demand-supply forces drive the markets
back to normal.

OPTIONS UNDERLYING

• Stocks
• Foreign currencies
• Stock indices
• Commodities
• And other Futures options

Are options on the futures contracts or underlying assets are futures

contracts. The futures contract generally matures shortly after the options
expiration

68
OPTIONS PRICING

Prices of options are commonly depending upon six factors. Unlike futures
which derives there prices primarily from prices of the underlying. Option’s
prices are far more complex. The table below helps understand the affect of
each of these factors and gives a broad picture of option pricing keeping all
other factors constant. The table presents the case of European as well as
American Options.

EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION

PRICES

EUROPEAN OPTIONS AMERICAN OPTIONS

Buying Buying
PARAMETERS CALL PUT CALL PUT

Spot prices(S)

Strike price
(XT)
Time to ? ?
expiration (T)
Volatility

Risk Free
Interest Rates
(r)
Dividends (D)

69
Spot prices

In case of a call option the payoff for the buyer is max (S – XT, 0) therefore ,
more the spot price more is the payoff and it is favorable for the buyer. It is
the other way round for the seller, more the spot price higher is the chance
of his going into a loss.

In case of a put option, the payoff for the buyer is max (XT – S, 0) therefore,
more the spot price more are the chances of going into a loss. It is the
reverse for Put Writing.

Strike price

In case of a call option the payoff for the buyer is shown above. As per this
relationship a higher strike price would reduce the profits for the holder of
the call option.

Time to Expiration :

More the time to expiration more favorable is the option. This can only exist
in case of American option as in case of European options the options
contract matures only on the date of maturity.

Volatility:

More the volatility, higher is the probability of the option generating higher
returns to the buyer. The downside in both the cases of call and put is fixed
but the gains can be unlimited. If the price falls heavily in case of a call
buyer then the maximum that he loses is the premium paid falls heavily in
case of a call buyer then the maximum that he loses is the premium paid
and nothing more than that. More so he/she can buy the same shares from
the spot market at a lower price. Similar is the case of the put option buyer.

Risk free rate of interest:

In reality the r and the stock market are inversely related. But theoretically
speaking, when all other variables are fixed and interest rate increases this
leads to a double effect: Increase in expected growth rate of stock prices
discounting factor increases making the price fall.

In case of the put option both these factors increase and lead to a decline in
the put value. A higher expected growth leads to a higher price taking the

70
buyer to the position of loss in the payoff chart. The discounting factor
increases and the future value become lesser.

In case of a call option these effects work in the opposite direction. The first
effect is positive as at a higher value in the future the call option would be
exercised and would give a profit. The second effect is negative as is that of
discounting. The first effect is far more dominant than the second one, and
the overall effect is favorable on the call option.

Dividends:

When dividends are announced then the stock prices on ex-dividend are
reduced. This is favorable for the put option and unfavorable for the call
option.

71
Bull spreads

Simple option positions carry unlimited profits, limited losses for buyers
and limited profits, unlimited losses for sellers (writers). Spreads create a
limited profit, limited loss profile for users. By limiting losses, you are
limiting your risks and by limiting profits you are reducing your costs.

Those spreads which will generate gains in a bullish market are bull
spreads.

How is a bull spread created?

one can create a bull spread by using two calls or two puts. If you are using
calls, you should buy a call with a lower strike price and sell another call
with a higher strike price.

Example:

CALL STRIKE PRICE PREMIUM PAY/RECEIVE

Satyam May buy 260 24 Pay

Satyam May sell 300 5 Receive

Net 19 pay

When should one enter into a bull spread like above?

If you are bullish on Satyam which is quoted around Rs. 260. you believe it
will rise during the month of may. However, you do not foresee Satyam
rising beyond in that period.

If you simply buy a call with a strike price of Rs. 260, the premium of Rs. 24
that you are paying is for unlimited gains which include the possibility of
Satyam moving beyond Rs. 300 also. However, if you believe that Satyam
will not move beyond Rs. 300, why should you pay a premium for this
upward move?

You might therefore decide to sell a call with a strike price of Rs. 300. by
selling this call, you earn a premium of Rs. 5. You are sacrificing any gains

72
beyond Rs. 300. the gain on the strike call which you bought will be offset
by the loss on the 300 strike call which you are now selling.

Thus, above Rs. 300 you will not gain anything.

What will the payoff?

The maximum loss is Rs. 19 i.e. the net premium you paid while entering
into the bull spread. Your maximum receivable from the position on a gross
basis is Rs. 40 i.e. the difference between the two strike prices. Thus, your
maximum net profit is Rs. 21 (Rs. 40 minus Rs. 19).

Various closing prices (on the expiry day) will result in various payoffs
shown in the following table :

Closing price Profit on 260 Profit on 300 Premium Net profit

strike call strike call paid on day
(gross) (gross) one

250 0 0 19 -19
255 0 0 19 -19
260 0 0 19 -19
270 10 0 19 -9
279 19 0 19 0
290 30 0 19 11
300 40 0 19 21
310 50 -10 19 21

The above table shows that maximum loss will be of Rs. 19 if Satyam closes
at Rs. 260 or below (i.e. the lower strike price) and the maximum profit of
Rs. 21 will arise if Satyam closes at Rs. 300 or above (i.e. the higher strike
price).

HOW MANY BULL SPREADS CAN BE CREATED ON ONE SCRIP?

There are a minimum of 5 strike prices available. On volatile scrip, the

number of strike prices is around 7 on an average. There are 7 calls and 7
puts on each scrip. You can create several spreads. On calls alone, you
combine strike 1 with strike 2, strike 1 with strike 3 and so on.

73
The number of spreads on calls will be 21 and a similar number on puts.
Thus, there are 42 spreads on one scrip in one month series alone.

How does a Bull Spread work in a Put option?

Interestingly, the bull spread logic remains the same. You buy a put option
with a lower strike price and sell another one with a higher strike price. In
this case however, the Put option with the lower strike price will carry a
higher premium than that with the higher strike price.

Example:

If you buy a Reliance put option strike 280 for Rs. 24 and sell another
Reliance put option strike Rs. 320 for Rs. 47, this would be a bull spread
using puts.

On day one you will receive Rs. 23 (Rs. 47 minus Rs. 24). Your maximum
profit is this amount Rs. 23 which will be realized if Reliance closes above
Rs. 320 (your higher strike price). Your maximum loss will be Rs. 17 and
will arise if Reliance closes below Rs. 40 on closing out of the position. The
payout of Rs. 40 minus the option premium earned of Rs. 23 will result in a
loss of Rs. 17.

Various closing prices will result in various payoffs shown in the following
table:

74
Closing price Profit on 280 Profit on 320 Premium Net profit
strike Put strike Put received on
(gross) (gross) day one

250 30 -70 23 -17

270 10 -50 23 -17
280 0 -40 23 -17
297 0 -23 23 0
320 0 0 23 23
330 0 0 23 23
340 0 0 23 23
350 0 0 23 23

75
BEAR SPREAD:

In a bear spread, the profits and losses are both limited.

Strategy view: investor thinks that the market will not rise, but wants to cap
the risk. Conservative strategy for one who thinks that the market is more
likely to fall than rise

How to use a bear spread?

In a bear spread, you buy a call with a high strike price and sell a call with
a lower strike price. For example, you could buy a Satyam 300 call at say Rs
5 and sell a Satyam 260 call at Rs. 26. You will receive a premium of Rs. 26
and pay a premium of Rs. 5, thus earning a Net Premium of Rs. 21.

If Satyam falls to Rs. 260 or lower, you will keep the entire premium of Rs.
21. On the other hand if Satyam rises to Rs. 300 (or above) you will have to
pay Rs. 40. After set off of the income of Rs. 21, your maximum loss will be
Rs. 19.

Satyam Profit on 260 Profit on 300 Premium Net profit

closing price strike call strike call received on
(gross) (gross) day one

250 0 0 21 21
255 0 0 21 21
260 0 0 21 21
270 -10 0 21 11
281 -21 0 21 0
290 -30 0 21 -9
300 -40 0 21 -19
310 -50 10 21 -19

76
FUTURES

• The first derivative product introduced in the Indian securities market

was Index Futures.
• In the world, first index futures was traded in U.S. on Kansas city
board of trade (KCBT) on value arithmetic index (VLAI) in1982

What are index futures?

• Index futures are the future contracts for which underlying is the
cash market index,
• For example : BSE may launch a future contract on “BSE sensitive
index” and NSE may launch a future contract on “S&P CNX NIFTY”

Product specifications BSE_30 Sensex futures

• Contract size Rs. 50 times the index

• Tick size 0.1 points or Rs. 5
• Expiry day-last Thursday of the month
• Settlement basis – cash settled
• Contract cycle – 3 months
• Active contracts – 3 nearest months

Product specification S&P CNX Nifty futures

• Contract size – Rs. 200 times the index

• Tick size – 0.05 points or Rs. 10
• Expiry day – last Thursday of the month
• Settlement basis – cash settled
• Contract cycle – 3 months
• Active contracts – 3 nearest months

77
Frequently used items in index futures market

• Contract size – the value of the contract at a specific level of index.

It is index level * multiplier
• Multiplier – it is a pre-determined value, used to arrive at the
contract size.
It is the price per index point
• Tick size – it is the minimum price difference between two quotes
of
similar nature.
• Contract month – the month in which the contract will expire.
• Expiry day – the last day on which the contract is available for
trading.
• Open interest – total outstanding long or short positions in the
market at any specific point in time. As total long
positions
for market would be equal to total short positions,
for calculation of open interest, only one side of the
contracts is counted.

• Volume - no. of contracts traded during a specific period of time.

• During a day, during a week or during a month.
• Long position – outstanding/unsettled purchase position at any point
of time
• Short position – outstanding/unsettled sales position at any point of
time.
• Open position – outstanding/unsettled long or short position at any
point of time.
• Physical delivery-open position at the expiry of the contract is
settled through delivery of the underlying.
In futures market, delivery is low.
• Cash settlement-open position at the expiry of the contract
is settled in cash. These contracts are designated
as cash settled contracts. Index futures fall in
this category
• Alternative delivery procedure (ADP)-open position at the
expiry of the contract is settled by
two parties – one buyer and one
seller,
at the terms other than defined
by the exchange. World wide a
significant

78
 portion of the energy and energy
related contracts (crude oil,
heating
and gasoline oil) are settled
through
Alternative Delivery Procedure.

ANALYSIS ON BIGGEST EVER CRASH IN THE INDIAN STOCK MARKET

Tumbling emerging markets? Whatever be the reason for the huge drop in the
Sensex, the confidence of the average retail investor in the bourses has taken a
strong beating.

79
ON May 18, the Sensex, which had been on a record upswing, even crossing 12600 points
on May 10, registered a fall of 826 points to close at 11,391. Such was the fall that on June
9, despite a gain of 514.65 points, the Sensex closed at 9810.46 points.

Investors who had shifted from equity shares to commodities in order to neutralise the risk
factor have also lost heavily as global commodity prices too have plunged sharply.

The plummeting share market was followed by a wave of panic selling, most of it on loss.
The brokers, who had hoped to book profits in the short-term, began exiting the markets in
a hurry.

But, while more seasoned brokers and long-term players might just manage to recoup their
losses, it is the average retail investor, one of the over two lakh across India, who has been
hit the hardest.

Forced by the rising cost of living and falling interest rates in fixed deposit schemes of
banks and post offices, the common man suddenly seemed interested in stocks and mutual
funds. Applications for opening of demat accounts reached new heights. But now after the
May 18 debacle and the decline thereafter, the common man is no longer much interested
in the markets.

Incidentally, such was the panic in the wake of the recent crash that police was deployed at
many places, including the Kankaria Lake in Ahmedabad, to prevent investors and loss-
stricken broken from taking the suicide route. In Mumbai, a desolate businessman, who
had lost over Rs 50 crores in the market crash, tried to end his life by consuming poison.

Worried, the Union Finance Ministry stepped in and asked the government-backed mutual
funds to pump in money to sustain the markets and ensure that there was no liquidity
crisis.

But, the mutual funds too have come unstuck when it mattered the most. Most of the
mutual fund managers, including those which had a track record of 20-30 per cent
annualized return on net asset value (NAV), have started showing signs of anxiety. Faced
with an unusually large number of requests for redemption in the initial days of the market
crash, the funds also pushed the sell button to meet cash requirements.

While opinions differ on what really triggered the collapse, there seems to be unanimity that
the three major reasons were:

80
 ¾ Correction by the markets,
¾ Pulling out by the foreign institutional investors (FIIs) and
¾ The general meltdown in the international markets, though strictly not in this order.

Just consider the facts:

the Sensex had taken 48 trading sessions to jump from 9,000 to 10,000 points, 29 trading
sessions to take it from 10,000 to 11,000 points. The next 1,000-point mark took even
lesser time to achieve. It took all of just 15 trading sessions for the Sensex to touch 12,000
points from 11,000.

SENSEX – TEN BIG FALLS:

DATE FALL
May 18, 2006 826 points
April 28, 1992 570 points
May 17, 2004 565 points
May 15, 2006 463 points
April 4, 2000 361 points
May 12, 1992 334 points
May 14, 2004 330 points
May 6, 1992 327 points
April 12, 2006 306 points
March 31, 1997 303 points

81
On 24th May, the Finance Minister issued a statement in Rajya Sabha on ''Recent
Developments in the Stock Market'' where he sought to downplay the market crash and
reiterated that the rise in the interest rate in the US due to inflationary expectations and a
global fall in metal and other commodity prices were the prime reasons for the market
meltdown.

These factors have no doubt contributed to the crash. It is also true that stock markets
globally have witnessed downturns over the past one week. However, the market crash in
India stands out both in its magnitude as well as its specific underlying causes

Data from the SEBI show that FIIs' net investment stood at - 2200.30 crores rupees for the
entire month of May till 23rd May 2006. FII net investment on 22nd May, i.e. the day of the
crash was - 1361 crores rupees. It is clear from the data that heavy selling by the FIIs
caused the market meltdown. This is further corroborated by the fact that the exchange
rate has declined continuously in the month of May in keeping with the withdrawal of
funds by the FIIs. The rupee which stood at Rs 44.90 against a dollar on 2nd May 2006
slided to Rs 45.73 by 24thMay 2006, indicating the capital flight

82
Movements in Sensex and cumulative FII investment ($mn)

The FIIs are worried about the following macro factors in the Indian Economy:

India's Current Account Deficit (Balance of Payments on trade account) is at US $ 13.2

Billion, which is around 3.5 % of its GDP. This fact is public since March'06. The other
BRIC economies have Current Account (BoP) surpluses. That this level of BoP also they feel
that India attracts too little FDI.

FDI into China in calendar 2005 was US $ 53.0 Billion. Brazil and Russia had an FDI of US
$ 15.0 Billion each in 2005. India only attracted US $ 6.5 Billion during the same period.
Again this information is public since Jan'06. The US $ will strengthen further as compared
to the currencies in BRIC economies.

Inflation will hit the Indian economy hard as the prices of gasoline and diesel will be raised
further. They also feel that there is an imbalance in the Indian Banking Sector.

83
American markets fell, followed by crash in the emerging markets. The fall was further
compounded by global meltdown of prices of base metal prices

Aluminum, Copper and Zinc. Gold also corrected sharply from a high of US $ 726 pto at
LME on 12th May’06 to US $ 619.00 as on today at LME. FIIs pulled out about US $ 1.6
billion in May’06 from the Indian Equity Markets as compared to US $ 10.0 billion from the
emerging markets.

FIIs have pumped in US $ 4.0 billion into Indian Equities from Jan to April’06

84
The analysts have given the following reasons for the correction in global equity markets
including India, which was more severely hit:

¾ Global fall in emerging markets lead by fall in DJIA and NASDAQ.

¾ Global crash in prices of base metals – Aluminum, Copper and Zinc. There are views
that Copper prices can fall further by 20 %. Gold will be stable.

¾ Hike of interest rates in USA.

¾ Slowing down of the American Economy, this could lead to recession in 2007.

¾ The change of monetary policies in Japan. The Bank of Japan may hike interest
rates from the current ‘zero level’ regime in Japan.

¾ A stronger American Dollar vis a vis currencies of emerging economies including

BRIC.

¾ On account of all these factors equities on global emerging markets got hammered.
The corrections were in the range of 10 to 25 %. Indian Equities were among the
worst hit.

Relative movement of Sensex and NASDAQ

85
Money-making never looked so easy as the Indian stock markets nearly trebled in two
years.

From a low of about 4,500 points on the Bombay Stock Exchange (BSE) index in May 2004,
the markets embarked on an upward spiral and the BSE index was trading at a giddying
12,800 points.

Economic powerhouse

The world began to take notice and even started to believe in the potential of India as an
emerging economic powerhouse of the 21st century.

Indian companies offered good growth potential. Foreign investors alone put in more than a
record $10.5bn last year and mutual funds gave returns of up to 200%.

As more and more money started to come into the stock markets, optimism soon turned
into euphoria.

In the last few months, investors were further lulled into a feeling of a invincibility as the
BSE index started to make gains by about 1,000 points virtually every other week.

And whenever there was a fall in stock prices, it was almost always extremely short lived.
The markets rebounded with added vigor in a matter of a few trading sessions.

86
So when the markets began to crack this may the initial reaction of a majority of investors
was that it was just another of the many "corrections" seen in this otherwise one-way
market.

Only this time the "corrections" continued to deepen. By Monday - when the markets
crashed by over 1,100 points leading to a temporary suspension of trading - there was
blood on the street.

The scenario was even messier in several individual stocks, which lost nearly half of their
value.

But it was a complete massacre for those market speculators and traders who use the
forward and options system in the Indian bourses to bolster their positions by speculating
which way the market would move.

There was such panic in the markets that the Indian Finance Minister, P Chidambaram,
was forced to hold an impromptu press briefing.

He talked up the market by saying that investors need not fear a meltdown in stock prices,
as the long term Indian economic and growth story remained unchanged and looked solid.

The Central Bank stepped in to allay fears of a liquidity crunch, and the market regulator
the Securities and Exchange Board of India (SEBI) - made soothing noises, pointing out
that all systems were in place and that the stock exchanges were in perfect shape to deal
with any situation.

The end result is that the market is showing signs of limping back to some kind of a
recovery.

'More volatility'

However, the events of May have left the Indian investor much poorer, with confidence at a
new low.

It is important to understand the reasons behind the crash and find an answer to the
problems confronting Indian investors what happened in India was due to a combination of
domestic developments and events on world markets.

Emerging markets across the world cracked and so

did India. There are concerns about oil prices, dollar
stability and valuation, fears of an interest rate hike
and the US economy slowing down.

Stability has come in to the markets now although a

little more volatility cannot be ruled out.

A sense of stability has now returned, and in the long

term, the Indian markets still look healthy. Bombay traders have had an up and down time
this year

87
For a long term investor who is prepared to wait between three and five years, investment
in equity remains a safe bet for a steady income.

But is still seems as though the party is over - at least in the short term - for those who
invested in the Indian markets hoping to make big sums overnight.

But, experts are still optimistic that the honeymoon between the FIIs and the Indian
markets is still not over.

Most watchers of India's economic revival remain bullish on its long-term prospects. The
recent setback in the Sensex does not negate the fact that, since the government instituted
its market reforms in 1991, the stock market has steadily multiplied in value, similar to
that other remarkable Asian growth story: China.

88
89
90
91
92
93
94